Putnam Lovell recently issued its analysis of trends the global fund management industry, entitled “After the Belle Époque.”  Following a Belle Époque era within the financial services industry, which the authors characterize as “blessed” and exhibiting “stellar performance,” global fund management now faces many challenges. Among them: shifting demographics among retirees, structural changes in the relationship between manufacturers and distributors, more diverse and complex products, and changing fee structures.  Readers interested in the full copy of the Putnam Lovell study can request a copy here.

We reviewed the study with an emphasis on analyzing the impact on financial advisors serving HNW/UHNW clients.  We identified six important themes and asked two leading industry experts for their analysis:

Chip Roame is the founder and CEO of Tiburon Strategic Advisors, a market research and strategic consulting firm based in California.

Geoff Bobroff is the president of Bobroff Consulting with a practice focused on the mutual fund industry.

Both are frequent speakers on topics related to fund management and are often quoted in the media.

(1) Shifting Demographics among Retirees

The Putnam Lovell study contends the following:

Perhaps the most important change, in America and beyond, involves the so-called Generation Y, born after June 1976. In many countries, there will be fewer Generation Y members than baby boomers. Additionally, they will save less. Many demographers agree that Generation Y will tend to prolong its adolescence—partly due to the education debt it will amass, especially in the United States—and therefore be slower to marry, have children and buy homes, all of which are traditional life events that typically precede significant saving for retirement.

The rich—and, to a lesser extent, the mass affluent, with portfolios exceeding US$100,000—are the groups that hold out hope for further expansion of the fund management industry. Wealthy individuals continue to diversify out of illiquid businesses and properties into a broader range of traded securities, boosting the size of their investable portfolios. The number and net worth of dollar millionaires will balloon even faster in emerging economies. Concerned about absolute returns, but in general more risk tolerant, wealthy individuals are more apt to ask for more sophisticated, higher-fee products. Consequently they should exert a greater influence on fund management revenues during the next five years. The mass-retail marketplace for investment services, centered on less profitable and more deposit-oriented products, has been shrinking, and likely will remain static for the near term.

The larger bonanza will involve the estates baby boomers leave their children. Estimates regarding the size of this wealth transfer vary but the minimum is widely considered to be US$20 trillion. Heirs likely will reallocate these assets after transition, creating another opportunity for fund managers to gather new business. The resulting and complicated estate planning and tax questions place significant power in the hands of advisors—fund managers or, more likely, closer family intermediaries such as lawyers, accountants, financial planners, brokers and private bankers. During the next five years, fund managers will need to spend more time learning about gatekeepers to these asset pools, and less time lining up outside large pension and sovereign funds. Getting to know these new clients and intermediaries will consume significant management and servicing time, particularly because many of these customers will reside in foreign countries.

The implication for advisors is a growing opportunity to serve HNW and especially UHNW clients, at the expense of the less wealthy.  How significant – if at all – do you expect this trend to be, and do you agree that advisors should gear their practices toward the estate planning issues of baby boomers?

Bobroff:  The break in the marketplace between the under $1 million client and the over the $1 million client “The real interesting nugget we will see in ten-plus years is a re-birth of the direct market as the Gen X's start saving and inheriting assets start to use the web as the new advisor, tapping into new technology to allow them to be more self reliant.”  -- Bobroffhas been a theme for years. The past few Cap Gemini/Merrill annual surveys of investors with $1 million show this focus. Most brokerage firms and private banks are targeting the same market.  But, according to the Cap Gemini Study, there are only nine million globally and the US has about 30% of that number. Thus everyone is trying to get the three million or so millionaire clients.  For the fund industry and firms like Schwab and Fidelity, it leaves wide open the $100,000 to $1,000,000 client--the vast majority. It is clear that the baby boomers are inclined to delegate functions to financial advisors, and the` real question is how to deliver those functions cost effectively (the internet could aid in this broader delivery).  Advisors are trying to figure out how to deliver advice in a cost effective way.  The real interesting nugget we will see in ten-plus years is a re-birth of the direct market as the Gen X's start saving and inheriting assets start to use the web as the new advisor, tapping into new technology to allow them to be more self reliant.

