Blending Insights. Current European industry perspectives on blending active and index products. May 2014

Transcription

1 FOR PROFESSIONAL CLIENTS /QUALIFIED INVESTORS/ INSTITUTIONAL INVESTORS ONLY Blending Insights Current European industry perspectives on blending active and index products May 2014

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3 Table of contents Introduction... 2 Executive summary... 4 Current industry practice... 7 Catalysts Trends in indexing and blending Methods for blending Challenges and obstacles to blending Lessons on indexing and blending Looking to the future Conclusion Blending Insights: Table of contents 1

4 Introduction Introduction It is a time of rapid change in the European investment landscape. A challenging post-financial crisis environment is driving the need for greater diversification to seek returns and manage risk. Investors are diversifying across a wider range of asset classes, making more use of tactical strategies and demanding more flexibility in the products they use. The low yield world is focusing investors on the costs of investing, while changing regulation is leading to greater alignment between clients investment portfolio choices and their risk-return profiles. Together these factors are transforming the use of active management, indexing and the blending of investment styles across the asset management industry. We are consistently asked by clients how other professionals are approaching the question of whether and how to blend active management and indexing. Often we find that this discussion remains mired in an active versus passive debate. As a result, we set out to better understand the current thinking of individuals and institutions. To do this, we interviewed 35 advisory, discretionary and multi-asset institutional businesses based in 8 EMEA countries, namely Netherlands, Switzerland, UK, France, Denmark, Germany, Israel and Italy. We met with wealth and private bank advisory fund selectors, discretionary and multi-asset institutional portfolio managers, and research and ratings houses. The participants interviewed oversee approximately 2.4trn assets in the active fund, indexing or blending space for corporates, insurance companies, charities, high net worth individuals and retail clients 1, including: ``Five of the top 10 global private banks by Assets Under Management (AUM) 2 Our respondents embody a broad selection of the European asset management industry: the range of participants included those with predominantly active, blended or passive investment processes. To gain insights into how they approach blending we asked: ``How far have they moved down the path of blending, if at all? What has influenced them along the way? ``Where are they using active management, indexing or both? What methods are they employing? ``What has catalysed them? For those that haven t begun blending, why not? ``What challenges and obstacles in blending are they facing? ``What advice on this topic would they give others? ``And finally, what is their view of the future? Some of our participants insights into the dynamics of blending were unexpected; especially the impact that values and philosophy have on blending investment processes. These insights, in our view, are helpful to firms in reviewing their management of assets from an investment and business perspective. Specifically, they may assist in process appraisals against alternative approaches, drawing attention to key factors to consider and ultimately determining the right goals for organisations. ``Private banks with estimated AUM of 1.2trn in Europe 3 ``Multi-Asset institutional funds with approximately 142bn of AUM 4 1 Source: BlackRock, end Source: Scorpio Partnership Private Banking Benchmark Source: Interim financial statements of respective private banks, June 2012 and estimates from BlackRock. 4 Source: BlackRock, end Blending Insights: Introduction

5 The growth of indexing and blending The need to consider all aspects of active-indexing investment is very evident when the market share growth of indexing in AUM in Europe is considered. Indexing, through index mutual funds or Exchange Traded Funds (ETFs), now accounts for over 12% of AUM in the European asset management industry. This represents a doubling over the last six years. The growth of indexing has contributed to the increased combination of active management and indexing within blended strategies. 5 Introduction AUM split of active and passive European funds 5 100% 95% 90% 85% 80% 75% 70% Feb-14 % of AUM in Active Funds % of AUM in Index Funds % of AUM in ETPs % of AUM in active funds % of AUM in index funds % of AUM in ETPs 5 Source: Simfund, BlackRock. Please note: This data is for European domiciled funds, which excludes AUM in Cayman Islands, British Virgin Islands and Bermuda domiciled funds. Blending Insights: Introduction 3

6 Executive summary Executive summary There s no black and white answer. That is probably the biggest lesson we ve learnt. * The issue of how to approach blending is often seen as the search for the optimal balance of instruments that will yield one definitive answer to be applied to all portfolios. The reality is very different; as one participant put it, it s art more than science. What makes this the case? It is not just the lack of a single solution to blending but also the broader factors and influences that impact investors overall approaches. Investment philosophy is key: whether a participant focuses primarily on asset allocation and/or fund selection, their conviction in active or passive management and the characteristics of their client-base all help define their overall thinking. Typically, these are the starting points for how and whether a respondent engages in blending and indexing more so than any analysis of what market may or may not be efficient. There is no single answer to blending: we find our participants blending methodologies to be a mixture of quantitative analysis and qualitative judgment or, in some cases, a perception of what s best. With no single agreed method, the most oft-cited consideration is an assessment of asset class efficiency. While the majority make this their starting point, others challenge it, focusing on what is available for that exposure at any given time. The need for a dynamic blending process is required given the market cycle, varying investment time horizons and changing correlations. Shifting to a blending strategy is not easy: For European advisory businesses, one obstacle is the current rebate-based revenue model. In the multi-asset institutional and discretionary space, those coming from an active management background can find taking full advantage of indexing a challenge. The existence of an in-house asset manager can create tension within an organisation when switching funds; yet can be of benefit given the additional transparency they offer relative to external funds. Stakeholder management is essential. Across all businesses, respondents found that adopting indexing and blending requires them to re-think their value proposition and how they communicate their product line-up to their clients. What is driving this change? One of the main catalysts is a combination of rising client awareness of indexing, and growing sensitivity to costs in a post-financial crisis world of lower yields and lower expected returns. The increasing importance of asset allocation, including more tactical investing and a tougher environment for active management, has also led many respondents to use indexing and blending for the first time. Concentrated in certain countries, namely UK and the Netherlands, regulations are driving firms to re-think entire business models. While most of the focus is on the impact of no more rebates on the advisory revenue model, regulators are also forcing businesses to take greater consideration of client suitability, appropriateness of advice given clients riskreturn profiles and the balance of financial products in discretionary portfolios. Blending often evolves: what is surprising is how many of those that do blend found their investment approaches evolved from experiences rather than a strategic decision. This is often reflected in the way they have begun to use blending and indexing: evolving gradually from cash flow management and tactical use to full blending across strategic portfolios. Once businesses start to utilise indexing or blending, a key consideration is how firms fit these new solutions into their existing product line-ups and communicate what their new value proposition is. * Please note: The citations used throughout the document are direct quotes from our respondents. 4 Blending Insights: Executive summary

