Morningstar - Summer 2019 - 10

Dispatches

Great to Good
Asset management
firms enter a
whole new world.
PHILLIPS CURVE

Don Phillips

A colleague once observed that most companies
had to be great at what they did in order
to have a good business. Asset managers, on the
other hand, he noted, need only be reasonably
good to have a great business. For decades,
that observation, if anything, understated the
generous economics of asset management.
Shops that vaporized client assets by pulling in
huge sums at the peak of the tech boom, thus
making them net destroyers of capital over most if
not all of their existence, still enjoyed levels of
profitability that most corporations could only
dream of. In money management, for much of the
past five decades, you could be demonstrably
rotten at wealth creation and still have a highly
profitable business.
Those days, at long last, are gone-and it's a good
thing. Investors don't win in a game where
there's little penalty for those who create bad
experiences. Capitalism demands winners
and losers. In healthy markets, better players are
rewarded and losers suffer. Only in statesponsored enterprises, the type young socialists
currently praise, is mediocrity rewarded to
the degree it has been for so long in the asset
management business. Real competition has come
to the mutual fund world in the forms of passive
strategies and exchange-traded funds. It is
already clear that the asset management world of
the future will little resemble that of the past.
Greater convenience and lower costs for investors
are now the industry's dominant themes. The
customer is at last king.
One industry that may offer a clue to how asset
management evolves is the music industry.

Morningstar Summer 2019

In my youth, music revolved around vinyl record
albums. Like mutual funds with 8.5% loads, these
albums wrapped what you wanted-the music
and to a lesser degree the accompanying artwork-
in a bundle of expensive distribution costs.
The bulk of what you paid for went not for the
music, but for the ancillary costs of pressing vinyl,
opening retail stores, paying for sales clerks,
truck drivers, marketing, and mall rents. In time,
innovators recognized that by unbundling the
content listeners wanted from the packaging they
didn't, they could drop costs and add convenience.
Napster, MP3s, iTunes, and Spotify changed
forever the world of music. In financial circles,
passive investing and ETFs offer a similar bargain
to investors, lowering cost and increasing
accessibility. Active managers supplying model
portfolios follow in a similar vein, offering
instant MP3-like access to the content that
investors value without all the distribution costs
that weigh down returns.
The process of unbundling content from packaging
brought on even more profound changes to the
music industry. Once, artists engaged in moneylosing tours in an effort to promote the sale
of their albums. Today, musicians often give away
their music in order to encourage attendance
at their live shows and the sale of band-themed
merchandise. I see a similar thing playing out
among active managers who are losing market
share to passive strategies and ETFs. Some of
these managers will morph from trying to sell their
creativity (their funds being the equivalent of
songs) and focus instead on the "live performance"
of their creations-in this case putting their
funds into action via portfolio construction for the
end client. Fund managers will move into financial
planning-a service for which investors are
still willing to pay the generous basis-point fees
that active fund management once enjoyed.
We're already witnessing this trend as fund shop
after fund shop launches target-date funds,
adds robo-advice, or creates similar portfolio
construction services.
In a sense, it's the perfect revenge for active
managers who have been abandoned by planners
now using passive products. Moreover, active fund
managers have long complained that financial
advisors buy and sell their funds at inappropriate

times-piling in after good results and bailing before
rebounds. The reality of that behavior is
undeniable-most investors have asset-weighted
returns that greatly lag their time-weighted
returns and most investors use a planner. Active
managers have long thought of themselves as far
wiser and better trained than the financial
planners who sold their funds. Whether these
managers truly are superior to financial planners or
if they have all the people skills good advisors
bring to the table is an open question, but it's
a fair bet that the belief of many portfolio managers
that they have superior skills will lead them to
move in this direction-witness Vanguard CEO Tim
Buckley's recent proclamation that most financial
planners should leave portfolio construction to firms
like Vanguard, rather than tackle it themselves.
Just as the increased competition on active
management from passive offerings led to lower
costs and generally better outcomes for most
investors, so too will increased competition for
financial planners from traditional fund companies
also likely lead to lower cost and better outcomes. Such a shift addresses one of the weak
links in asset management today. The problem is
no longer money going to bad funds-as
happened regularly in the 1980s and 1990s. Today,
money goes to good funds on both the active
and passive sides of the ledger. Yet, investors still
assemble flawed portfolios, loading up on
what they wish they'd bought three years ago,
rather than what will best prepare them for the
future. That situation will likely improve somewhat
as scores of CFAs, disgorged from jobs in active
stock selection by the trend toward passive, move
into portfolio construction roles.
As a result, portfolio construction will become
more sophisticated, more homogeneous, less
costly, and more efficient. Investors, on the whole,
will be better off. Asset management shops
will be in a whole new world, one where they now
have to hustle and adapt like other businesses
in order to continue to enjoy success. Great
businesses among asset management firms will
be rarer, good ones harder won, and mediocrity
no longer a viable growth strategy. K
Don Phillips is a managing director with Morningstar. He is
a member of the editorial board of Morningstar magazine.

Morningstar - Summer 2019

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