London roundtable: Inflection point

After looking at fund flows and discussing industry consolidation, our Global Industry panel in London notes that the current state of markets offers active managers a chance to prove their worth.

Simon Fox (senior portfolio manager, strategic client solutions, Aberdeen Standard Investments)
Diana Mackay (managing director, global distribution solutions, Broadridge)
Martyn Gilbey (country head, UK, Franklin Templeton Investments)
Phil Middleton (head of UK intermediary business, Schroders)
Ian Penrose (head of distribution – UK, Ireland & Scandinavia, SYZ Asset Management)
Matt Piro (head of product for Europe, Vanguard)

Funds Europe – Which have been the most in-demand products or solutions for European investors in 2018?

Ian Penrose, SYZ – Multi-asset and passive US have raised money as people catch up with that established trend. Specifically at SYZ, we have had flows predominantly into low-volatility multi-asset and absolute return products. But we have also seen some interest in Japan, which has come back from a low base. Japanese equity seems to be an area of interest now.

Phil Middleton, Schroders – Italy’s multi-asset income sector has been very big and mixed-asset income is the biggest sector more broadly, such as in France, though with more of an ESG focus. Interestingly, German and Swiss investors seem keen on thematic funds. Thematic is appealing to global banks and global distributors.

Specifically in the UK, the biggest selling sector so far this year – and it is a great space – is the strategic bond sector.

Martyn Gilbey, Franklin Templeton – Institutional investors in particular are interested in alternative investments, which continue to grow as an asset class and encompass everything from real assets to private equity and hedge funds. In particular, the area we see in most demand in Europe and globally is private market exposure, both debt and equity.

I’d echo the point on thematics, particularly in continental Europe. There is increased demand for technology and ESG.

Matt Piro, Vanguard – We continue to see adoption of passive strategies as ETFs broaden their buyer base. There are new buyers and also new use cases. Flows are a little behind the pace of last year, as is much of the industry, but growth is continuing.

Simon Fox, Aberdeen Standard – Within European retail markets there is the overarching theme of the search for yield, and that comes through in multi-asset income and some higher-returning fixed income products. It is tied to the drive by individuals to find new sources of income in what is otherwise a challenging environment.

From an institutional perspective, I’d echo the point about private markets. The need for good sources of return and growth is taking institutions into alternatives – including the more exotic of the traditional asset classes, too, like emerging market debt, China A-share investing, frontier debt and other high-yielding fixed income opportunities.

Diana Mackay, Broadridge – Mixed asset has been the most successful this year. But I think you have to look at that with some degree of scepticism because this is an asset class that has been dragged back considerably by some big redemptions in certain absolute return strategies, and that’s played quite badly for some managers. You do see a winner-takes-all pattern in this space: for example, the Allianz Global Income Fund, where we believe a lot of demand comes from Asia. Mixed asset is ahead, but only just.

Equities are also in there but within this is a big move into passive, both US and global. Local currency bonds in Sweden and in Switzerland still do very well; emerging markets not too good at the moment; and most high yield big players of last year are seeing redemptions now.

In the UK there appears to be a lot of money coming out of UK equity income and into global strategies instead. UK equity, the core sector traditionally, is a big pain point. Brexit and market volatility are causes for that.

Middleton – Interestingly, though, if you look at some surveys around investors’ intentions, the UK is more on the radar again. At the gross-flow level for UK equities sold in the UK, whether it’s the All Companies sector or the income sector, there are healthy numbers. There’s a huge amount of rotation going on within those sectors. UK All Companies, for example, are usually on top in gross terms, but are now quite near the bottom on a net level.

Mackay – Some 30%-35% of fund selector portfolios in Europe are invested in their top three fund companies, which means that 60%-70% of client money is invested in funds from another 27 groups or so on the selectors’ partner lists. That doesn’t mean to say you don’t get periods of time when there is a concentration in flows. This happens mainly when the markets are very volatile and negative, but really the big ‘winner-takes-all issue is in the passive arena rather than in the active space.