Roame: We don’t disagree [with the Putnam Lovell thesis]. But ‘advisor’ is a vague term.  The vast majority of advisors don’t serve the UHNW segment, and that is not going to change.  There are roughly 400,000 advisors and an equal number of households with $1+ million in investable assets.  Are we going to see one advisor per household?  This is fantasy land, not reality.  Most advisors are singles and doubles hitters, serving clients up to $500k. “The vast majority of advisors don’t serve the UHNW segment, and that is not going to change.” - Roame

I have two cautions.  First, the industry is growing fastest among independent reps and discount brokerage firms.  These channels service average account sizes of $140k and $90k, respectively.  The brokerage market is growing slower and the bank market is severely lagging with respect to growth.  For these channels, I would not jump on the UHNW bandwagon, because the analytics don’t justify it.  Second, with regard to wealth transfer, I question which wealth transfer presents an imminent opportunity.  The WW2 generation, where the transfer is taking place now, doesn’t have money.  The boomer generation has more money, but they are 30 years from retiring.  These are nice buzz words but, if you think about it, the opportunity is not really there. 

There is a great market opportunity in the $300k account size range, but not with baby boomer estate planning.  The average boomer is 50 years old and is not dying any time soon.

(2)  “Outcome-Oriented” Products geared to the De-accumulation Phase

The Putnam Lovell study contends the following:

For their part, retirees need investment solutions that provide necessary replacement income, generally measured as a fixed amount. As life expectancy lengthens and interest rates remain low, fixed annuities are too expensive to use as staple income solutions. In the UK, there is growing debate over current rules requiring retirees to spend at least 75% of any lump-sum pension payment on an annuity. US fund managers have identified retirement income provision as the single most important product development issue they face, although many first-generation “retirement income” solutions have proven to be little more than variable annuities dolled up in designer dresses.

What types of “outcome-oriented” products do you expect to see from fund companies, especially those that will appeal to the HNW/UHNW clients of advisors?

Bobroff:  Some basic thoughts before attempting to answer your question.  Boomers have changed everything they have touched and we have to assume that they will change how retirement and retirement investing is accomplished. Boomers are under-saved and will probably work longer. In addition we are in a non-financial--hard asset market cycle which should last for several (10+) more years, which will cause traditional markets to underperform other investments.

At the current level of interest rates (10-year yield around 4%) it is hard to see how investors can hope to replace income as they draw down on their savings (retirement and after tax savings). Since the market correction in 2000-2002 many investors, especially retirement investors, have preferred selecting age based fund of funds, abdicating the responsibility to someone else to manage where their assets are invested. In addition, investors do want someone to allocate their assets to achieve a goal.  But it is very difficult to measure how the advisor is doing diversifying the assets. The HNW/UHNW are able to access managers that can achieve returns from various markets--commodities, leveraged approaches and emerging markets.  Hedge funds and private equity funds allow HNW etc. to achieve better returns in an era of lower returns.  The only outcome a HNW investor wants is solid positive investment returns.

Roame: If you talk about outcome oriented products too fast, you get too excited.   The HNW and UHNW segments don’t care about this; they have more than ample resources to fund their retirements.  It’s only the mass affluent that care about retirement planning.  There are 40 million mass affluent households that have some money but don’t know how to invest it to fund their retirement.  The guy with $300k in assets needs to replace his paycheck, and is asking “what annuity, reverse mortgage, or guarantee-type product can achieve that goal?”  This is the Holy Grail.  We are seeing some exciting entrepreneurial ideas around home mortgages. 

This is completely independent of the prior question (dealing with estate planning and the UHNW segment).  Advisors need to focus on one trend or the other.  They are both interesting trends but there is no clear intersection.

(3) The Power of “Professional Buyers” (e.g., TAMPs and wirehouse platforms)

The Putnam Lovell study contends the following:

Consequently, packagers—a term that lumps together distributors and assemblers, such as multi-management firms—increasingly have transformed themselves into professional buyers. Hiring gatekeeper executives from the pension consulting community, these professional buyers select third-party fund managers as subcontractors for their proprietary product or service offerings. These assemblers are less concerned about the investment manager’s brand name, and more about the quantitative and qualitative screens used to vet the advisors. The packager sells its own brand name to the customers.

More powerful professional buyers will transform fund distribution in several ways:

• As they focus on best-of-breed products for each asset class, professional buyers drive a final nail of disintermediation into fund complexes. Individual advisors previously tended to concentrate their selections among a few fund companies they knew well. But professional buyers will maintain deeper research about more vendors, and will pick and choose from a larger menu of unaffiliated managers.

• Centralizing manager selection within a home-office fund selection group, as most distributors and assemblers will do, makes traditional wholesaling methods obsolete. Large sales forces, armed with high-touch wholesalers eager to woo individual advisors or brokers with handholding advice, helped poorly performing complexes retain assets in the US and UK. Professional buyers need no such help; they instead want detailed explanations of investment technique. Branch-level wholesaling that helped shape some of America’s larger fund complexes will no longer prove as effective as strong consultant-relations teams staffed with highly qualified CFAs.
• As professional buyers seek to differentiate themselves from one another, they will rely on more proprietary fund selection techniques and weaken some of the influence of buy-rating providers such as Morningstar and Lipper. (Further moves toward so-called unconstrained strategies, where managers enjoy more tactical latitude in security selection, also will chip away at rigid buy-rating style boxes.) 