7 From these experiences, what advice did our respondents have? Blending is a learning curve: active management and indexing products require different operational and implementation knowledge to be developed. Don t shy away from adapting the product offering due to the fear that clients won t accept it but remember communication and a focus on costs are key. Key findings: three identities emerge Actively Active (30% of participants) These participants are currently focused on using active management to generate alpha. Indexing, where it is used, is only for cash flow management or as a last choice if other (stock selection or active fund) alternatives are unavailable. A high level of conviction in active management and focus on active fund or stock selection is a key consideration for these managers. Within the discretionary management space 40 per cent of our participants are Actively Active. A minority of these are under increasing external pressure to start blending but yet to start. Others, including a small minority of our multiasset institutional fund respondents, are comfortable with their primarily active fund/stock-selection approach and have no intention of adopting indexing or blending in any meaningful way. Among the advisory firms two thirds of those we spoke to are Actively Active; their current revenue model being one obstacle to adoption of indexing on their platforms. Embracing Blending (25% of participants) For those engaging in blending, their development varies. Approximately one-third of discretionary managers and 20 per cent of multi-asset institutional managers are here: either adopting indexing for tactical or short-term exposures, or moving towards a more comprehensive approach to blending. Catalysts such as client-demand, the market environment and active management s relative performance are balanced for some against a historical position as active-only managers and fund selectors. Dealing with the internal and external obstacles to blending is therefore a key focus. While initial catalysts for doing so have typically been external, many find internal momentum grows where they see the impact on business and client reception to be positive. The rest of our advisory participants are typically Embracing Blending and indexing on their platforms by moving to a fee-based business, especially for new clients. In fact, the introduction of more model-based advisory as part of the new fee structures is blurring the line in terms of value proposition between advisory and discretionary. Agnostic Allocators (45% of participants) Finally, we find respondents with a more agnostic process for blending and the use of indexing. A primary focus for them is to deliver alpha through asset allocation with the vehicle for implementation often a secondary consideration. 25 per cent of our discretionary and 75 per cent of our multi-asset institutional respondents were typically agnostic. Some respondents are now finessing their blending processes to see how far they can go with all the tools at their disposal. Others have focused on building index-only products, either as an end-game or a step towards a blended offering. Regarding the future Our participants gave us enlightening views on where the industry may be headed: 1. The expectation of fee and margin compression across the industry is strong. 2. There is a high level of consensus across all identities that there will be a shift away from the middle ground of active management towards indexing for beta on one hand and higher active alpha on the other. The middle ground is defined by many of our participants as active managers centred on close-to-benchmark portfolios. 3. Other participants question what indexing will mean in the future as this investment process continues to evolve. 4. In advisory, the post-retrocession world, while creating a more level playing field for indexing and active management, could herald a barbell shift by end investors towards discretionary and execution-only services. Where does blending go? Most respondents share the view that blending and indexing will continue to grow as participants develop their methodologies and product offerings. But is this trend inexorable or will there be a tipping point? A point, some believe, where the greater adoption of indexing creates more opportunities for alpha and a reversal towards active management. We shall see. Executive summary Blending Insights: Executive summary 5

8 Executive summary 6 Blending Insights: Executive summary

9 Current industry practice Current industry practice Blending Insights: Current industry practice 7

10 Current industry practice We start by examining the broader factors that influence the way our respondents Current industry practice approach the use of indexing and blending. Investment philosophies I ve been a fund selector for so many years, and I have to believe that I can add value through selecting funds. Fundamental conviction in active management Many of our respondents have come from a background of active management, whether as fund selectors, active managers or independent financial advisors (IFAs). Their historical position is one of active works and a primary focus on stock or fund selection. Amongst the respondents who are Actively Active, there are those who are focused on adding value through fund selection and feel under no pressure to embrace index products. In their words, they have been able to demonstrate that by going through a thoughtful and considered process, we can identify managers we believe will deliver their objectives and therefore produce a bigger return than you can get from just getting market exposure. Some with active-only discretionary products highlighted that while their firm historically has had a high conviction in active management, the simple reason for not utilising indexing or blending is that the business is not ready yet. For others the journey is just starting: Up till now we ve been of the school that says alpha exists, but we ve now come to a point that we agree it could be useful to use index products. This manager is considering using indexing for core beta where previously they have been comfortable using middle ground active managers. Finally, we find investors coming from a position of historical conviction in and use of active management and now Embracing Blending. Understandably, the shift to blend and introduce indexing has been a challenge given their starting points. A large discretionary manager reflects: We were quite anxious at the beginning. What does it do to your earnings model? And how will clients respond? For those who have done the difficult part of training themselves on indexing products and risks, the question they now face is what can we actually do with these tools? Agnostic to active management or indexing At the other end of the scale we found respondents who hold an agnostic view towards active management and indexing, our Agnostic Allocators. This is most prevalent in the multi-asset institutional segment. As one multi-asset institutional manager explained: So, we really try to go from an agnostic standpoint, throw it all in the machine and purely from a quantitative perspective, as emotion free as physically possible, to say is it possible for a fund selector to find value? Whether a portfolio is positioned through active management or indexing is driven by the investment case, rather than a commitment to a particular implementation style. This is a view that has grown in recent years as asset allocation has increased in importance for many professional investors. As a result, for them active management or indexing has become just a vehicle to deliver the right exposure: We ve always said the primary point for us is getting asset allocation all right. How you implement that asset allocation pool is a secondary decision. 8 Blending Insights: Current industry practice

11 One institutional manager felt that to implement a multiasset investment process, it was important to look at all the tools that you have available and assess whether those tools make sense, rather than just say: active management is this, passive management is this. Resources play some part in these decisions. A number of institutions told us they have developed their business around asset allocation due to the lack of resources they can dedicate to fund or stock selection. As this lack of resources is addressed, the next step in their evolution could result in a greater use of active management vehicles in the future. Additional investment criteria What other elements of investment philosophy determine active or indexing usage? A manager weighted towards active management explained that the key driver of their investment philosophy was sustainability (or socially responsible investing). The use of active funds or their own stock selection was driven by the fact that most of the indices that indexing products track don t qualify as sustainable. Another multi-asset institutional manager emphasises transparency or predictability in their choice of investment process. This has led them to adopt a high weighting of indexing instruments in their portfolios not because of any bias against active management but because they see a cost of active, because it makes things less transparent for us, as an asset allocation-driven style strategy. The need for focused delivery to their clients So, the reason for doing it was to meet the client s needs. They (the clients) said we want to deliver performance in a certain volatility range, whilst keeping the price down. We thought the most efficient way of doing that was to have a core of passives. The third key driver of how professionals approach blending is their client base. The key point is that the demands of the specific client, for example for low-cost solutions or certain benchmarks within an asset class can, and will, over-ride the firm or team s conviction concerning implementation. From an institution s standpoint, whether it is advisory, discretionary or institutional multi-asset, do they sell asset allocation, stock or fund selection, or a combination? For example, when discussing the challenges to greater use of indexing in the advisory industry, one of the largest advisory businesses in Europe noted the importance of what you hang your value proposition on in terms of what you re charging your client for. In their view, a client who values asset allocation makes it easier for the advisory business to become agnostic between active management and indexing exposure. However, if the end client valued research or fund picking, then picking an ETF actually detracts from the value proposition that the client values. Across advisory, discretionary and institutional multiasset, there are varying levels of client engagement in the management of portfolios. Multi-asset institutional/discretionary In the multi-asset and discretionary businesses, we identified a difference between institutional end-clients and retail/wealth clients. Retail/wealth clients: Many discretionary managers highlighted that the main focus of their retail/wealth end-investors was on performance and cost. According to one manager as long as that performance is ahead of benchmark, then the client doesn t much care what building blocks are used to deliver it. Institutional clients: For institutional clients, however, the clients are more discerning about the constituents of their portfolios. In the words of one multi-asset institutional manager, they re much more prescriptive about the types of instruments you can use. In fact, another multi-asset manager felt that having a comprehensive methodology for blending was a competitive advantage in the institutional space. As regards pension fund mandates, a manager explained the impact of changing regulation on how their clients interact with them: Of course, the regulator tells you that you are in charge of their portfolio. Even if you choose a fiduciary, you are still in charge and you don t just say, great, tell me in ten years what happens. A key factor in whether the institutional end-investor drives a manager to implement investment views via active management or indexing vehicles is cost. One institutional manager claimed that in their experience, large institutions with pricing power have been a driving factor towards their greater use of indexing. Advisory On the advisory side, the dynamic is very different with the ultimate decision for an investment and its implementation sitting with the end client. As a result, having a full offering across the active management-indexing landscape is increasingly important. In the view of one advisory manager, regardless of your own opinions, you need to be able to cover all the bases anyway. As such, irrespective of what they may want to recommend, he felt that his private bankers will be ultimately guided by the views of their clients. Current industry practice Blending Insights: Current industry practice 9