Gilbey – Passives are here to stay and are not just a reaction to the relatively benign momentum-driven markets we’ve had in the last seven or eight years. Speak to asset allocators and you will find they are much more tuned in to how they allocate their risk budget. That’s why firms like ours are investing in those business lines; it’s a recognition that the market has fundamentally changed.

Piro – More asset allocators are using ETFs to employ active strategies, too. You can think of it almost as a new way of approaching active and adding value through asset allocation decisions, whether strategic or tactical.

Penrose – It does change a little bit depending on segment, country and sector. The UK is typically considered as being ahead of continental Europe in terms of trends and there is definitely a segment of investors that is looking outside of the supertanker funds to differentiate themselves. Fund-of-funds and discretionary managers that build model portfolios can’t have the same ten funds as everybody else, so they’re approaching other firms such as boutiques for something different.

This may be less so in mainland Europe where ‘bank-assurance’ distribution is widespread.

Middleton – In the UK, outsourcing by advisers to discretionary fund managers (DFMs) is a significant and continuing trend. It might be for model portfolio services, a full DFM service, multi-asset or multi-manager. It continues at quite a pace and the DFMs have very big distribution teams focusing on that market.

Mackay – That is one of the most important distribution trends at the moment. It’s a complete shift in the value chain and it’s remodelling the market massively.

There is also a manager risk element. Distributors can sometimes feel they are overexposed to a particular fund or a manager and they start to pull out. This happens all the time. We are seeing it a little with iShares now.

At the same time, the big distributors have got huge pools of money that they’re looking to place in single strategies, and that makes many, many funds impossible to look at, just for sheer size, and this is where you’re seeing the big move towards sub-advisory activity.

Fox – From my perspective, it might not be that we’re seeing the mega funds driving flows this year, but we certainly do get a sense that, particularly in the wholesale space, people are looking for fewer and deeper relationships with asset managers. That is a repeated conversation that we have with distributors: they want managers that can offer them a broader array of strategies that they can then take on to their clients, and each one of those strategies is not going to be big in and of itself, but it’s about flexibility and a relationship where the asset manager can understand and empathise with the distributor.

Gilbey – What’s interesting there – particularly in December and January when MiFid II statements are published to investors – is whether this will result in meaningful change. Transparency rules and the pressure on captive distributors to show how the 200-250 basis points they’re paying breaks down between platforms, advice and manufacturing, could drive more flows into multi-assets and create more outsourcing. If that’s right, then the medium-term picture for multi-asset in Europe is healthy.

Funds Europe – Active funds in Europe have had a good year in terms of performance. What is the reason behind this and do you expect it to continue, given volatility?

Fox – The shift to passive is not illogical in the US, given that it is arguably a more efficient market than other markets – but also, over the last years, it’s been really hard to add value. It’s been a very narrow performance with mega-cap tech stocks driving that market.

If you look at the longer-term numbers in Europe, Asia and emerging markets, you can see much greater opportunities for actives to add alpha and value.

I still believe very passionately that there’s a lot of value that can be added and has been added in places like Europe, certainly over the last few years. There are lots of examples of managers that are adding much value within these certain markets.

Penrose – Let’s be honest: this is when active managers should be shining, when market dispersion climbs, when markets are more volatile, when correlation relationships historically start to break, when people look more at fundamentals – all of those things. This is when we’ve got to earn our money.

In the ten-year bull run, it’s been hard to keep up with passives, which have thrived in a rising market. But now is when we need to demonstrate that we know what we’re doing, that we can protect a little bit on the downside, that we can squeeze out some extra performance on the upside.

I’ve seen some first-cut numbers from October, and performances – certainly in some of the sectors we operate quite actively in – have been really wide, even as much as ten-point differences over a month between top and bottom funds in some of the equity sectors.

Gilbey – The current volatility should present increasing opportunity for value investors.

