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posted on 14 December 2017

Important Changes Are Occurring In The Investment World: Which Ones Really Matter?

by Elliott Morss, Morss Global Finance


I recently wrote a piece on what can be expected from blockchains and crypto-currencies. But there are other important changes taking place in the global investment industry. And some of these are just summarized in a series of articles from McKinsey & Company. In what follows, I comment on a number of the changes discussed in the McKinsey pieces.

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North America remains the world's largest asset management market by far, accounting for about half of total assets under management (AUM) but from 2012 to 2016 the region accounted for only about 20 percent of flows. And in 2016, North America was the only major global region where flows turned negative, with outflows of $161 billion despite rising markets. Low returns, lower flows, pricing pressure, performance challenges, a massive shift to passive, stubbornly increasing costs, and margin compression are all leading to a distinctly gloomy mood among the industry's ranks.

It is very hard to feel sorry for the global asset managers. According to Pensions & Investments, the 500 largest managers are earning fees to manage $40 trillion in assets.

The Swing to Passive

Buffett said to invest in low-cost index funds and apparently a lot of people listened.


Much attention has been focused on the massive flows into passive investments [mostly ETFs] in North American asset management. Market share of passive has indeed grown materially, from 12 percent in 2010 to 18 percent in 2016. Yet, interestingly, passive's share of the industry revenues has remained a constant 3 percent, as its growth has been accompanied by (and arguably driven by) aggressive price competition.

US Data

The Federal Reserve's flow of funds data are presented in Table 1. The growth of ETFs is apparent. However, even with their rapid growth, they constitute a small share of total equity holdings. It is worth noting that "pension entitlements" were almost $23 trillion at the end of September and a significant portion of ETFs and mutual funds were purchased for investors via pensions.

Table 1. - Equity Holdings by Type (bil. US$)

Source: Federal Reserve

Passive versus Active Management in Emerging Markets

In an earlier piece, I argued that you should have Chinese equities in your portfolio. I went further:

I am not alone in believing that picking stocks in the US is close to being a random bet because new information is almost instantly reflected in stock prices. And studies have shown that the majority of mutual fund managers underperform their market indices. However, Chinese equity markets are not perfect. And as Chinese policies change, a plausible argument can be made that you should invest in a fund with a "seasoned" Chinese investor in control.

Others agree. For example, Glen Finegan, the head of global emerging market equities at Janus Henderson recently wrote a piece titled "The Dangers of Benchmark Investing in Global Market Equities." In light of this, the results in Table 2 are surprising. It includes the best performing (3-year returns) mutual funds (initial investment $25,000 or less) and ETFs. One would have thought that active managers with an average of 7 years investing in Chinese equities could pick up on market imperfections and outperform the indices. But that does not appear to be the case. In fact, the average ETF return (13%) slightly exceeded the mutual fund return (12%). And that was with mutual funds that had on average managers with 7 years of experience.

As one might expect, McKinsey data for the US shows indices outperforming active investors as well. McKinsey:

2016 was challenging for traditional active investing, much worse than 2015, which itself was no banner year. The pain was felt across almost every major active equity strategy. The number of large-growth funds outperforming passives fell from 49 percent in 2015 to 30 percent in 2016, the number of medium-size value funds outperforming dropped from 54 to 20 percent.

I am not sure what to make of these findings. Going forward, I will carefully compare the performance of ETFs and mutual funds before investing in emerging market countries.

Table 2. - Chinese Equities: Mutual Funds and ETFs Compared

Sources: Morningstar, Yahoo Finance

How Will ETFs Evolve?

Buffet's recommendation, the low fees and ease of trading ETFs will result in continued rapid growth for them.


ETFs are increasing the size of the asset management market. The ETF market has also been evolving with respect to what it delivers to investors. To be sure, most ETF demand continues to be in "bulk beta," the cheapest, most basic portfolio building blocks that track mainstream market-capitalization-weighted indices. But, concurrently, investors are proving receptive to innovations that come at slightly higher cost. Two categories in particular, active ETFs and smart beta have been growing faster than bulk beta (though off a low base). Active ETFs and smart beta experienced compound annual AUM growth of 41 percent and 30 percent, respectively, from 2012 to 2016. Bulk beta, in contrast, grew at 17 percent over the same period. Given the robust demand across almost every part of the ETF market, we expect the industry to continue its double-digit growth over the next several years, possibly becoming a $6.0 trillion market by 2021 (from $2.9 trillion in 2016).

