May 15, 2018

Next Bear Market Could Demolish Active Fund Industry

The next major bear market will demolish the active investment management business by accelerating the speed at which money is already moving to low-fee passive investment managers.

History Will Repeat
Over the past couple decades, repeated market crises have eroded confidence in the ability of active managers to deliver.

During the 2000s bull market, investors lost faith in equity funds - particularly the high-flying technology funds that grew out of the 1990s bull market. The investing tenets of the 1990s failed and investors spent years redeeming their money. That is, until a savior arrived: managed portfolios.

Managed portfolios were sold with the promise of managed risk levels via asset class, geographic, manager and style diversification. The one-trick-ponies of the 1990s were replaced with more holistic products with a broader array of features and benefits, the most important being the ability to theoretically manage and reduce exposure during bear markets.

The mythology of the managed portfolio persisted even among sophisticated advisors until the 2008 global financial crisis. The crisis proved that most investment managers were incapable of correctly anticipating, and positioning a portfolio for, a major bear market. Some argue that nobody could have predicted the financial crisis. However, many investment managers should have seen that the cracks in the foundation of the global economy were widening since the fall of 2007. Of those who did anticipate the problems and wished to reduce risk exposure, many still maintained their bias to benchmark weightings to mitigate the career risk of making a bad bet too far from the herd.

Some investment managers did anticipate the crash, took action and made billions. Yet most investment managers did not, and advisors lost faith in the ability of managed portfolios to deliver downside protection in a bear market. Independent advisors thereafter abandoned these products.

A larger phenomenon also began during the global financial crisis. Given the experiences of the previous two bear markets, many advisors lost faith in active management overall. Consequently, an increasing number of advisors started shifting client assets to passive, cheaper ETFs and index funds. 

Even those who still believed in active management moved assets simply to exploit the timely opportunity to harvest tax losses while retaining market exposure. This caused a spike in ETF and index fund flows despite the worst market since the Great Depression (Figure 1).

The final straw was fees. After the financial crisis it was widely expected that market returns would be lacklustre for years shifting the focus from the uncontrollable (returns) to the controllable (fees). Suddenly, investment managers that dominated the low-cost space - like Vanguard - were pushed to the forefront of the industry, by offering cheap passively-invested funds and ETFs to the masses. A decade later we now know that returns would turn out pretty good. Nevertheless, the focus on fees persists.

Figure 1: Look at the 2008/2009 area of the chart below. You can see that cumulative flows out of active funds (blue) steepened and flows into passive index funds and ETFs accelerated. 
Source: Investment Company Institute, Simfund, Credit Suisse
The Next Crisis
If the 2000s bear market was 'strike one' and the 2008 global financial crisis 'strike two', the next crisis will be 'strike three'. The stage has been set for the next major bear market to decapitate the active investment management business. Considering about 50% of US investment fund flows went to the king of passive investing, Vanguard, in 2017 - a good year for market returns - the flows from active to passive funds during the next bear market could exceed anything witnessed before.

Where does that leave the active investment management industry? With a much smaller share of industry AUM and tightening margins, which will trigger industry consolidation. Furthermore, margin pressure will re-make cost structures within the investment management industry by automating many critical functions. This means that there may be far fewer competitors and fewer jobs within the investment management industry beginning in the next couple years.

If you work for an active investment manager you better prepare.

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