Penrose – If the macro environment persists into 2019 in terms of volatility and geopolitical risk, but also lower returns, then this is the moment that active managers have to demonstrate their skill. This is the time, whether you’re a single asset class manager or multi-asset, that you have to be able to demonstrate your fundamental stock-picking value, whether value or growth. And I think investors are giving us that opportunity.

Fox – There’s a danger we make too much of the idea that active managers will save investors in a downturn. The reality is inflection points are really difficult to navigate, but a lower return environment and more volatility over a prolonged period, that is really the time when active management should add value. We have a window of opportunity to prove our point.

Piro – It is an interesting topic around inflection points. One of the big shifts in our industry globally was 2008 and 2009 and the results delivered during that period. It did accelerate the adoption of passive. So, if this is a period of time where investors have expectations of active management, active managers will need to deliver.

Although statistics can sometimes be dangerous, the numbers do show that – regardless of asset class – active management, on average, has a hard time delivering. The key is to buy the best products and identify them in advance. There will be an increased focus on how exactly to do that and costs will be an important factor.

Broadly, fixed income does appear to be an area where active has held up better and passive adoption has been lower. Why is that? Partly performance. Shortening duration has been a good thing this year, a lot of managers have been right there; a little extra carry has been a good thing. You do see a bit of a difference as you dig into the asset classes.

Middleton – Some of the outperformance you saw from active managers around the time of the financial crisis was huge. Alpha can be delivered through periods like that.

Fox – One point on active management is we often get sucked into looking at it as an asset class-versus-benchmark debate. In fact, people are turning to managers to help them access newer asset classes and opportunities within a multi-asset context. That’s not traditionally what we called active management, but investors need to have someone that can help navigate different asset classes and varying opportunities and be able to package those together in a solution. The value actives can add for clients is not just a benchmark-relative discussion any more.

Mackay – A key driver in the debate, remember, is price. If you can get the return you want from a passive at the right price, you’re not going to look at the active options unless you can get considerably more.

Penrose – Yes, but one of the key outcomes of the growth of passive has been to drive down the price of active. Active has become far, far more competitive.

Gilbey – But so has passive!

Penrose – True, but it comes back to this question about predictability and outcomes. Price is the only certainty upfront about passive. It’s benchmark minus price, and if the price is low, it’s a great idea.

If you can do more quantitative and qualitative research and attempt to get a tighter range of potential outcomes, that makes the argument for paying the extra active fee an easier argument to justify. If the range of probability says return could be 1.5% over benchmark, it’s worth paying 60 basis points for it as opposed to 10 basis points.

Gilbey – McKinsey has very interesting data on fees. Average total fees for equities in Europe in 2010 were 97 basis points, but by 2017 were 78 basis points. Fixed income has gone from 69 basis points to 60. Average fees at these levels are supported by large, relatively untouched legacy products; these are not fee levels we recognise for new opportunities in these asset classes.

Mackay – For sure. We did an event for asset managers a couple of weeks ago in London/Paris/Milan. There were about 110-120 groups and we asked them what their view was on how far the pricing of active funds would go down. The consensus was around another 20%.

Gilbey – We should also differentiate between mutual fund distribution through traditional channels and sub-advisory, which is the institutionalisation of retail. The fee range between, say, a smart beta UK equity portfolio and an institutional active UK equity portfolio is not significant.

Funds Europe – Has ESG become mainstream?

Fox – The expectation for an investment manager is now that they will consider environmental, social and governance issues when they are making investment decisions. ESG in that sense has become a core component of investment management, or at least that is the view of clients. The extension of that is that voting and engagement are also part of that process.

What is really exciting is the emphasis on making a positive impact. People are looking for funds that are purposefully focusing on stocks and companies that are likely to have a positive impact on sustainability.

Gilbey – A quarter of global AuM [assets under management] is now invested along ESG lines in its broadest context, according to [management consultant] McKinsey. That number is 53% in Europe and in the early 20s in the US. In Europe, 60% of institutional investors regard ESG as a core requirement. It is 20% in the US.

