Are UK asset managers lost?

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The writer is a contributing editor to the FT.

The UK is second only to the United States as a center for wealth management. The business is incredibly profitable and employs tens of thousands of people in high-paying jobs. But the mood among executives at traditional asset managers has been little celebratory recently due to the headwinds they face.

Private pension funds account for half of the UK's institutional market, and the rise in bond yields since the pandemic is causing a double whammy for managers' returns. First, fees have fallen primarily in line with the financial value of bond portfolios. Second, these increases have transformed defined benefit pension systems from chronic deficits to massive surpluses.

This negates the need for pension sponsors to pay deficit reduction contributions, which average $15 billion a year. Additionally, a growing number of sponsors may exit their businesses entirely and transfer their assets to bulk pension insurers through acquisition transactions.

Investment consultant LCP expects these purchases to reach up to 590 billion over the next decade. Additionally, the Department for Work and Pensions will expand its Pensions Protection Fund powers to become a public sector aggregator for smaller schemes where cost-effective buy-in is not possible. This could result in an additional $80 billion outflow. Collectively, these trends will cause the UK institutional market to shrink by a sixth by 2034.

It is true that actively managed institutional portfolios perform better for clients overall. Nonetheless, passive investing thrived. Boston Consulting Group estimates that since 2010, 90% of net inflows to the industry globally have been in passive strategies, with active strategies recently turning into full net outflows.

Low-cost passive investments have expanded more rapidly across retail markets. This is partly due to the disastrous long-term performance of active retail funds and partly due to regulatory changes. Of 1,462 active global equity funds managed in Europe, only 18% outperformed low-cost passively managed funds over three years, excluding fees. This rate declines to 6% over 10 years.

Twenty years ago, Huw van Steenis predicted that investors would gravitate towards passive funds for their cheap benchmark performance and professional managers that can deliver big returns. His widely cited Babel thesis left no room for traditional active managers. It proved prescient.

Since then, a series of mergers and acquisitions have forced many companies to come together for warmth, seeking better economies of scale or a combination of expertise to navigate the new environment. But as Mark Burgess, independent non-executive director at Aviva Investors, told me, we have seen companies large and small coalesce into mediocrity and turn into a meaningless mass.

It's easy to become discouraged about the fate of individual companies or markets, and you're probably right to do so. But there are also reasons for optimism.

First, several traditional UK companies, such as Schroders and LGIM, have paid higher fees by making intelligent acquisitions or investing to expand alternative capabilities. It may seem unreasonable to expect customer allocation to the private market to grow as quickly as it has over the past decade, but UK businesses are increasingly able to offer attractive propositions.

Second, the buyout represents a transfer of asset supervision, rather than a complete removal of assets from the UK financial ecosystem. This may destroy some individual companies, but the industry doesn't need to get any smaller anytime soon.

Third, the attraction to Brexit is starting to fade. The vote to leave the EU put at risk the ability to delegate asset management across borders, putting almost three-fifths of its overseas client books at risk. But now that risk appears to have passed and the essential capacity for organizational change and business development has been restored.

Finally, there are still significant tailwinds to consider. Life expectancy in high-income countries is expected to continue to increase and populations to become wealthier. As an international wealth management centre, UK wealth managers must be able to capture this growth.

Many active managers have wondered whether passive investing is for them what digital photography was for Kodak. This may make sense when it comes to retail money. But retail is only part of the landscape. Proactive managers who adapt to the new institutional market can still succeed.

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