Wealth managers seek new ways of delivering investment value

In 1965, Intel cofounder Gordon Moore predicted that computer processors would double in performance capability every two years. Mr Moore’s observation about the exponential advances in technology proved so accurate that his framework is now called Moore’s Law. Half a century later, Moore’s Law is changing the nature of market efficiency: we are witnessing the emergence of sophisticated investors armed with supercomputers that capture and eliminate market inefficiencies in microseconds.

Operating on lightning quick networks, today’s supercomputers have fundamentally changed investors’ chase for alpha (where excess returns of a fund relative to a benchmark index is alpha).

It is now near impossible for a typical fund or wealth adviser to consistently deliver superior investment performance and subsequently, returns. The numbers do not lie: in the first quarter of this year, 81 per cent of US equity funds and 94 per cent of US large cap funds failed to beat their index.

In response, droves of investors have been abandoning the pursuit of alpha and embracing index ETFs. The rationale is simple: if you cannot beat the market, then join the market (Figure 1).

The trend towards index investing is likely to continue for two principle reasons.

First, as index funds become more popular they also become cheaper to invest in, creating a positive feedback loop: lower prices makes them more attractive, and more investors results in still lower prices (Figure 2).

Secondly, even after years of strong growth, index funds only account for 32 per cent of US stockmarket assets: there is still room for a lot more growth in this space (Figure 3).

Wealth and asset managers that market funds on the basis of superior investment performance should pause for thought. With the commoditisation of returns, investors can turn to low cost robo-advisers which will achieve market returns for as little as 10bps. Investment performance is no longer an obvious ‘value added’ component in the wealth advice relationship.

The silver lining in these trends is that although alpha is shrinking, investors still clamour for managed accounts and professional investment advice. From 2010 to 2016, managed assets increased by 80 per cent while transactional assets increased by just 10 per cent over the same period. To wealth and asset managers this means clients still place significant value on advice – but in alpha’s absence, firms will need to create new ways of delivering investment value. 

One solution for wealth and asset managers is to align client portfolios with their priorities and preferences. These preferences will of course vary from segment to segment – some investors may focus on the investment process, finding value in transparency, reliability or convenience. Other segments may prioritise the impact of their investments. For example, are their holdings environmentally responsible, or helping to inspire positive social change?

From a product development standpoint, asset managers need to understand the segments they serve and must in turn create products that optimise the value proposition for each client segment. From a distribution perspective, wealth managers need to more deeply profile the clients they serve to create customised portfolios based on each client’s priorities and preferences beyond investment returns.

This fundamental change in market efficiency will create new sets of winners and losers across our industry. The bad news is that firms can no longer rely on beating the market in order to attract and retain clients.

The good news is that there is a tremendous opportunity for firms to deliver non-alpha investment value to clients. In our view, firms that understand their clients well enough to capitalise on these trends will emerge as truly differentiated providers of investment value, even in this new era of post-alpha wealth management.

Peter Keuls is the leader of McLagan Partners’ wealth management consulting practice