Piro – Yes, though ESG is being talked about more in the US, and it does depend on the type of client. This is an obvious statement, but the younger generation, such as the clients that we have in the millennial range, are asking about ESG a lot more. The assets aren’t there yet but in 20 years’ time, they will be.

The regulatory tone is just different in the US. There are sustainable investing initiatives at the European Commission level – but there is not something comparable in the US, not to the same degree.

Mackay – Europe’s very much ahead. Our brand survey asks about ESG perception of fund groups. All the top groups are continental European. Robeco is the top pick, but there are quite a number of small boutiques, too.

ESG is not mainstream yet as far as the end investor is concerned. Most groups still find it quite tough to sell on an ESG flag alone, but there is demand coming from the end investor. In the next ten years for sure, it will be mainstream, and the European Commission seems intent on moving in that direction.

Piro – I’d agree. I think it’s going to become adopted more. It is something we talk about in every client meeting, whether it’s exposure in a portfolio, or activities from a stewardship and engagement level. As a result, we have seen the industry be much more transparent about the activities we employ.

But it is another area where we as an industry need to work together, because there are so many terms that are confusing. We talk about impact, but how are we going to measure that impact? How are we going to demonstrate that the portfolio or the product delivers an impact and is not simply holding companies that on the surface look like they’re aligned with ESG values?

Penrose – I imagine all of us around the table are signatories to the UNPRI [United Nations Principles for Responsible Investment] and that probably means we’re all captured by data about the market share of ESG managers, even though within our own range of products, we have more focus on ESG within some products than others. At group level, we would consider ourselves signatories and are adopting those principles.

ESG has become a hygiene factor now in pretty much any RFP [request for proposal] you answer. There is still a wide spectrum on how exactly it’s adopted and it’s probably going to have to go further.

For example, I can see the day when investors – certainly those who are used to using technology and investing via their mobile phones – will want to proxy vote themselves. Maybe we end up having to use blockchain to work out who’s holding what, and whether there are technology solutions for that, but I think us engaging on people’s behalf is only really step one of this.

At the end of the day, we are custodians of one person’s money investing in other companies, we will end up having to just enable them to do their own governance and their own assessment.

Piro – The performance side will be another interesting part of the conversation. Do we want to do good without sacrificing performance? Of course we do, and many investors do, but I think the only thing you can say with certainty is that the performance will be different to the market, so it gets back to the issue of promises in terms of outcome. There will be active strategies, absolutely, whereby that approach will add value. But it deviates from the benchmark returns and we would have to be clear that we’re delivering.

Gilbey – It is important to be transparent with clients around our approach to ESG and how we’re voting their shares.

On the performance side, we don’t see ESG from detracting from it.

Lastly, we think over time, investors will need to get creative around ESG as it ;becomes mainstream across all asset classes.

Penrose – There will still be stocks in the benchmarks that for a lot of people will be considered uninvestable if you adopt an ESG approach. Defence sectors, chemicals, even energy for some people. So there could be a time when benchmarks we are measured against diverge significantly and there’s nothing we can do about it if we’re adopting ESG. It’s a conflict that typically only shows up when the market turns down.

Middleton – Fund selectors now have an ESG specialist in some of the big fund selection teams, while at institutions, we ran an institutional investor survey last year and 67% said ESG would become more important or significantly more important over the next five years. There were 2% who said it would become significantly less important. I don’t know who that was. Nearly a quarter said no change, but it’s here to stay.

Funds Europe – At the end of 2018 or through it, there has been significant market volatility. How does that affect your outlook and how do you think it will affect investor demand for the following year?

Middleton – Great opportunities for active managers in a lot of areas. The market has pulled back but it presents some really good value in certain areas – like European equities, which has underperformed the US significantly, yet the outlook for European economy is still pretty strong.

Our multi-asset team has increased equity exposure, so we’re pretty upbeat about things.

