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Professional money management involves two sides. On the one side, you have the need to provide risk-adjusted returns to clients whose objectives are diverse: growth, asset protection, and risk management being top of the list.
On the other side, there is the need to convince investors of the value of your active investing acumen. Whether this is down by demonstrating a track record, a dedication to a particular proven investment philosophy, or by providing unique ideas based on financial and/or industry knowledge, money managers need to convince their clients that they provide a service worth paying for.
For years, particularly in the heady days of the 1990s and 2000s, this was fairly easy to do. Great volatility, strong returns for alpha-yielding strategies, and unique opportunities unavailable to or misunderstood by the majority of people provided opportunities for money managers to deliver a valuable service to clients.
Since 2008, things have changed. Now that we are in the sixth year of a strong and consistent bull market after one of the biggest crashes in human history, both retail and institutional investors are getting impatient with active management. Pointing to studies where passive investing outperforms active investing, or studies where mutual fund managers underperform indexes on average, many investors are beginning to eschew the active management world and throw their money in index funds.
While this has begun to distort the market, we may be in the beginning of the passive indexing revolution. Some research suggests that about 10% of S&P 500 assets are passively managed, and passive funds grew by almost 20% in AUM during 2013. In 2014, Vanguard’s index funds alone have seen over $100 billion of inflows so far.
Likewise, many younger investors are attracted to low-cost investing while discounting the possibility of sustainable alpha delivery. The growth of software-based asset management firms that help individuals minimize fee expenses, such as Uber founder’s FeeX, don’t even bother projecting potential returns for actively managed funds, instead pointing out to consumers how much money they can save on fees by investing in low-cost index funds.
For active money managers, this trend is either an annoyance or an existential threat. Many active funds have seen outflows year after year, and outflows are accelerating for some products. Hedged strategies are also seen as particular duds, because they are not delivering greater returns relative to the S&P 500.
Of course, all of this is symptomatic of a strong bull market. When the entire market is rising, shorting anything will drag down returns.
However, this does not mean the demand for finance professionals is disappearing. There are many reasons for this.
For one, many high net worth individuals and institutional investors look to allocate funds for asset protection. Hedge funds and long/short strategies exist not only to augment returns, but also to adjust for risk. In other words, these investors realize that a long/short book will underperform bull markets, but that’s okay—because it will also outperform a bear market. And while we’re in a bull market now, it will not last forever.
Secondly, there are several additional aspects of finance that require more active management. Several mutual fund companies, for instance, are investing more seriously in private equity, where valuations are unclear and performance can be stronger than in the public market. Additionally, many funds are looking at combining convertible debt, preferred stocks, and bonds to augment returns while minimizing risk, and while also providing exposure to other markets that are not captured in the S&P 500 or another vanilla index fund.
Finally, there is the growth of so-called smart beta funds, which are passive funds tied to alternative indexing strategies that may outperform the S&P 500. Some companies, such as WisdomTree, have seen tremendous growth by capturing smart beta strategies that work consistently over time. While smart beta is growing and outperforming, there are still many smart beta strategies that are not yet captured in a fund and which may attract more funds in the future. The analysts of tomorrow will be the ones to design these smart beta products, and to profit from them.
There is still room for active money management in the market, although demand is currently weak. A bear market or at least growing volatility will cause an upheaval from the passive investing masses, as they realize that a steady dollar cost averaging in an S&P 500 fund is not a guaranteed way to make money all the time in all markets. At that point, risk-aversion will kick in and investors will be clamoring for strategies that minimize losses, even if they fail to deliver above-index returns. We’re not there yet, but it will come eventually.