12 Other client characteristics Interestingly, respondents also highlighted the impact that age and domicile can have on their use of blending and indexing. Several highlighted the preference of their older investors for individual stocks and bonds whereas, according to one participant, my personal feeling is that the younger investors are much more in favour of investing in ETFs. In advisory, what is your business structure? Finally, in the advisory space the structure of the business is a very important determinant of how active management, indexing and blending are actually implemented. While some firms have a centralised process, this is not always the case. Current industry practice One global advisory manager highlighted differences driven by the location of their end-investors. According to them, the US and Asia lead the way in the adoption of indexing due to being more transactional markets whereas European investors are more driven by long-term considerations. As a result it was important for their business to adapt their offering for each jurisdiction. Current industry practice One advisory head explained how in their firm, the advisor is king. As a result, the fund selection process breaks down as the advisors don t need to follow the fund buy list when constructing client portfolios. It is unclear how this structural influence will evolve as much of the industry moves to fee-based models. ` `The level of conviction towards active management is a key driver of whether or not to blend. An agnostic starting point typically implies a greater use of blending and indexing. ` `Criteria such as socially responsible investing or transparency often drive investment style. ` `Client demands can govern implementation, especially for businesses with institutional clients. ` `In the advisory business, the level of centralisation in a business is an important determinant of blending and index usage. A full offering across the active management-indexing landscape is increasingly important. 10 Blending Insights: Current industry practice

13 Catalysts Catalysts Blending Insights: Catalysts 11

14 Catalysts What is driving professionals to change their investment approaches? Through the course of our conversations, we identified several catalysts, most notably the impact of client demand, cost constraints within the current challenging investment environment and changing regulation. Catalysts Client-driven Unsurprisingly, client demand was highlighted by all our respondents as a major catalyst. Multi-asset institutional/discretionary Many discretionary managers are finding that to meet their clients needs, they have to deliver performance in a certain volatility range, whilst keeping the price down. As a result some felt that now the most efficient way of doing that was to have a core of passives, depending on their level of risk tolerance. Clients are now challenging managers choice of vehicles more and more: they have seen certain markets where they believed they would have a good performance and then the active manager got it wrong. So they don t want that risk anymore. Their reaction is to say: Just give me the benchmark and at least I know what I m going to get. Questioning by clients is playing a key role in pushing some of the more reticent Actively Active businesses to the point where they acknowledge the usefulness of index products. Their clients expectations are such that index products are expected to play a role in their portfolios. One such participant commented: There is some expectation in investor communities, in the market, that passive products should play a role in people s portfolios. They noted the importance of the media in making clients more aware of relative performance to a benchmark now, than they were five years ago. Advisory In advisory, clients want greater flexibility and place a higher premium on liquidity. For example, one business commented: The inclusion of ETFs into the recommended list started about one and a half years ago due to client demand, as ETFs offer the most cost efficient way of managing some asset classes, especially if these asset classes are overweight tactically within their portfolio. A large private wealth business highlighted the impact of client awareness by stating that since their clients were now aware of the existence of index products, it was necessary to embrace them rather than just treat them as the scary alternative to retail funds. Regulation As expected, regulation was identified as a major driver. While this is widely acknowledged in the advisory business with the UK Retail Distribution Review (RDR), regulation is also impacting blending and index usage in the discretionary business. The main countries where this is occurring are the UK and Netherlands but the extent to which the regulator is perceived as influencing the choice of different products across different regions varies. In particular, the Dutch regulator, the Authority for the Financial Markets (AFM), is seen as encouraging particular types of products, while the UK regulator, Financial Conduct Authority s (FCA) guidance is more focused on the suitability of funds for end investors. In the Netherlands, a Dutch discretionary respondent described how the AFM has seemed to take a pro-indexing approach: The regulator has played a very interesting role here. A few years ago they were more or less telling everybody you should offer passive over active and I remember the asset managers at that time were quite astounded that the regulator was taking such a pro-passive approach. This pressure from regulation is felt across different types of investors, highlighted by a large Dutch pension fund manager drawing attention to the fact that the trustees of pension funds are finding indexing exposure easier to justify on a risk-return basis than active fund exposure. According to the manager: The regulation is not outrightly saying, You have to go passive but, of course, the trustees have to justify what they are doing and it s easier for them to 12 Blending Insights: Catalysts

15 justify a passive selection than an active selection, which is inherently more risky in their mind. Unlike the AFM, the UK s FCA is not perceived as directly steering the investing community towards one type of investing. Instead, UK regulation is described by a number of clients as being very focused on two issues: ``the suitability of investments for the end investor; and ``the investment process rather than investment performance. A market participant claimed that the regulators are not worried so much if it works, but more about if it s suitable for that particular risk profile. Linked to suitability of product for clients is the issue of transparency. One of the consequences of more regulation is that transparency is seen as a key differentiator of financial services companies. It is perceived that index investing provides an attractive level of transparency. Across regions, regulators are encouraging greater emphasis by market participants on justifying investment decisions and tailoring products to clients risk tolerance levels. Discretionary and advisory businesses are encouraged to screen clients to determine their risk profile and match investments to those profiles. The regulators are seeking to ensure that a range of different solutions are on offer, increasing the likelihood that investors are advised to invest in appropriate solutions. In the opinion of one market participant, the regulator is trying to make sure that solutions are not too simplistic. Solutions could be an income producing solution, a growth solution, a capital preservation solution or a drawdown solution. The increased transparency that changing regulations are generating is a trend that anyone who leans against will be hurt according to one discretionary manager. In his view, anyone who embraces that trend will have a competitive advantage and that clearly passive solutions are in a much better place than active solutions to provide that level of transparency. In the words of another, as an industry: We need to rebuild trust. And there passive helps, because it s transparent. Impact of current investment markets The starting position on returns on equity and fixed income does not do the trick anymore, so you have to do more, you have to be more diligent. strategies to add value. In addition, low yields and returns in markets have ensured that it is no longer possible to just invest in a combination of core equity and bond investments, and expect to deliver a targeted return. These changes in investment markets have been a catalyst to stimulating a greater focus on indexing and the need to blend within investment processes. In summary, a number of current market factors such as: ``the era of low yields and low returns; ``the greater need and opportunities for tactical strategies; ``the requirement to protect active fund exposure; ``the use of index products in enhancing cash management; and ``the need for greater liquidity have led to the increased blending of products in multi-asset portfolios. Cost If we are in a lower return world, then the cost on a relative basis (active versus indexing) will matter more. A key catalyst to blending is the increased focus on low cost solutions by clients, managers and IFAs. Given the difficulty of achieving high returns in a low return environment and the need to enhance risk-adjusted returns through effective asset diversification, the costs of investing are increasingly important. The low cost structure of indexing products is therefore making managers consider them increasingly attractive. For large institutional pension funds, one manager claimed that in a nutshell, we do two things: Take active fund risk where we think it makes sense, and do it as cheaply as possible. Apart from minimising costs to the client, a benefit of blending more index products into the investment process is that net performance figures are higher. This was referred to by a large discretionary client: The less cost we have, the better my performance looks, compared to the index of course. While on the advisory side, businesses will have to justify their existence post RDR as they re providing a service, rather than a transaction. Catalysts Over the last few years the breakdown in historical asset class correlations and the increased volatility of capital markets has increased the need for effective asset allocation and provided more opportunities for tactical Blending Insights: Catalysts 13