• Perhaps most importantly, by centralizing distribution for large organizations with a single decision-making unit, professional buyers can wield their pricing power fully, particularly on platforms where the home office pre-selects investment options for all advisors. Couple this with the subadvisory dynamic many professional buyers will use—keeping any fund packaging efficiencies for themselves—and pricing pressure could rise.

Bobroff:  Gatekeepers have black boxes and quants monitoring (hiring and firing) managers.  The goal is to keep the customer and change managers when they falter.  Thus assets are far more active, moving from one manager to another, since maintaining performance for long periods is very difficult and there are many managers waiting in the wings to replace the current list of managers.

Brokerage and financial advisory firms are in control of client assets and managers are subject to short-term investment performance concerns. Management fees are under pressure which will only continue in a lower return environment. “Management fees are under pressure which will only continue in a lower return environment.” - Bobroff

The larger firms have their quants but many of the smaller firms are relying on Morningstar and others like that to do the screening.  The quant groups have not demonstrated the ability to pick the up and coming managers, but rather select past performers, which is the problem of the “rear view mirror.”

Some of the real challenges facing the fund industry are what will be the form of the post-accumulation product.  But the challenge won’t come home to roost until the retirement dollars start to move post retirement. We must not forget the bulk of the fund industry’s long-term equity and taxable fixed assets are held in retirement accounts and/or after tax savings accounts which may not be in the basic grasp of the broker/financial planner until retirement.

I agree that the advisor and other forms of asset collectors are king. Asset managers may get marginalized unless they have the ability to produce consistent and solid investment performance, which is very difficult.  As advisors build portfolios of investments for clients, the challenge is to make sure they are not in conflict, that they are able to be successful in identifying strong managers for the future, have the willingness to fire underperforming managers, and ultimately bring their pricing down as investors accumulate larger pools of assets. Advisors are in the driver’s seat with respect to money managers in this cycle.

Roame: We wholeheartedly agree [with Putnam Lovell’s thesis].  Professional buyers represent a trend which we refer to as “institutionalization of the market.”  The front-line consumer and advisor will be less of the decision maker.  It will be the wirehouse wrap managers that decide what is on the platform.  Research services, such as Morningstar and Littman Gregory, will decide which products get sold.  This is incredibly important and changes everything.  It adds professionalism “The front-line consumer and advisor will be less of the decision maker.  It will be the wirehouse wrap managers that decide what is on the platform.” - Roameand eliminates the old-line golf buddy salesperson.  We see this as a good thing, because it makes decisions a lot more analytical.  Brand name matters less.  Performance versus peers matters more.  Costs go down.  We know that smarter buyers buy cheaper products.  Index funds, enhanced index funds, ETFs, and low cost active funds will benefit, as do the big players, like Fidelity and T. Rowe Price.  All this is good for investors, because it means consumers pay less for products.
Lastly, this fundamentally changes what a wholesaler looks like.  Fund companies will need analysts to sit with research staff at the likes of Morningstar, Littman Gregory, or the TAMP providers.  This takes a very different type of salesperson, and a lot fewer of them will be needed.

(4)  Performance-based Fees

The Putnam Lovell study contends the following:

Both individual and institutional clients will boost their demand for performance-based fees, forcing asset managers to develop a more complicated chemistry of asset-based and incentive revenue. Blending cyclical and non-cyclical revenue streams to stabilize earnings will prove to be a critical survival skill for fund managers, and further accelerate true convergence strategies.

Do you agree that the mutual fund industry will see a significant trend toward performance-based fees?  Does the primary resistance to performance-based fees come from the fund industry’s need to maintain revenue streams that are non-cyclical?  Would performance-based fees weed out poorly performing funds (make the industry more efficient)?

Bobroff:  There have been many times in the past when pundits suggested more performance-based fees be implemented, but it clearly has not occurred for retail type products like mutual funds.  Over the years only a few fund groups or funds have added performance fees.  In the institutional space performance fees come and go more frequently and thus we might see that.  As pressure has increased in the institutional space for lower fees one way to potentially offset the impact is to lower the base fee and add a performance component. The resistance to performance fees reflects the concern about trying to run a business where revenues are fluctuating more than just the market.  Performance fees could be seen as weeding out underperforming managers but, in the mutual fund space, boards of mutual funds are not inclined to fire the manager.  In the institutional space managers are fired for underperformance, rather than staying with a manager because they are giving something back for weak performance.

