Arecent book by CFA charterholder Dr. Ronald N. Kahn, The Future of Investment Management, draws its inspiration from the changes that have transformed the finance industry over the last several decades.
The book was published by the CFA Institute Research Foundation and launched at CFA Institute’s annual conference in June. It explores key ideas and trends that have influenced the industry over the centuries, from its earliest recorded history in the 18th century to the present day, and looks ahead to how the industry might progress in the next five to ten years.
Against the backdrop of rapid change, Dr. Kahn analyses how our understanding of risk and expected returns has evolved, and focuses on seven important trends, which are currently shaping the future of investment management.
Herewith, a brief discussion of each of these trends.
• Active to passive
The more or less one-to-one shift from active to passive or index funds has been a phenomenon that’s been going on for at least ten years now. Dr. Kahn calls this bad news for active managers, and it’s not hard to see why. The brief against active management is extensive and backed up by ample data. Although behavioural finance and excess volatility, for example, show that active management can outperform, that outperformance tends to be short-lived.
Active managers can identify informational inefficiencies that the market doesn’t yet understand and trade on them. But informational inefficiencies are what Dr. Kahn calls “narrow and transient sources of return” — they work until the market figures them out, and then they stop working.
In my opinion, passive investments are not designed to outperform the indices they track, but they provide exposure at a very low cost. Active funds, on the other hand, are the vehicles for fund investors to seek long-term market outperformance, although only a minority of fund managers are able to deliver it. The mutual fund industry in Asia, for example, seeks to combine the two approaches.
• Increased competition among active managers
Increased competition means there are fewer hidden market inefficiencies. At the conference, Dr. Kahn cited a paper by R. David McLean and Jeffrey Pontiff which shows that as academics uncover market inefficiencies and publish them, the market trades the inefficiencies out of existence.
• Changing market environments
Shifting environments are mixed news for active management, said Dr. Kahn. “On the good side, as investment moves from active to index…the other side of the trade is likely to be an index fund.” That means active investors will be mostly competing against uninformed indexes.
The challenge then is for the institutional investors, those that occupy big positions and may have front-running and other concerns.
• Big data
“If there’s any great news for active management,” Dr Kahn said, “this is it.”
The data revolution, spurred by the rapid growth of the internet in the past 20 years, has closed the information gap in investing. However, the key is knowing how to use this information correctly.
Definitions of big data vary, but Dr. Kahn said they tend to be higher in volume and higher in frequency and reveal digital traces of human behaviour. Big data takes a variety of forms, including text, search data, social media, images, and video, and can provide investors with insight into alpha-generating market inefficiencies or potentially leading indicators that get them ahead of consumer sentiment. “This explosion of available data, along with the analytical development of machine learning,” Dr. Kahn said, “is the greatest new opportunity for active management in many years.”
Indeed, here in Asia, KPMG says more Chinese asset managers will connect their technology dots in ways that unlock an entirely new level of agility, efficiency and value.
• Smart beta
But next to the potential possibilities big data may have for investment management and active investing is the disruptive force of smart beta.
“These are active products with some of the benefits of indexed products,” Dr. Kahn said. “It’s not an investment innovation; it’s a product innovation.”
Such strategies are transparent and rules-based efforts to outperform the market. Small-cap, momentum, value, growth — these are all factors that were previously a form of active investing but have now been systematised and effectively indexed.
“None of these are new ideas,” Dr. Kahn said. “We’ve taken successful components of active management and are selling them cheaply.”
We can see this trend growing here in Asia. Nearly 40% of investors in Greater China have replaced actively-managed funds with smart-beta products in the last 12 months, according to a Brown Brothers Harriman survey published in April this year.
• Investing beyond returns
Environmental, social, and governance (ESG) investing and sustainability have generated an enormous amount of interest in Europe, and increasing interest in the US and Asia.
Dr. Kahn describes this trend as “investing beyond returns” and said it’s not strictly about risk and returns, but something else. He connects it to the concept of utility function.
“We may all want portfolios that reflect our own particular utility,” he said, “and it may be harder to put together a one-size-fits-all product.” Nevertheless, he believes that ESG can be delivered with more certainty by investment managers than active returns.
We know this from our own research. One of the most striking findings in the 2019 CFA Institute report on ESG Disclosures in Asia Pacific: A Review of ESG Disclosure Regimes for Listed Companies in Selected Markets is that interest in the topic has grown significantly in the region. Many Asia Pacific markets have taken steps toward mandating or encouraging disclosures in some or all aspects of ESG within the past two decades.
• Fee compression
Given all these headwinds, fees have come down, even within product categories.
And one area where Dr. Kahn expects further declines is in active fixed income, where fees have further to fall.
Optimistic about the future
At the heart of Dr. Kahn’s book is an optimistic message: although the profession is in a state of flux, this disruption can present great opportunities, particularly for those just entering the profession. Technological advances and shifting boundaries between active and passive investing will make way for new products and sources of information which can help managers perform, and help clients achieve their objectives, whether based in the Americas, Middle East and North Africa, or here in Asia.
* Nick Pollard is the CFA Institute’s managing director, Asia Pacific.