16 Catalysts Performance of active funds The relative performance of some active funds in recent years was highlighted by respondents as another major catalyst for indexing and blending. According to one institutional asset manager: In the last couple of years not many active managers have delivered, even in asset classes like high yield and emerging markets, the areas where you would expect that in difficult markets, active managers would actually add value. Some predominantly active discretionary managers described how recent years had made them consider the use of index products as we have seen a number of years when active management has found it quite difficult to outperform. This view was shared by another Actively Active asset management team who commented that although they outperformed in 2008 and 2009, the top down thematic market of the last two years has convinced them that blending has a role in their investment process. One manager considering embarking on blending stated that: Personally I am convinced that it is useful to have active management, now and in the future, but the experience in 2011 and, partly 2012, makes it clearer that we should also have an important part of our portfolio in the passive space. For many, 2008 is referred to as a watershed: Let s face reality, you know, adding alpha post 2008 is more complicated. Growth in index product range On the indexing side, the range of products has grown sharply. As awareness and education has improved, it has persuaded more teams to use them more broadly. One multi-asset institutional manager felt a key driver for their indexing usage was that over time our knowledge on the team about ETFs has increased. This point was reiterated by another large manager: I think the market has grown up to understand what tool they re looking for and then what the best instrument to use is. So you can shop around seeking a good passive fund. Business opportunity The final catalyst we identified is the business opportunity that blending can offer based on the potential priceperformance mix, and recognition of the gap between the cost of active and indexing funds. One discretionary business claimed that an attractive fund proposition to them was a combination of active asset class allocation, implemented through active funds and index strategies at the right price point. So, between the two, a pure active or pure passive is an opportunity for us to fill the gap with a range which played to our strengths. As the industry and client demand evolves, the business opportunity of embracing a blending strategy within a product line-up could be a key catalyst going forward. What are the catalysts? ``The key drivers of blending include cost, regulation and client-demand. ``Client demand for lower cost, more liquid solutions is rising with greater awareness of indexing. ``Regulation: For advisory businesses, especially in the UK and the Netherlands, new regulation is changing the revenue model that has historically favoured active management. For discretionary, some regulators are seen as influencing the choice of products, favouring more indexing. ``The challenging post-crisis market environment has led to more strategic and tactical asset allocation and hence a need for a broader range of products. ``Relative performance of active managers in recent years and the growth of indexing availability are contributing to greater blending. 14 Blending Insights: Catalysts

17 Trends in indexing and blending Trends in indexing and blending Blending Insights: Trends in indexing and blending 15

18 Trends in indexing and blending While there are many factors that are influencing the way different respondents approach blending, we can identify clear trends in the adoption of indexing and blending by businesses and how these tools are being used. Trends in indexing and blending Was the shift to blending or index product usage strategic or did it just evolve? One crucial observation from our conversations is that for many, this is something that developed often out of one experience. According to one discretionary manager who has embraced blending over the past three years: It sounds strange, but there was not a time when we sat together and said: okay now we re going to do this. It more or less evolved. Often the decision to think more strategically about blending was triggered by a specific investment event. Several managers described experiences of where due to risk management or investment opportunity, they used indexing for the first time. A large multi-asset institutional manager spoke of a confluence of events whereby the combination of low valuations and new money coming from a region where they had no manager research capability, led to a growth in indexing usage. One discretionary manager related how all of a sudden we realised that we had quite a substantial part in ETFs and they performed quite well. Then the demand from the private bank came as well. So the idea started to evolve that we could offer a dedicated passive mandate. However, this is not always the case. One advisory firm reflected on how their adoption of blending came out of a strategic decision to re-think their product line-up and shift to a fee-based model. Where to use in discretionary and multi-asset: core, tactical or just ancillary? In the discretionary/multi-asset institutional space, we found that the way investors use indexing varies widely, from full adoption of blending strategies to tactical asset allocation to just cash flow management in a predominantly active management mandate or portfolio. Full adoption Our Agnostic Allocators have taken the step to incorporate indexing as an implementation option across all parts of their portfolios, core and satellite, strategic and tactical. This might be either through fully-blended portfolios or in indexing-only portfolios. Those participants who are Embracing Blending also tend to be incorporating indexing into their core usage. Tactical asset allocation As we highlighted in <Catalysts>, a driver of blending has been the growth of tactical asset allocation (TAA). Often we found that a positive experience in TAA was the introduction to indexing and opened the door to more core or strategic use across portfolios later on. If you place a high emphasis on tactical asset allocation and think that this is going to be your most important driver of active returns, then it might make sense to actually not really spend that many resources on selection, and use ETFs to express your Tactical Asset Allocation. 16 Blending Insights: Trends in indexing and blending

19 An Actively Active discretionary manager, who is considering starting blending, highlighted this as an area that attracts them both from ease of implementation and burden on operations: It s very efficient for us to take a position, underweight equity or overweight equity, with just one product. Traditionally if I say I want to go underweight equity and I have, for example, 35 individual stocks in my portfolio, I would have to sell 5% of every stock. The same manager says they could see the potential to grow index product usage in the advisory business as a way to help clients implement the firm s tactical calls. The sentiment was echoed by a large wealth manager who prefers to use indexing for tactical asset allocation, especially for smaller clients given the cost. A key benefit of using index products for tactical shifts is the negative impact that frequent changes in allocations have on active managers. Having a liquidity sleeve in their portfolios enables the implementation of tactical strategies, while allowing the active fund investments to remain intact. This is particularly important as the active strategic investments often have a longer time horizon. According to one multi-asset institutional manager, while you can trade in and out easily using indexing tools, you can t give money to somebody you just appointed for a benchmark plus three mandate and then tomorrow say: I ve a negative view on equities, and take your money away. Cash flow management Related to tactical allocations is the need for discretionary and multi-asset institutional funds to manage cash flows, an area where indexing can be used as a buffer. Indexing, especially ETFs, is particularly useful in this regard when managers get notification flows into their funds after the cut-off time to invest on that day. This was a particularly common use cited by a broad range of respondents. Notably it is also the one area where Actively Active managers who aren t planning to adopt significant use of indexing do use index products. The main reason for passive vehicles is to manage flows and exposures, which you want to manage in a very efficient, low transaction cost way, without disturbing your active managers. Risk control reduce tracking errors in volatile times A fourth specific use of indexing is in portfolio construction, helping to control the volatility of a portfolio given a risk budget. For example, one participant who manages pension money described the value indexing brings to them in controlling tracking error in a portfolio given a certain funding ratio (the ratio of a pension plan s assets to its liabilities). So we use it a little bit to control that active risk, to keep it within the parameters that are given, either by the clients, i.e. risk-taking willingness, and of course the funding ratio, which is the risktaking ability. Advisory is lagging It s more difficult in advisory. In discretionary 35% is passively managed. If you look at the advisory portfolios you see around 5%. It is clear that the adoption of indexing and active management together is at a more advanced stage in the discretionary and multi-asset institutional world than the advisory space. One obstacle to adoption in the advisory space, the revenue model, is discussed in <Challenges & Obstacles>. Importantly, several advisory managers also highlighted the competition to indexing from individual stocks and bonds in the advisory space, as a result of clients preference for individual securities in their portfolios. Where advisory indexing adoption has increased, is in firms that have shifted part, or all, of their books to fee-based models and developed discretionary-like model-based advisory businesses. One advisory business drew our attention to the fact that a key change in their business was that active funds are now only included on their recommended list if they are outperforming a comparable index product. However, as we highlighted earlier, the impact of this can depend on how centralised the decision structure is within an advisory business. Trends in indexing and blending Blending Insights: Trends in indexing and blending 17