Penrose – The potential for us to deliver on these opportunities is, I think, strong, including on the absolute return side. But there are some potential clouds on the horizon from an investment sentiment point of view.

There is typically a lag between firms like ourselves delivering performance and people picking up on that, talking to us and allocating funds to our strategies.

There is the potential that if rates rise, we might see some inflation creep back in. There are obviously geopolitical risks, including in the UK early in 2019 that may affect people’s appetite to commit money to long-term savings and long-term investing. This may affect how we all see flows, just at the time when the potential is there to deliver some good performance.

That’s a message that we need to get out to people, that now actually the potential is good and that you shouldn’t stop saving, you shouldn’t stop paying into your pension, you shouldn’t stop using your tax wrappers, the opportunity is there. Companies that six months ago were more expensive are now cheaper.

Piro – Market return expectations are fundamental. It’s important for asset managers to be clear on that. The starting point for fixed income, yields for example, is of course the simplest thing to look at.

Yields have moved up, that is good for the long-term return outlook – but nonetheless expect lower yields than what you’ve been accustomed to over the last, say, 30 years. Similarly, with equities, they’re a little rich. It’s about having reasonable expectations for market returns.

We also have to remember two things: one is it’s been a pretty good last decade for investment performance. Small bumps along the way, but overall the last decade has been strong. Then industry-wise, from an investor sentiment and demand perspective, last year was a bumper year everywhere and expectations are that momentum can continue, so it’s probably right to temper that considerably.

Gilbey – People still want yield and people are still having to take ever more responsibility for their own long-term savings.

On the supply side we are in for some choppy waters, and I think there is always opportunity in markets defined by volatility. I think asset management firms are going to have to be increasingly disciplined on costs – particularly in publicly listed asset managers – to make sure their own valuations remain decent. So there is opportunity in these environments, but I think we’re going to have to be a bit more disciplined in the way we invest and operationally manage our businesses.

Mackay – On the client side, I think it looks quite negative. One of the issues is first-quarter MiFID II reporting next year, which will require distributors to deliver to clients a statement of the costs they have incurred for their fund holdings. This is expected to encourage many clients to question the worth of their investments, given that market performance in 2018 has been quite poor.

I expect to see some retreat to cash in the early part of 2019, although most asset management groups think it’s something that you can deal with through effective marketing.

There will be opportunities – but you’re going to be all eating each other’s lunch. I doubt whether new money will be pouring in in any big way.

Fox – We’ve clearly moderated our views over the last 12 months, but I think there are still reasons to be positive about what’s going to happen over the next couple of years for the economy and for markets as well. There might be a little bit more volatility, but we’re coming from such low levels.

I think the key thing that we are going to see though is this recalibration from an investor perspective in terms of, ‘Have I actually invested in things that are going to deliver what I really think they’re going to deliver?’

To the extent that the tide has been lifting all boats over the last few years, everything was going up and it didn’t matter how, but there has certainly been this year a differentiation of performance coming through due to volatility, and that is going to cause people to verify that they are in things that they believe in.

Funds Europe – So, are you feeling positive or negative for 2019, and why?

Gilbey – I’m cautiously optimistic. And clearly we need to get through Brexit.

Piro – We will be out talking with every client, reminding them of the importance of being willing to take risk and allocate capital to equities and fixed income, because that is what is expected to deliver over the long term, even if some have short-term concerns.

Penrose – From a relative performance point of view, we’re pretty positive for the year. I would hope that these are the environments where we’ve got the best shot of beating our benchmarks virtually across the board.

Fox – It is very exciting if you think that ten years ago, basically investors had the choice of equities and bonds, predominantly, to build portfolios, but the opportunities that we can help access today have an incredible breadth. You can find some really compelling opportunities in different asset classes and regions. There are some good reasons to be positive.

Middleton – I’m certainly optimistic, because there is opportunity.

Mackay – I’m negative for next year, but not on performance grounds, just on the lack of investors willing to put their money into funds.

©2018 funds europe



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