Certainly, considerable innovation among ETFs will continue to occur. Already we see "active" ETFs being created. Already, reports there are 202 actively traded ETFs in the U.S. markets, with total assets under management of $45 billion. Of that number, only 68 were focused on equities with only one focused on emerging markets (First Trust RiverFront Dynamic Emerging Markets (RFEM) and none on Chinese equities.

BS Terms

Richard Quandt has written a great article about wine descriptors titled "On Wine Bullshit: Some New Software." I followed that with a piece noting that marketing efforts for wine and investments are quite similar in that they both use terms meaning little. And we still hear about the Callan charts purporting to show how different investment categories perform well in different years. The following from McKinsey falls into this vein,


Meanwhile, multi-asset strategies and alternatives have both grown in parallel,

By reframing the portfolio construction process with respect to different types of risk exposures (for example, corporate, interest rates, or inflation) instead of types of asset classes, new approaches are blurring the boundaries between asset classes, creating competition across previously distinct categories (for instance, private equity in the place of some public equities).

Factor investing seeks to go beyond broad market-capitalization-weighted indices to identify a more granular set of performance drivers, such as macroeconomic growth, currency fluctuations, or momentum. Factors are the cornerstone of a passive investment strategy - so-called smart beta - that has been rapidly gaining traction with investors by providing a finely calibrated set of portfolio building blocks. Interestingly, factor-based investing challenges both active management (because a good portion of "alpha" is attributable to exposure to these factors rather security selection) as well as passive management (because classic passive management ignores these factors). As they gain acceptance, asset classes will become increasingly fungible; meanwhile the line between active and passive investing will become increasingly blurred as smart beta utilizes both active and passive methods. The net result will be an increased level of competition not just within individual asset classes, but also across them.

I am really not sure what McKinsey is talking about here. "Factor-based investing," "fungible", granular performance drivers?"

Alternative Investments

McKinsey goes on to make two important points about the growing importance of alternative investments - venture capital, private equity, hedge funds, real estate investment trusts, commodities as well as real assets such as precious metals, rare coins, wine, and art.


Alternative investments, driven by client needs and a challenging external environment. By and large our expectations have played out correctly, with alternatives becoming a $7.5 trillion industry, accounting for approximately $2.3 trillion of new money entering the industry over the past five years. This "liquidity transformation" in favor of private markets is a logical response to performance. Since the global financial crisis, the hedge fund industry has suffered from structural challenges in the form of low rates and seemingly unidirectional markets.

McKinsey notes the decline in hedge funds:

In every year since 2009, a diversified portfolio of hedge funds has underperformed a standard 65 percent equities/35 percent fixed-income portfolio. The converse has been true of the private markets, with private equity outperforming the 65/35 portfolio over that same period. The hedge fund industry is therefore facing existential questions. For the first time since the financial crisis, the hedge fund industry shrank in absolute terms, with outflows of $70 billion and an uptick in fund closures.

Private Equity as an Alternative to Stock Markets

There has been considerable talk about all the companies that are being taken private. This appears to be true of the New York Stock Exchange but not Nasdaq.

Table 3. - US Stock Market Changes

Source: World Federation of Exchanges


...the outperformance in the private markets is hardly a secret and new money is rushing in. Private equity firms hauled in $626 billion globally in 2016, revisiting the highs set before the financial crisis. And several large investors have signaled the importance of their private-market programs and upped their allocations. The surge in private-market demand is raising some concerns regarding future returns and the potential for a bubble. Some market observers point to high valuations, intense competition from strategic investors, and high levels of undeployed capital as red flags.

Until now, funds for private equity have come primarily from institutions and wealthy individuals. In the near future, we might see private equity firms starting to raise money from individual equity investors.


New technologies are opening up new opportunities for investments. Some will work and some will not. But for the most part, private investors should benefit as investment costs fall.

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