20 Blending within product line-ups When institutions think about building a process for active management, indexing and blending, a key point to consider is what the product line-up will be. We found that how a new index-only or blended product would fit with existing products was something that was not as well thoughtthrough as might be expected. Broadly we found three approaches: 1. Mixing within asset classes within mandates: these firms offer fully blended products where their blending approach combines active fund and stock selection with indexing within and across asset classes. 2. Mixing within mandates but deciding for each asset class: these firms, while going down the blending route in terms of offering a blended product, have generally decided by asset class where to use active funds or indexing tools. 3. Not blending within mandates: finally, some firms are more comfortable offering active fund or indexing products in their line-up. For example, they have launched an indexing-only product to fit alongside an existing active multi-manager product. One reason given was the difficulty they felt in explaining why a product was part actively managed and part indexed. By only offering non-blended mandates the decision is put back into the hands of the client so that it s not the firm that has to make the recommendation. Trends in indexing and blending Trends in indexing and blending ` `While some firms have made strategic decisions to blend, for the majority it has evolved out of one or two experiences. ` `Tactical asset allocation is a common entry point - often opening the door to full adoption of blending. ` `The need to give active managers time to deliver leads all types of investors to use indexing as a buffer for tactical or cash flow management. ` `The advisory business is lagging in blending partly due to the historical revenue model. Where this is changing is for firms who are shifting to fee-based models. Competition to the growth of indexing comes from the desire for advisory clients to hold traditional stock and bonds, not just active fund management. ` `How an index-only or blended product is incorporated into an existing product line-up requires forethought. 18 Blending Insights: Trends in indexing and blending

21 Methods for blending Methods for blending Blending Insights: Methods for blending 19

22 Methods for blending For those who are Agnostic Allocators or Embracing Blending, the key question has been how to blend. What struck us in conversations was the wide variety of ways in which respondents have approached this question and the insights they have gained. Methods for blending Broadly, we found that Agnostic Allocators have done the most investigation to find a theoretical solution. What surprised them, however, were the conclusions they reached: that there are no easy answers. I think the fact that we ve tried to go all the way down a very technical route and come all the way back down to what is more a qualitative approach has been a bit surprising. One manager examining the research on the topic described their key take-away as it s difficult to produce alpha but not impossible. Ultimately, the reality of the importance of a qualitative or judgmental component in any blending process was widely accepted. Asset class efficiency The most common factor driving implementation decisions is the assessment of asset class efficiency. Which asset classes are deemed efficient and therefore lend themselves to indexing versus which are still inefficient and therefore offer opportunities for active management? There is a broad range of approaches to this efficient market aspect of the decision: from in-depth internal research, to relying on currently available external research or high-level assessments, to just personal opinions. Several multi-asset managers described their approach as comparing active funds to the benchmark: If the peer group is all below the benchmark, over all time periods, that doesn t seem to be an opportunity to go active. But when we see that a lot of active managers of decent enough selection are consistently above the benchmark, then we recommend our clients to think about active. While most have an approach of picking specific asset classes to invest in via active management or indexing, others are flexible in their investment approach within each asset class. One participant felt that blending within each asset class was a good way to manage that exposure over market cycles. Asset class trends If you really want to have true diversification, you can t just go down the passive route. What were the trends across various asset classes? Plenty of disagreement illustrated the reality that there is no one answer to blending, although there are some common themes. A summary of the key areas mentioned to us was as follows: US equities We were surprised by how often US large cap equities was used as an example of an efficient market and therefore a domain of indexing. So US equity, I continue to make the case related purely to the dispersion within large cap equity. Given the difference between the best performing stock and the worst performing stock, you d have to get it extremely right as an active manager to add significant value over the index. However, one multi-asset institutional manager saw an opportunity to blend within the market a high income paying active manager with a passive vehicle, while a predominantly active fund-focused manager still felt they could find alpha. However, one manager highlighted the importance in their view of a forward-looking assessment of alpha on a riskadjusted basis not just relying on historical performance return comparisons. 20 Blending Insights: Methods for blending

23 Fixed income In fixed income the arguments were more divided. In the government bond space, one discretionary manager felt that given the low yields, the focus needs to be on cost reduction. Interestingly several highlighted that while European government bonds had been a place for indexing over the past decade, it was undergoing sufficient change as to warrant a re-think as to whether active management may now deliver better risk-adjusted returns. High yield credit and emerging market debt were cited by several respondents as lending themselves more to active management because basically you want to manage the default risk. However, in the investment grade space it was more mixed with views ranging from one manager s opinion that a US investment grade manager can t add that much alpha to another s view that you can still add value on the corporate side by doing proper selection. We also heard more generally of difficulties in using indexing in fixed income relative to equities which we explore in the <Obstacles> chapter. Emerging market equities Many respondents used emerging market equities to illustrate their views on efficiency. Broadly, this is an area that people feel should offer opportunities for managers to outperform the benchmark. However, one manager sees this changing as emerging markets evolve: To be honest in EM equities, we re moving more towards the passive side, but historically we thought EM equities as an area where we can add skill. In describing their approach to emerging markets, a discretionary manager differentiated between broad and country exposure. If I want to play emerging markets on a global basis, an ETF can be good. However, to invest in countries like Indonesia and Vietnam he would prefer an active mutual fund as he felt the liquidity will be better managed by the mutual fund manager. Alternatives Finally, in the alternatives space we found a mixture of views. The multi-asset manager, who earlier highlighted the difficulty of using just index products for true diversification, used the example of property where they believe it simply can t be managed on a passive basis. In the commodities space the range of views was more diverse. Two large multi-asset managers felt the key to commodity investing was the commodity market rather than stock selection skills, whereas one disagreed, saying that for them, commodities should be just through active funds. Not just asset class views other issues I think it s very important to know what asset class we are talking about, what time horizon we have, and do we really have best-in-class managers in that peer group. Some respondents argued efficiency was not the most important consideration that availability of a good manager was more important. A static or dynamic process, the time horizon for the investment, and how an investor or end-client values liquidity can all play a key part in the blending decision process. Finding good active managers Anyone who says to you: UK equities is a very efficient market and that s why I m entirely in passive, just hasn t done any work behind that. For some, not relying on an asset class efficiency view but on whether there were good managers is essential. One manager gave the example of high yield where, having highlighted it as a market that lent itself to active management, said if we didn t have any managers that we believed could outperform the benchmark, then we wouldn t invest actively in the high yield space. Static or dynamic? We will make that decision at that particular point in time, and then decide whether to go active or passive, but it s a function of time. The decision to go passive in US/UK small cap today is not going to be the same as the decision three years down the line. While some respondents make decisions on where to use active funds or indexing vehicles over the long-term, others stressed the need for a dynamic decision process. The market cycle was highlighted as a key driver of these blending decisions as different cycles have different implications for overall returns and active relative performance. As noted earlier, one example given was European government bonds. One participant highlighted fixed income as a place of regimes where during long periods of time, when ratings are relatively stable, investing in the index is the best way but noting other times when active management was required. Recognising that your process may require a dynamic element doesn t make it easy: I think that we ve been doing this long enough to know there are cycles in alpha generation. But it s very hard to time. Methods for blending Blending Insights: Methods for blending 21

