McKinsey & Co. has posted a new report assessing the state and the future of the North American asset management industry, encompassing both active and passive managers and looking at five mega-trends.
Skipping to the chase, the trends are these:
- The end of an anomalous eta of “exceptional investment returns.” McKinsey estimates average return on equities will fall between 150 and 400 basis points below what has long been expected, triggering “urgent needs across client portfolios.”
- Clients will re-examine their beliefs and relationships, catalyzing an unprecedented shake-up in active management. The shake-up will force greater efficiency in platforms, the development of “new levers for value creation,” and better risk budgeting as product differentiation.
- This shake-up will also contribute to the third big trend, “a boost in the steady stream of assets moving into alternative investments.” Investors will have to seek higher returns in illiquid private markets, especially in real assets, and even more especially in the infrastructure space.
- The digital revolution accounts for the fourth trend, allowing as it does for “vast improvements in the effectiveness and efficiency of operating models,” allowing in turn for “operational alpha.”
- Finally, there will be a tightening of regulatory requirements that “will force asset managers to reframe their distribution relationships and retool their products to position themselves as fiduciaries.”
Thirty Years Ago
Going back 30 years, one comes to 1986. In that year, Mikhail Gorbachev first stressed the words glasnost and perestroika to a Congress of the Communist Party of the USSR; Microsoft first offered its equity to the public; and the London Stock Exchange abolished fixed commission charges, enjoying its Thatcherite “big bang.” It broader terms, the bitter Volckerite medicine of the early ‘80s in the United States had by then clearly succeeded. The Dow Jones began 1986 at 1,500, and by the end of the year it was closing in on 2,000.
In retrospect, the period that began at that time has been characterized by low inflation, low rates of interest, the availability of rapid growth in the People’s Republic of China (which has fueled growth everywhere else), the rise of automation in ways til then inconceivable, and consequent robust corporate profits.
Unfortunately, a reversion to historic means is setting in now, and will likely dominate economic statistics over the next 20 years.
Masking the Reversion
Central bankers have sought to mask the reversion to the mean in recent years by unusual policies that have created “an extended wave of beta that has lifted even weaker asset managers to respectable performance.” This extended wave has only helped ignore troubles, and the industrialized world is now reaching the awkward moment when the reversion can no longer be delayed.
Over the last 30 years, U.S. equities have shown an average annual return of 7.9%. European equities have done the same. But even with an optimistic recovery scenario, McKinsey estimates that the average over the next 20 will be 6.5% in the U.S., 6% in Europe. Under a slow growth scenario, they put both U.S. and Europe returns at just 4%.
Institutional investors, pension funds especially, will be left with a gap that they’ll have to fill. The assumed portfolio return for U.S. public pension funds is 7.6%, and this has been a somewhat reasonable goal of late given the equity market return just noted. But given a traditional 40/60 portfolio, recent performance of late has been 6.7%, creating a gap, “or need for alpha,” as the study says.
On the premise that the expected returns are headed down long-term, that gap will grow and that need will become more pressing. Given optimistic assumptions, and sticking with that 40/60 portfolio, the return on public pension portfolios will be 4.7% in years to come, or 2.9% below the assumed return.
Assuming that there will be such a growing gap and that alternatives will be called upon to fill it: which alternatives? McKinsey’s answer in simple terms is, “investor confidence in hedge funds is waning, while private equity continues to meet investor expectations.”
The demand for gap filling investments will flow nicely into certain real world needs, so the North American public may benefit from a lot of investment funds becoming available for infrastructure projects.
By a coincidence of timing, the Minnesota Center for Fiscal Excellence recently posted its own thoughts on this last point, under a title and subtitle that together say it all.