Roame: We see this as a significant trend. Performance based fees will “Performance based fees will never be the majority in the industry, but will represent an increasing minority.” - Roamenever be the majority in the industry, but will represent an increasing minority.  We estimate about 3% of funds today are performance-based, and this might go to 20%, but not to 70%.  There are players, such as Dunham & Associates, that offer only performance-based funds.  Their argument that is this is ‘right thing to do’ will resonate with institutional and informed advisors, and brokers that can capitalize on this approach as a selling angle.  It won’t become the majority because public managers will be penalized for unsteady earnings.  Their stock price will be beaten if they rely too heavily on performance-based fees.

(5) The Future for Hedge Funds

The Putnam Lovell study contends the following:

Nevertheless, apparently close parallel performance to key benchmarks has led many institutional investors to question the high fees hedge funds charge. Volatile markets and shrinking liquidity have exposed a growing number of hedge funds as closet beta providers with exorbitant fees. Increased scrutiny, savvier institutional investors, and less liquidity to lubricate returns will tax hedge funds like never before, driving 20% of an estimated 10,000 hedge funds and funds of hedge funds out of business in the next five years.

Will any of this result in greater usage of hedge funds by advisors?

Bobroff:  While many managers may exit the business or at least liquidate the current underperforming fund another fund will be established. If traditional market returns are weak in a non-financial asset market then hedge fund managers will have more opportunity to be successful.

Roame:  We buy all three major hedge fund databases, and they don’t match each other.  The data is terrible; there is no reliable measurement of industry returns and this misleads the whole market.  In addition to bad data, advisors are handcuffed by an inability to access good funds.  And there are tons of blowups.  The average hedge fund that advisors can access might not be that good, even if the strategy they are pursuing is currently working well.  The intellectual, thoughtful, asset allocation-oriented advisors will hold out for a while on hedge funds.  The more sales-oriented types may jump in with both feet. 

The hedge fund industry will get more professional, “The intellectual, thoughtful, asset allocation-oriented advisors will hold out for a while on hedge funds.  The more sales-oriented types may jump in with both feet.” - Roameand this will be driven by the use of hedge funds by pension plans.  Pension funds, governed by ERISA, will force higher standards for data.  It is also good that Morningstar has jumped in to the hedge fund data business.  We have high expectations, over the next three to four years, that hedge funds will be a better place to invest your clients’ money. 

(6)   The Future for the Mutual Fund Industry

The study argues that traditional long-only mutual funds may be an endangered species, because they depend more on “inertia” (i.e., brand loyalty) to retain AUM than they do on performance.  They cite the fact that 33 of the 50 largest fund companies have less than the industry average (38%) in 4- or 5-star funds.  It goes on to say that:

US fund vendors, therefore, increasingly have two options. They can improve their performance, thereby standing apart from cheaper ETFs and effectively combating fee pressure. Alternatively, they also can leverage their existing operational strengths—their distribution connections, their scale, and most importantly their back offices—and begin to subcontract fund management to better-performing institutional boutiques. A growing number is pursuing the latter strategy. Assets in sub-advised US mutual funds have tripled in the past five years, and now account for nearly 14% of the long-term fund marketplace.

Do you agree with this assessment, and if so will this ultimately translate to better performance for investors? 

Bobroff: In assembling portfolios, large cap domestic portfolios are apt to be replaced by an index fund or an ETF as a core investment. However, on the domestic front, small and mid cap active management still has delivered vs. indexes and ETFs.  “On the global side, active management is the place to be vs. indexes or ETFs.” - BobroffOn the global side, active management is the place to be vs. indexes or ETFs. If the growth over the next 5-10 years is global investing than the question has to be whether the active manager is well positioned to take advantage of this changing landscape.

Roame: By and large we agree, but it will take a lot longer than many would argue.  A decade from now it will be a new world.  We will see a bifurcation, as has happened in many other industries.  Super-big players with big brand names (e.g., Vanguard, T. Rowe Price, and American Funds) and good performance will endure. “Fund companies in the middle will struggle.  These are the firms with big wholesaling staffs that depend on personal relationships between funds managers and advisors, but without stellar performance records.” - Roame At other end will be a constant plethora of new funds doing well with specific styles and strategies.  Fund companies in the middle will struggle.  These are the firms with big wholesaling staffs that depend on personal relationships between funds managers and advisors, but without stellar performance records. Inertia gets challenged over the next decade.  We will see advisors using a handful of big complexes with good performance, or doing their own due diligence with smaller providers. The traditional wholesaler model with mediocre performance is under threat.

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