24 Time horizon The time horizon of any given investment is another factor in the blending decision. There is a need to give active managers time to play out, because of the cyclicality of the excess return that is produced by the manager, though interestingly there is little consensus over how long that should be. In general, the shorter or more tactical the investment, the more likely investors will choose the indexing route, while for longer investments, more investors are inclined to consider active funds. I would say that it is reasonably important because funds are fixed pricing and you ve got to tell them four hours before you want to deal and anything can happen in those four hours. So from that perspective, ETFs are a good use of being able to use liquidity. As with other aspects of the blending decision, the client mandate plays an important role: We are still talking about pension funds, by their very nature, they re very long-term investors. So I think it s not been necessary yet to use the daily liquidity that ETFs provide. Methods for blending If I want to invest in a total return fixed-income portfolio for the next three years, I will go into an actively managed portfolio, because they will avoid a lot of the things you don t want to see that are sometime in indices. If I want to tactically play a bond index, I m definitely going to buy the ETF. If I want to play views on high yield in the US for the next two weeks, I m going to buy the ETF. Liquidity The question of liquidity, in particular intra-day liquidity, got a more mixed response in terms of its importance in portfolios and blending. Investment size What methods are employed for blending? ``There is no single answer to blending. Sometimes the relative size of an investment within a portfolio drives implementation in whatever is the quickest and easiest way. If it (our model) only wants 3% in corporate bonds, we re not going to split that three. We re not going to mess around; we ll just shove it all into passive. So practicalities will also drive some of the decisions. ``Blending methodologies are a mixture of quantitative analysis and qualitative judgment. ``Asset class efficiency is the most common starting point for blending decisions. While there are trends, there is little consensus on which markets are the most efficient. ``Some feel blending should be more dynamic, based on what is available for that exposure at any given time. ``Market cycle, the investment time horizon and size of any given investment are cited as key considerations. 22 Blending Insights: Methods for blending

25 Challenges and obstacles to blending Challenges and obstacles to blending Blending Insights: Challenges and obstacles to blending 23

26 Challenges and obstacles to blending Blending active funds and indexing strategies does not come without challenges. Ranging from product specific obstacles to broader changes in mind-set, these need to be overcome to get the most effective use from blending. Challenges and obstacles to blending Changing a mind-set I guess philosophically as managers, this desire to push up the active weighting, but hitting into the cost constraints, that s going to be an interesting one to see how that plays out. Introducing indexing instruments into a historically activemanager-only investment process did not come naturally to some of those with an active management background (those who have moved from being Actively Active to Embracing Blending). According to one discretionary manager who has evolved a blending strategy, it will be a challenge for those who have set their stall out on being active managers. Having added indexing-only and blended products to their traditional multi-manager product offering, the same manager commented on one of the key differences with indexing instruments: the lack of an emotional attachment to them, like you do with active funds and active fund managers. Whereas with indexing, you are a lot more willing to sell the investment, investing with a manager is an emotional thing, you are making a commitment. Harnessing this ability to be more active around allocations, to think more often about when to move, is going to be a challenge because I m so used to being a long-term investor. Interestingly the same manager observed the danger of not bringing the fund selection team with you. While he could now afford to look for managers that are even more concentrated than normal in his new blending strategy, the fund selection teams were probably still focused on finding good funds in general. As such, his challenge was to educate them, on what s required in a portfolio and the way that we re thinking on the portfolio front. Having an in-house manager A second obstacle raised was the potential issue of having an in-house active manager business which could create pressure to use internal funds. One discretionary manager reflected: I remember in the past we had our own asset manager, it was more difficult, there was always a little bit of an internal conflict when you go open architecture. Some respondents noted that for them the introduction of blending was not difficult because they either didn t have in-house funds or felt under no pressure to use them. We also found that many of their clients anyway limit the amount of in-house funds they are happy for their portfolios to hold. One participant with in-house funds noted that, while it can create profit and loss issues across the businesses, it cannot influence the investment decision. However, they agreed that it is a sensitive issue, especially when taking money away from a manager with a good track record because of an asset allocation decision. In this regard, communication and stakeholder management internally was seen as critical. So it s just communicating, making sure everyone understands what we re doing and why we re doing it. On the opposite side, there are benefits to having in-house funds. For one discretionary manager with an investment philosophy requiring transparency, using external vehicles is a challenge. That doesn t mean they won t do it but it means that the hurdle to get us to do it is that bit higher. For others, in-house funds can bring a cost saving, benefiting their end clients. 24 Blending Insights: Challenges and obstacles to blending

27 Advisory revenue model One specific obstacle to indexing and blending in the advisory business is based around the rebate revenue model. Many advisory respondents highlighted the difficulty in promoting indexing through their distribution channels where they are still reliant on a rebate paid to them by mutual fund providers. Notably, while in other European countries the revenue model of advisory could remain a significant obstacle to blending, several advisory businesses in countries such as Germany and Israel told us they are already making a shift to fee-based advisory for new clients. This was occurring even in the absence of formal regulatory changes. Communication For those that launch new indexing-only or blended products, communicating to end clients around the product line-up is critical. Some Actively Active who are considering this move worry about how existing clients in active management-based portfolios will perceive it: One of our struggles is if we start using indexing, we change the propositions we made to our clients. And the story we tell them right now is we have a great team which picks the best fund managers. If we then say: for part of the portfolio we are using passive products, that s a different proposition. Conversely, a manager of an indexing-only product highlighted the difficulty given his firm s active management house image with end clients. So when it comes to marketing our passive products there is not the same level of support as there is for the active products. Selling a story From a sales perspective, having a story that you can sell is key. There is a view that the active management story is easier for many salespeople, especially those used to selling only active funds. What I see relationship managers (RMs) asking me is a story of the fund. It s easier certainly to come up with a story for an actively managed fund than for a passively managed one. Furthermore, while cost can be a driver for using indexing within a fund, many salespeople don t want to simply say we use passives to keep the cost down; they want there to be more of a story around them. However, others feel that the story of indexing is now evolving with the regulatory changes and recognition of the importance of asset allocation. For advisors, there is a story now, the story is the adviser is no longer transactional, by and large, and therefore the adviser has to offer a service, and passive is part of that service. For many asset allocators the key was educating the salespeople to sell asset allocation rather than a product: If you re selling an ETF, you re selling asset allocation, because you re just getting beta exposure. You can t sell the ETF. You ve got to sell the beta exposure, and that s a very different sell than, I got this sexy product. Scaling Scaling a large blended asset allocation discretionary business across countries is operationally challenging. According to one global wealth manager, while the asset allocation element is straightforward, what makes it exponentially difficult is the implementation due to all of the restrictions you might have from a registration perspective, from a tax perspective. Availability and structure of indexing For managers who have embraced indexing within portfolios, one of the obstacles to greater usage is the lack of available exposures. According to one asset allocator, sometimes it s frustrating because those vehicles don t always exist. This was seen as a particular barrier in fixed income where investors were constrained by indices not being available and being weighted only to the amount of debt outstanding. The lack of availability of indexing was not limited to the existence of exposures, but also access to existing products in the advisory space. IFAs in the UK can find it difficult to access ETFs on fund platforms, while in wealth management, the short-track records of many ETFs make them difficult to promote. Education A further obstacle is the lack of education on indexing instruments. According to one discretionary manager: 90% of the clients don t know what a tracker-only index fund is, certainly in retail they don t know what it is. So there s a lot to do about education, explaining what it does for them. One predominantly active fund-focused manager argued that clients, who were less informed than others, were very much driven by price alone, which led them to choose indexing exposures. They failed to ask themselves the question if they could be better off by paying more? Challenges and obstacles to blending Blending Insights: Challenges and obstacles to blending 25

