Building Blocks & Multi Asset Gridlock
The days of traditional actively managed ‘building block’ products are quickly waning. Products offering large-part market exposure and an often (very) small-part market outperformance for a very hefty fee are a remnant of a previous era. These funds are in the midst of a perfect storm. A highly disruptive product innovation cycle has combined with a regulatory driven narrowing of economic incentives to distributors to sell them. As asset growth stagnates and investors’ focus continues to shift to other products, active managers risk missing a key component of their AuM, stable revenues and opportunities for growth.
Multi-asset funds have huge potential to fill the gap – but not without limit or conflict. While fund investors are increasingly handing over responsibility for asset allocation decision making to external managers, they are risking their own livelihoods. Most intermediaries are paid by their clients primarily for doing asset allocation and picking managers to fill specialist roles within it – this changes with the rise of pre-fabricated multi-asset solutions.
Best in Class Building Blocks
Before multi-asset investing took center stage post-2009, investment managers were focused on creating specialized building block funds to meet the demands of asset allocating clients. The idea of an intermediary handing over the asset allocation reins to an external manager was out of the question. “You build the blocks, we choose and assemble the blocks,” was the operating mantra. But following a nearly universally disastrous experience in 2008, a few, then quite nascent, flexible asset allocating funds rose to the top of performance charts. Professional investors took note as clients demanded a solution. Increasing recognition that a handful of multi-asset and alternative strategies were some of the only things that worked during the extended period of market turmoil was the catalyst for what is now a pronounced and lasting shift in the market. Professional investors are buying allocating to these products, willing to listen to ideas and/or trying to figure out how to compete directly.
With their focus on getting on centralized ‘buy lists’ with building block funds and inclusion in discretionary portfolios, ‘strategic partnerships’ proved to be a huge success for managers and distributors alike. In the mid 2000’s, these were ‘green field projects’. But now, strategic partnerships and recommendation lists for major intermediaries have all but been determined – the rate of change has slowed considerably. Even before the shift away from building block core funds, changes to recommendations in well-established asset classes and categories occurred on the edges. This is a recycling as opposed to new money story. It is primarily when a major competitor fails to meet the expectations of investors that money is set into motion. Investors’ interest has been drawn elsewhere.
2009 marks a serious shift in product utilization by investors and development by investment management companies. It became a complete about-face since for more than a decade development of building blocks, often managed by a single star manager, was the only game in town.
Throughout the early 2000’s, open architecture environments were adopted. Global Financial Institutions (GFI’s), primarily consisting of banks, drove forward the scaled development of a best-in-class, open architecture approach to using investment managers. This approach, in variety of formats, was mirrored elsewhere – in some instances fully open environments, guided in others. In all, it was a boon to the global investment management industry. In many ways, it enabled the international growth a number of U.S. managers whose businesses surged.
Block Modus Operandi
Central to the mechanics of engagement, intermediaries matched the risk profiles and appetites of their investing clients with proprietary asset allocation models guided by a strategic ‘houseview.’ In turn, specialist building block products of investment managers were researched and then selected to fill the asset allocation models implemented by advisers. A sea change at the time, this opened the door to distribution channels within GFI’s previously inaccessible to managers.
In summary, open architecture access offered:
diversification of exposure to and reliance away from in-house investment managers,
access to best in class products, identified through an institutionally derived selection process,
benefits of co-branding with known global players including sizable marketing/educational budgets,
very favorable economics derived from the distribution of funds.
Under the building blocks model, relationships between participants along the value chain are clear: managers construct specialist building blocks while intermediaries assemble them through an asset allocation model. The links of the chain between managers and intermediaries are strengthened by fee sharing arrangements derived from product generated revenue. There is a linear and defined role for each player.
Six things are abundantly clear about the building block model:
Building block specialist funds are limited in capacity. Getting them to the scale necessary to propel the growth of a large firm is fraught with challenges and creates a range of difficult to manage risks once so-called blockbusters are created.
For intermediated and direct investors alike, asset allocation weakness becomes apparent during crises. Owning a bunch of different building blocks does not equate to diversity.
Select investment management companies credibly do more than building block funds. Their firm-wide capital market knowledge, research budgets and investment capabilities can be harnessed through flexible, multi-asset strategies. Market tested performance has evidenced the legitimacy of these efforts.
Relationships between manufacturers and distributors that formerly entailed pure cooperation and mutual benefit are quickly evolving as former rationale for alliances is dissolving. Commercial terms driven by regulatory changes are a key catalyst – incentives drive activity.
ETF’s and passive strategies are eating the lunch of lumbering, middle of the road funds that have largely provided market access for fees that are too high. Market access is cheap and getting cheaper. Structured beta funds are further taking assets from these ‘not active enough’ building block funds.
