Global PA & Moonshot Operations Senior Director - BCG X
Today, most asset managers remain firmly focused on defending and building actively managed core assets, the traditional business that has long provided their recurring revenues. They do so even as the market evolves and the share of those actively managed assets slowly shrinks as a portion of the whole.
A smaller group of managers, meanwhile, are capitalizing on the market’s recent evolution, successfully building capabilities in solutions—the asset allocation offerings that, along with passives and specialties, now capture a disproportionately large share of the market’s growth. By placing bets on solutions, these pioneering managers have stepped into the vanguard to dominate the market’s strongest flow of new assets: revenues are expected to rise at 2.5 times the rate of those of actively managed core assets.
These managers are tapping a trend toward solutions that has accelerated since the financial crisis, driven by several factors:
Investors have grown frustrated and disillusioned with the performance of traditional, benchmark-pegged actively managed core assets. When a benchmark is down 15 percent, outperforming it by 3 percentage points still produces a loss. A poor return is a poor return.
Investors’ historical focus on maximizing risk-adjusted returns was undermined by the volatility of both equity and fixed-income markets during the crisis. A rethinking of investment goals has produced a stronger recognition that asset pools exist to satisfy future liabilities—such as pension plan obligations and retirement expenses—not just to maximize immediate returns.
The traditional diversified asset-class strategies have failed the financial-crisis test. Correlations between traditional classes converged, and results suffered. The winning strategies were more oriented toward macro trends and strategies that shifted allocation dynamically to take advantage of opportunities across asset classes—not only within them.
The increasing complexity and internationalization of financial markets—and the growing difficulty of navigating them—has created new, specialized asset classes along with the need for greater asset-allocation expertise. The days of the simple 60-40 domestic equity-bond portfolio are over.
Small investors have joined institutional and other large investors in seeking exposure to esoteric, nontraditional, and uncorrelated asset classes. They now want access to hedge funds and private-equity funds embedded inside solutions, because they lack the scale or expertise to make those investments directly themselves.
As a result, both retail and institutional investors are increasingly turning toward outcomes or solutions that are specifically oriented to their investment needs. The complexity of managing these solutions while reacting quickly to market developments has opened an opportunity for pioneering asset managers to capture net new flows if they can develop the appropriate capabilities. In the past, these solutions have often been the traditional realm of wealth managers, financial advisors, and investment consultants.
As the solution market has grown and evolved, the nature of solutions themselves has evolved. They have become increasingly customized and complex in both the institutional and the retail spaces.
On the institutional side, increasing numbers of large plans are turning to full and partial plan-outsourcing services, which, in many cases, are delivered in a customized fashion rather than in comingled funds.
True liability-driven investment (LDI) solutions—such as those implemented by a growing number of U.K. and Dutch pension plans—are increasingly customized for pension funds. These LDI solutions are being tailored to manage interest rate, credit, market, and liquidity risks in order to meet anticipated liabilities. As the market continues to grow and deepen, we expect holistic LDI solutions to grow and replace partial LDI solutions, which are often no more than portfolios of long-term bonds that attempt to address liability and risk profiles.
The key capabilities required for developing and launching truly holistic LDI solutions are built on a foundation of deep technical knowledge. They include actuarial and analytical capabilities, risk management capabilities, and an understanding of liability cash flows. It is interesting that there are only a few insurance subsidiaries among the leaders. While insurers generally have the required core capabilities, they often lack relationships with the investment consultants who intermediate most of the new business in major pension-fund markets, including the U.K. and the U.S.
On the retail side, in which packaged solutions have traditionally been more common, the market is seeing the development of more custom solutions, as well as an explosion in the types of thematic solutions. Increasingly, the latter target specific outcomes for retail investors, such as inflation-hedged funds, income funds, liquidity management, tail risk management, and volatility-managed, tax-managed, and absolute-return or risk parity funds.
Target date funds (TDFs), with a more specific asset-allocation glide path, have largely replaced the earlier generation of target risk funds for retirement planning in many defined-contribution (DC) plans. TDFs currently total $400 billion in the U.S. and are expected to grow to $1 trillion by 2016 because they are the main default-option funds in most DC plans.
Notably, within the high-growth TDF category, there is a rising demand from DC plans for customization. The demand is driven by specific needs, as well as the desire for greater diversification and a growing interest in alternative investments.
Many large corporations are investing in TDFs tailored to the varying needs of specific employee groups. These include expected retirement ages, corporate beta exposure, promotion and income curves, and employee-stock-option-plan variations in participation rates and stock portfolios.
Custom TDFs are expected to grow from $46 billion to $218 billion—a CAGR of 36.5 percent—from 2011 through 2016, as more large companies with significant resources discover the benefits of tailoring multiple glide paths for employees. Highest adoption rates are expected for larger plans—those with more than $1 billion in AuM.
Most of this demand will be for semicustom TDFs, which could meet 80 to 90 percent of plan needs, with just 9 percent of demand for truly custom TDFs. Semicustom TDFs provide such benefits as greater fee transparency, more diverse asset allocation, and more control of underlying managers.
While custom TDFs are currently dominated by a few managers, this wide range of potential benefits suggests opportunities for other players to differentiate themselves. They might do so, for example, by offering access to real estate investment trusts and commodities, using ETFs and passive management to reduce fees, or by introducing multimanager and open-architecture construction.
We believe that the market for solutions is likely to keep building and evolving at a fast pace and that innovation will be critical for players that aim to share in its success. Beyond the current offerings, potential future trends include the following:
Thematic, personalized solutions
Enhanced TDFs and risk funds
Sophisticated alpha generation
Access to private assets
Coinvesting with the manager’s own assets
Blurring lines between consultants and asset managers
Outsourcing investment decisions
Managers hoping to successfully surf the growing solutions wave face fundamental decisions about how to participate and what capabilities they should focus on developing.
As a starting point, managers need to assess their capabilities in a number of dimensions, including from a manufacturing perspective. Do they have the ability to manage money other than against a defined benchmark? Do they have an asset allocation capability—strategic, as well as tactical and dynamic? Do they have capabilities across multiple asset classes? Can they manufacture all the elements of a solution themselves, or do they need to outsource some asset classes? Do they have a manager search and oversight capability?
From a distribution perspective, managers must give careful thought to the design of the go-to-market model; traditional managers are unlikely to have existing channels or people capable of selling solutions. The solution sales cycle is often longer than a single asset-class sales mandate. Managers must also consider how to circumvent potential channel conflict with investment consultants and other gatekeepers offering competitive solutions. It is critical for solutions managers to develop and maintain relationships with end customers and home offices—without disintermediating investment consultants.
Finally, managers must develop a thorough understanding of their cost structure and maintain rigorous discipline in the pricing of solutions. This is the case particularly for custom solutions, which may be difficult to scale across multiple clients. Additionally, managers need to have nimble middle and back offices to facilitate creating and operating a solutions offering.
Managers that succeed in getting these elements right will have the key to unlock enormous growth opportunities.
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