The Looming Threat That Could Decimate Wall Street's Fund Managers

The Looming Threat That Could Decimate Wall Street's Fund Managers

Why you should care

Because the legacies of the financial crisis may finally be coming home to roost.

For all the turbulence in the financial services industry over the past decade — Lehman Brothers filed for bankruptcy a little under nine years ago — not much has changed in the aftermath of the crisis. OK, a bunch of bankers lost their jobs (and a lot of money), new regulations forced substantial changes in how the industry operates, and markets soured on emerging economies and fell in love with tech. But in comparison to disruptions elsewhere — retail, energy, accommodation, transportation, media — financial services are yet to have their “Uber moment.” But new currents are now threatening to completely hollow out the buy side of Wall Street, with some fearing that the legacies of the crisis are finally coming home to roost.

The first threat comes from market forces and technology: While alpha-male, alpha-seeking stock pickers in actively managed funds struggle to justify their fees by outperforming a steadily growing market, low-fee, index-tracking passive funds have become all the rage, along with algorithmically driven robo-advisers (most of which assign users to a passive fund). As a result, $326 billion poured out of actively managed funds in 2016 — more than the outflow during the 2008 crisis — while $429 billion flowed into passively managed assets, according to a recent report from investment research firm Morningstar. The shifts are dragging down how much active managers can charge for their services — the asset-weighted average fee for active funds has fallen steadily from around 1 percent in 2000 to 0.75 percent in 2016, says Morningstar. Passive funds now account for one-third of the market.

Most of the growth in passive funds has come at the lower end of the market — from small investors with relatively uncomplicated financial needs. But now even the big money at the upper end is on the move. In 2016, $106 billion was pulled from hedge funds after several years of meager returns, according to data from eVestment. Some of that is headed for private equity funds, but an increasing number of big investors are opting to cut out the middlemen altogether in favor of direct investment.

“Shadow capital” now accounts for more than one-quarter of all fundraising for private equity investments.

Direct investment involves big owners of wealth (pension funds, sovereign wealth funds, college endowments or family offices) directly buying equity in privately held companies, the sort of deals usually done by buy-side money management funds. Sometimes they join forces with funds in “co-investment” deals — direct investment and co-investment together make up so-called shadow capital, which now accounts for more than one-quarter of all private equity investments, an all-time high by dollar value, according to research from private equity advisory Triago.

The total volume of shadow capital remains unclear — only a portion of such funds are directed toward private equity investments, with direct real estate and infrastructure investments also major destinations. “The quality of disclosure is very, very poor,” says superstar Harvard Business School investment banking professor Josh Lerner, but what little data exist suggest that “a very significant amount of money is being put to work” in this way. For example, the Canadian Pension Plan investment board, which annually discloses the nature of its investments, lists more than $78 billion of direct investments across equities, debt, real estate and infrastructure in 2016, compared with less than $1 billion 10 years ago.

“It’s very easy to understand why they want to do it,” says Lerner. After the 2 percent management fee and the 20 percent share of profits typically charged by fund managers — the “2 and 20” — net returns from investment funds have been meager at best. “People are like, if we could only get the magic of private capital without the drag of the 2 and 20, we’d be doing great,” Lerner says.

It’s an argument familiar to Angelo Robles, founder and CEO of the Family Office Association, a trade group of wealthy private family investors. “By far the biggest investment trend is [family offices] being more active as direct investors,” says Robles. Combined with other market and technological pressures facing the buy side, “the world of finance is in for a major shake-up,” he adds, as the nimble assets of family offices and other sources of liquid capital move toward abandoning intermediaries.

Not everyone is convinced that direct investing will be the new normal forevermore. “The more people that are playing this game of trying to short-circuit or bypass funds, the worse they are performing,” says Lerner, “presumably because there is more competition.” He continues: “So in an era like today where it seems everyone’s trying to do it … I tend to be a little bit more on the cynical side” about whether this marks a permanent shift or not.

So, what are prospects for the combined trends of direct investing from the top and passive investment from the bottom collectively cannibalizing Wall Street’s investment services? “You are likely to see a shakeout in the active management space,” says Vasant Dhar, a professor at New York University’s Stern School of Business, who adds there will “probably” always be a place for human-managed funds. While machines might take all the remaining jobs in short- and medium-term money management, long-term quality judgments of companies remain a distinctly human quality, he argues.

Nevertheless, the financial services industry might finally be undergoing its long-awaited disruption. “You can see a lot of sectors in financial services where disintermediation is gonna happen,” says Lerner — the fancy way of saying eliminate the middlemen. But for some the threat is more imminent than others: “If you’re an actively managed mutual fund,” Lerner says, “the writing is on the wall. The party is over.”

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