28 Operational challenges of using ETFs Five obstacles to using ETFs were commonly cited: 1. Trading ETFs is something most have had to learn given their differences with mutual funds. One manager s trading system made it difficult to get the best from ETFs with multiple trading lines as it doesn t look at which market is the most liquid. As a result, they preferred to use index funds. 2. Tracking error: explaining ETF tracking error to clients was something respondents didn t expect to have to do: Another thing which was a surprise for me is that there can be still quite a deviation in terms of tracking error. And maybe people don t realise that, people don t understand that so we really have to explain to them how it works. 3. ETF data was raised as a real problem for some. System issues centre on the difficulty to look-through to actual exposures on internal risk-systems or the fact that internal administration systems can only use index funds instead of ETFs as one participant found when they started to look at using ETFs. 4. Internal approval for ETFs was a greater challenge than expected for one discretionary business that had moved to Embracing Blending. 5. Due Diligence for ETFs is different to that required for active mutual funds. Several respondents highlighted how due diligence changes with a big focus on the operational side when introducing ETFs. This business found a culture clash having mutual fund analysts looking at ETFs. One global wealth manager felt strongly that this notion of structural due diligence is a very important aspect, and there are still a lot of market participants that ignore that. The risk is that people are attracted to ETFs they don t understand, which can raise issues of suitability for advisory clients. Challenges and obstacles to blending What are the challenges to blending? ``For the advisory business, the biggest obstacle is the rebate-based revenue model prevalent in most European countries. ``For those from an active management background, blending effectively can require a shift in mind-set; there is less emotional attachment to index products. ``In-house asset managers can be a challenge, especially when switching funds, yet can be of benefit given the additional transparency they offer relative to external funds. ``Selling blending or indexing is different to promoting an active management story; communicating to clients around the product line-up requires thought. ` `Lack of availability or understanding, and the operational challenges of using indexing products are obstacles to greater adoption. 26 Blending Insights: Challenges and obstacles to blending

29 Lessons on indexing and blending Lessons on indexing and blending Blending Insights: Lessons on indexing and blending 27

30 Lessons on indexing and blending As we conducted our conversations with respondents, we asked them: what lessons did they learn? The advice they gave ranged from what they learned about their client base to how to engage in blending most effectively, and why index products can be useful investment tools in multi-asset value propositions. Lessons on indexing and blending Focus on your clients You ve got to think about your own clients first. It s all about the returns, rather than having a philosophy. Staying focused on what your client needs is critical to get the best out of blending and indexing. As our respondents noted: 1. Don t be scared that clients won t accept blending. 2. Introducing indexing is not self-explanatory: communicate what you re doing and provide the same level of service as your clients would expect in activeonly management. 3. Think ahead about your product line-up. 4. Always keep in mind the cost factor. Keep an open mind I m an active guy; I grew up with active management. You do passive if you can t do active. I really changed my opinion on that. One needs to keep an open mind on what makes sense and if there s no way to make money in an active class, then swallow the pill and go passive. 1. Don t think of indexing products as competing products it s possible to find solutions where active funds and indexing can work together. 2. Consider all the options available to assume an asset class is already efficient might result in missing an opportunity to invest in a successful active fund. 3. It s a constant learning curve: from understanding the products at your disposal to learning how and where to use them and how to switch between them. Don t try to be too prescriptive. 4. In indexing, operational considerations are critical. 5. Deciding which index product to use can be difficult; evolve a process for this. 6. Implementation is crucial get the right skillsets in place. 7. Stakeholder management is essential. What advice would our participants give? ``Communication is key: both internally and to clients. ` `It is a learning curve; operational, implementation and cost considerations are critical. ``Stakeholder management is essential. 28 Blending Insights: Lessons on indexing and blending

31 Looking to the future Looking to the future Blending Insights: Looking to the future 29

32 Looking to the future The final aspect of our conversations related to our respondents thoughts on the future of blending. Their outlooks unveiled some thought-provoking insights not just about the future of blending and indexing but, about the asset management industry in general. Looking to the future Fee compression One thing is quite clear, that we will see pressure on prices, on margins, in our business. Cost pressure is tangible and the majority of our respondents feel that that pressure will continue to grow as we see fee compression across all parts of the asset management industry. On beta, one discretionary fund believes: If you can t get the market returns, you think twice about how much fees you can give away. While, according to another: There is pressure on the active side as well. I think you will see for the next couple of years that margins on the active side will adapt more towards the passive vehicles, because otherwise they will lose business, even if they are good. An intriguing question that was raised was what happens if the costs of using active funds and passive vehicles converge. So, if pricing is the same, if there is no difference, do you want to go for active or do you want to go for passive? This manager felt that such a situation would make it more difficult for index products. Others felt that even if the costs were similar, that wouldn t necessarily mean choosing active funds for every exposure. As well as fee levels, transparency of fees is something that will increasingly become a focus. We built the business on being clear and transparent, so we haven t actually changed our approach very much; I think the market has moved more toward the way we have always done things. Advisory business model The advisory business model is going through a time of change, driven primarily but not exclusively by changing regulation. Two potential trends were highlighted: Level Playing Field In the RDR world, active versus passive becomes, as far as the industry is concerned, a much more level playing field now. Without rebates it doesn t matter what kind of product you take, you will look more at the total performance of your portfolio and for the beta components choose the cheapest solution. One advisory business also emphasised the impact of the end of rebates on internal costs. It costs a lot of money to have a research team, such that in a world without trailer fees, the temptation is just to use some ETFs. Barbell to discretionary and execution-only The second trend is a potential client shift from advisory towards execution-only and discretionary businesses as advisory starts to employ a fee-based model. Given the greater adoption of indexing vehicles in these two areas relative to advisory, this shift could significantly increase blending and indexing usage. The fear is that once you start moving towards an advisory model, a lot of our advisory clients will say: well, in that case, either we ll go to discretionary or the execution-only option. We re not willing to pay for the advisory, unless you can prove that you add value on the advisory side which is worth paying for. Several respondents in the UK wealth space believe that discretionary will be a beneficiary of UK RDR. According to one head of wealth discretionary, bankers will migrate their business to discretionary because their book is much more scalable if they have us manage the money, rather than needing to contact the clients all the time to generate revenue. He believes that one of the key drivers is the operational complexity and overheads new regulation will bring to the advisory business. (UK) RDR actually implies a lot more work, in terms of paperwork for a banker. The higher burden of process management, of proving communication and therefore greater cost overheads, doesn t exist for discretionary portfolios. In fact the trend towards execution-only platforms leads one wealth manager to believe that the level-playing field of UK RDR won t necessarily drive indexing usage up in the advisory space itself: 30 Blending Insights: Looking to the future