Digital technology has enabled a newly devised means of engaging investors directly. New entrants are joining the competitive environment often without respect for formerly defined and near-universally accepted rules of engagement. Both wealth and investment managers are under threat of a common competitor.
As evidenced by both recent flow trends and the eager onslaught of anticipatory product launches, professional investors’ focus is shifting from narrowly defined building blocks to products with broader and more flexible profiles. Interest in building blocks, primarily as a function of commercial incentives and availability of cheap beta, is waning. Investors are seeking more from investment managers. Multi-asset strategies as a whole are the beneficiary of this shift in demand. Professional investors have come to recognize and accept the potential benefits of products that actively manage not only within but also across defined asset classes. Much still needs to be done to define the respective roles of managers and intermediaries in light of evolving regulatory, commercial and investment frameworks.
Shift of Power
Asset allocation is a powerful tool – it drives both investment results and commercial terms. Historically, the asset allocation process is the mechanism for intermediaries to maintain direct involvement with clients, ensure an arms-length control of investment manager partners and legitimize value for fees rendered. As responsibility for asset allocation decision-making shifts (at least in part) from intermediaries to managers, clear business challenges are emerging.
Intermediaries have been significant buyers of the multi-asset funds but to what end? While fund investors have increasingly handed over responsibility of the asset allocation decision-making to external managers, such actions are fraught with business and career risk. If the job of the intermediary has primarily been doing asset allocation and picking managers to fill specialist roles within it, then the intermediary’s function must evolve too.
The central issue that investment and wealth management business leaders must focus on is the extent to which intermediating distributors will continue to ‘outsource’ not only the stock selection (specialization) but also the broader asset allocation decision-making process without fear of being dis-intermediated. Bypassing building block funds in favor of cheaper and more predictable ETF’s has proven to be a viable means for intermediaries to maintain their central asset allocation function and a larger portion of the overall fees paid by clients. Given that costs to implement beta (even if its deemed ‘smart’) are a fraction of the traditional building block funds, a greater portion of the fee is potentially left in the hands of intermediaries. The premium that investors were previously willing to pay for access to market exposure has been compressed with the combination of technological platforms and ETF’s.
The European fund industry is at the very center of this perfect storm given the rapidly emerging commercial terms between intermediaries and managers. No one is going into this new commercial reality voluntarily. Regulators, with the momentum and weight of the public will behind them, are redefining commercial terms. Incentives that have aligned the activities of managers and intermediaries are dissipating around the world albeit at differing speeds (some countries/regions are likely to trail the changes by years) but nonetheless, the trend is moving in a single direction. Fees for investment products are going down and the once comfortable relationship between managers and distributors has been unsettled. Without doubt, there is less commercial incentive today for an intermediary to use outside managers’ products than any time in the past.
Entities that were once aligned for a hand-in-glove partnership now find themselves increasingly at odds and perhaps, ultimately, as competitors. In short, distributors are inclined to be manufacturers themselves; utilizing low cost underlying beta access vehicles to implement as opposed to full fee specialist active funds.
The intermediary role of global financial institutions has been an absolutely crucial route to growth for what are now many of the world’s largest investment managers. Innovation amongst them is needed to keep these relationships engaged and purposeful.
New Terms of Engagement
All the while, there is a genuine need for a continued partnership between large investment managers and broad retail distribution platforms. This working relationship must evolve to recognize the changing trends in the industry. The rise of “fee-based” arrangements between clients and their financial advisers is central to these developments.
This changing relationship reflects a response to shifting regulatory persuasion on the commercial terms between investment managers and those who have, for a sizable share of fees, ‘distributed’ products to their clients. For the last 20+ years, these conditions have defined the nature of the relationship. This mode of commercial engagement along with the investment framework it has engendered no longer fits. However, since this paradigm has guided industry thinking and activities for so long, it has proven to be tremendously resilient.
The Future of Multi-Asset
Multi-asset is the path forward for investment managers seeking the scalability needed to continue growing AuM in a meaningful way and diversifying key risks. Global financial institutions with retail platforms are the ideal counterpart for these capabilities. Their client base is large with definable goals and investor profiles that can be ascribed to a varied range of set target models. These entities continue to seek innovation and a scalable means to match the investment goals of large groups of clients.
Post-RDR and amidst a sea change in the way asset allocation is implemented, a huge opportunity is available to forward-thinking industry participants to create a mutually attractive solutions-delivery framework. The synthesis of asset allocation and implementation, once thought of as purely distinct functions, might create an elegant solution for the contemporary needs of investors and the business and investment markets in which their advisors are operating.
Broadening the inputs into the overall asset allocation decisions made by intermediaries provides a range of benefits and possibilities sought after by end-investors. A proactive approach to cooperative competition on the part of investment managers will be required to make the case tenable.