Value In Beat Up Alternative Asset Managers?

RBC Capital Markets analysts Kenneth Lee and Mark Dwelle look at the beat up world of asset management and like some of what they see. The list of problems facing traditional asset management firms is deep and well-known. In a world where the Department of Labor reached above the US Securities and Exchange Commission to develop a fiduciary rule for recommending investments that limit a firm’s profitability, computer-based “robo-advisers” threaten to make human asset advisers obsolete at a time when Eugene Fama categorized portfolio management as a part-time job. Yet in such a hostile environment, hidden value inside the asset management industry can be found. Just look for the artificial intelligence, niche investment strategies and firms engaging in a consolidation strategy.

Asset management firms - Passive investing is not the big trend, the "age of specialization" is upon us

The advent of passive investing has been viewed in some quarters as threatening to active management. Low fee ETFs that generally don’t attempt to pick stocks to “beat the market,” on the surface, point to a game-changing revenue adjustment model for asset managers. But it is looking below the surface where Lee and Dwelle see opportunity.

While passive might indeed continue to prevail, a more significant trend is forming, that being the “Age of Specialization.”

“The most attractive investment strategy niches include alternatives,” the report said, pointing to strategies such as long/short equity, global macro, absolute return and specialized fixed income.

What is attractive about niches outside the mainstream is that sophisticated investors pay for unique knowledge or the ability to achieve an important strategic goal, such as noncorrelation.

“Active specialty equity, which includes international/global equity, natural resources equity, real estate equity” – all with different performance drivers – enjoyed high fee rates relative to the more vanilla strategies.From the RBC perspective, the best strategies combine passive with a “smart beta” approach. True passive – an easy to replicate S&P 500 index, for instance – can lead asset management firms to starve in a fee abyss. But those strategies outside the mainstream that deliver on their promise of true “alternative” performance drivers, even if it is undiscovered "beta," command appropriate fee value.

Distribution has always been a challenge as chokepoints on both the institutional and retail side limit exposure

A significant headwind in the asset management industry is the distribution channels.

In institutional channels, the path to an asset manager allocation is most often paved through the road of consultants. While many – if not all – major consultant hedge fund evaluation methods are not public, they have in fact correlated with a high percentage of allocations towards the largest hedge funds.

Separately, a systematic asset allocation model, one used in an integrated strategy diversification method, might come up with a different allocation pattern. Institutional consultants, further, often rely on “soft” methods of analysis that, like a baseball scout of old, and have tended to prefer managers leaving the most attractive impressions rather than selection based strictly based on statistical performance. For institutional investment products, particularly those that are true “alternative,” conforming to this at times clubby standard has led to exclusion.

On the retail side of the business, more onerous regulations exist and the power of the investment platform becomes a challenge to new competition, RBC notes:

For retail distribution, we note wirehouses, with thousands of brokers, are the major players with the most share. Due to their reach into the most retail AUM, and limited ‘shelfspace,’ wirehouses can wield significant influence over asset managers. We note that while the RIA (registered investment advisor) channel is much smaller vs. wirehouse, AUM within the RIA channel has been growing at faster rates over the past few years.

Asset management firms that intelligently embrace artificial intelligence into their client and back office workflows – not fight it – will succeed, as will firms that limit competition in strategic roll-ups, particularly those addressing the platform and distribution issues.

Looking over the asset managers relative to the future frame, the RBC report recommends APAM, ARES, IVZ, LM and OMAM based, in part, on filling niche needs or the potential to be a roll-up beneficiary.