33 I don t think we re going to see a massive take-off in advising passive products because if you look at the industry trends, the biggest growth in custody assets has been on execution-only platforms. Future of active fund management So the small percentage of active managers that have great track records will get piles of money and the majority of them won t. Squeezing the middle ground Across our respondents we found a strong consensus that the middle ground of active funds, or index huggers as they were referred to by one manager, will ultimately lose out to a barbell shift towards cheap indexing for beta and high active, benchmark plus two or three, for alpha. Notably this was a view shared by those who are heavily engaged in blending from Agnostic Allocators to those who are Actively Active and not looking to embrace blending or indexing. We heard consistent comments that sub-scale funds with poor track records won t be around for long, as investors focus more on finding exceptional managers, who invest money in a slightly different way and think less about indices. One institutional multi-asset manager who says he can just get beta from indexing, is looking to mix that with bigger active bets. He feels that if he is going to pay up for active management going forward he wants to pay for someone to take real risk. In advisory, one large wealth manager said: When you brainstorm into the future everything that s going to be strategic, where there is alpha to be added by active management, we will continue to have a very strong mutual fund offering. Everything where it is very difficult to add alpha, what I would define the plain vanilla world, I think there will be a trend towards ETFs. Or will active management rebound? However, some investors warned about extrapolating the recent market cycle into the future: After 2008, everyone was talking about ETFs because in 2008 active management failed. But they forgot they had tremendously outperformed for ten years prior to that. That s how human behaviour is. Evolution of indexing A key question asked by several participants was that of what is indexing? In particular, the point was made around the active aspect of asset allocation: So some people are set in their ways, they only do passive. What they don t realise is that s an active decision and quite often they say we only do passives, (but) their asset allocation is active. Another active-management focused manager raised the issue of index choice. In his view choosing a specific index within a given exposure for an index product to track, was making an active bet. Looking forward, there is a sense that this question will become increasingly important. One institutional manager, who is a large user of indexing products, believes you re starting to see the fragmenting of what we mean by index and therefore what we mean by passive. He argues that the market is evolving to a point where indexing doesn t equal cap-weighted. Ultimately in his opinion, passive or indexing will come to mean replicate some strategy without deviation. Simple, transparent, I can go out and easily construct a reference so I can track what you re doing. Others are more sceptical of too much innovation. Commenting on active index products, a multi-asset institutional manager said that in this view index products are building blocks. Having simple building blocks is better for creating complex investment solutions: So if you know exactly what ingredients are going into your cake, you can get a very powerful cake. If you re putting in ingredients that are bundled up and mixed up already, you re not really going to be sure what your cake s going to taste like. Risks to further growth of indexing: As well as the evolution of indexing, we heard warnings of the potential risk to further growth should an index product go wrong. Regardless of what type of product it was, it would hurt the whole industry potentially. One Actively Active manager went further, predicting that current misperceptions about what indexing products deliver will result in major disappointments for investors. So I think there will be a lot of bad experiences for these guys in passive investment, because the understanding is still poor. Looking to the future We think the likelihood of active managers not delivering again for the next ten years is lower than it was for the last ten years. Blending Insights: Looking to the future 31

34 Blending: the short and the long-term Going forward, most expect continued growth in blending and indexing. One manager with a blended product described it as the sweet spot : We do think that in time, that blended will be the range that we sell the most of. That combination of value for money, plus the active overlay, plus the active fund selection, that combination is the sweet spot of what everyone wants. One institutional multi-asset manager felt strongly: We as a multi-asset desk have been hurt by active investments. Fees are still quite high in the industry and given those two things, active doesn t work. I think diversified beta is going to make a strong emergence and that s where the industry is heading. In the advisory world, the issue of suitability given the range of ETFs available remains an issue, however: In my opinion we are just at the beginning and we just need this notion of client suitability, and to understand to whom we can sell these ETFs. A key point to note, though for firms operating across countries is the difference in uptake as according to one, we re probably heading in the same direction but at a different speed. But it s not all one-way. There is a strong view, especially amongst those Actively Active respondents with strong conviction in active management, that people will pay for performance, as they feel they have been able to convince our clients that active is worthwhile paying for and are confident they can continue that success. One felt that once market conditions normalised that usage of indexing would drop back again, while several respondents put forward the notion of a tipping point: People have moved slowly into passive. I think they will keep moving into passive even if active management delivers, then at some stage the pendulum might swing back. Further, we shouldn t forget the importance of the interaction between active management and indexing. The liquidity provided by active management was highlighted as a key ingredient to allow indexing to deliver beta in a cost-efficient way. Far from being an either/or, these differing ways to get exposure to markets are intertwined more than ever. Looking to the future What of the future? ``Likelihood of continued fee and margin compression across the industry. ``High level of consensus for a shift away from the middle ground of active management. ` `Indexing will continue to evolve to mean more than just market-cap weighted. ``In advisory, changing regulations will create a more level playing field for indexing and active management and see a barbell shift by end-investors towards discretionary and executiononly services. ``Blending and indexing usage will continue to grow but there may come a tipping point where increased opportunities for alpha may trigger a reversal back towards active management. 32 Blending Insights: Looking to the future

35 Conclusion Conclusion Blending Insights: Conclusion 33

36 Conclusion In this paper we have attempted to convey current thoughts around active and index product blending by professional European investors. From the interviews with our respondents, it is clear that this is a multi-dimensional subject of great interest, debate and trepidation. There is no one answer to blending; no consistent methodology that can be applied across the industry. For those deciding whether to journey down the road of blending, the influences and challenges that teams and institutions have to consider are many. Our participants expect more change ahead: fee and margin compression, the squeezing of the middle ground of active, and the evolution of what indexing means. Ultimately most expect the catalysts that have driven changes in the industry thus far are likely to accelerate the pace of blending going forward. Looking forward: key questions to consider When reviewing their active and indexing blending approach from both an investment and business perspective, firms could address these questions. Key questions to assess your current position 1. Of the three identities discussed in this paper, which resonates closest to your current approach towards active and index blending? 2. How effective is your current blending strategy? 3. Do you feel you have arrived at your current state strategically or more through evolution? 4. Which catalysts have played a primary role in your current approach to blending? Looking forward: will your future look like your current state? Conclusion 1. When you look ahead, what would you like your approach to blending to be? How will this differ from your current stance? 2. If you see your approach to blending evolving, which identity might you target as your destination? Why? 3. What is required for you to get there? 4. Are there specific asset classes where you would be more likely to consider blending? 5. What challenges do you believe you will encounter? 6. Will your value proposition to your clients need to evolve? If so, how will you communicate this? 34 Blending Insights: Conclusion

37 Executive editor Stephen Cohen Stephen Cohen is Head of ishares Investment Strategies EMEA. His team is responsible for providing clients with in-depth ETF market, portfolio and product analysis together with insights into global markets and implementation strategies. Stephen joined BlackRock in 2011 from Nomura where he was Global Head of Equity Linked Strategy, responsible for derivative, convertible and delta-one products. He has considerable experience as an investment and market analyst across asset classes, having worked in both Convertibles and Fixed Income research and sales at Nomura, ING Barings and UBS. In addition, Stephen has been a Director of Enovara, an Irish funds company. Stephen holds a First Class honours degree in Economics from the University of Southampton. editors Paula Niall Paula Niall is a member of the ishares EMEA Investment Strategy and Insights team. Prior to joining BlackRock in 2012, Paula was a Global Equity & Multi-Asset Product Specialist at M&G Investments and Fidelity International. Her responsibilities included presenting on investment views and pitching for new business to institutional clients and consultants. Paula spent 12 years as an active Global Institutional Equity fund manager managing both pension and mutual funds, including years with AXA Investment Management. Paula holds a Masters in Economic Science and Bachelor of Commerce from University College Dublin and is an associate member of the Institute Investment Management & Research. Muhammad Masood Muhammad Masood, an Analyst within the ishares Investment Strategies EMEA team, joined BlackRock in Muhammad has a Bachelor of Science in Finance and Economics from the American University of Paris and a Master of Science in Finance and Economics from the University of Warwick. ishares EMEA Investment Strategy and Insights (ISI) team provides investors with thought leadership on the ETF market. The team delivers in-depth analysis of ETF products and portfolio solutions as well as education and research on broader industry trends. As part of ishares global investment research team, ISI is responsible for insights into global markets and EMEA implementation strategies. The team is composed of investment professionals with buy and sell-side experience of investment management, market strategy, and trading. Blending Insights: Editors 35