The Future of Investment Management

This presentation for the 2019 CFA Institute Research Foundation Workshop for the Practitioner addressed issues covered in my book The Future of Investment Management.

Investment management is in flux, arguably more than it has been in a long time. Active management is under pressure, with investors switching from active to index funds. New “smart beta” products offer low-cost exposures to many active ideas. Exchange- traded funds are proliferating. Markets and regulations have changed significantly over the past 10–20 years, and data and technology—which are increasingly important for investment management—are evolving even more rapidly.

In the midst of this change, what can we say about the future of investment management? What ideas will influence its evolution? What types of products will flourish over the next 5–10 years?

I use a long perspective to address these questions. I analyze the modern intellectual history of investment management—roughly, the set of ideas, developed over the past 100 years, that have influenced investment management up to now. For additional context and to understand the full arc of history, I briefly discuss the early roots of the field. As I discuss this history, I review the various ideas and insights that ultimately coalesce into a coherent understanding of investing, in spite of its uncertain nature.

One central theme that emerges is that investment management is becoming increasingly systematic. Over time, our understanding of risk has evolved from a general aversion to losing money to a precisely defined statistic we can measure and forecast. Our understanding of expected returns has evolved as the necessary data have become more available, as our understanding of fundamental value has developed, and as we have slowly come to understand the connection between return and risk and the relevance of human behavior to both. Data and technology have advanced in parallel to facilitate implementing better approaches.

Our systems of understanding this intrinsically uncertain activity of investing continue to expand, affecting the investment products we see today and those we expect to see in the future. It is as hard to imagine index funds and exchange-traded funds dominating the investment markets of the Netherlands in the 1700s as it is to imagine their absence in the global investment markets of 2018.

With an understanding of the ideas underlying investment management today, including several insights into active management, I discuss the many trends currently roiling the field. These trends, applied to the current state of investment management, suggest that investment management will evolve into three distinct branches—indexing, smart beta/factor investing, and pure alpha investing, where “pure alpha” refers to active returns above and beyond those arising from static exposures to smart beta factors. Each branch will offer two styles of products: those that focus exclusively on returns and those that include goals beyond returns.

The following is a chapter-by-chapter summary of the book. Chapter 1 provides an overview and introduction. Chapter 2, on the early roots of investment management, briefly defines investment management and discusses its development. What is investment management, what are its required elements, and when did those elements first appear? Investment management may go back to ancient times, but its clear historical record begins in the Netherlands in the late 1700s. Those early records show that investors already appreciated diversification and thought about value investing.

Chapter 3, on the modern history of investment management, traces the evolution of ideas and practices that have influenced the field up through today. The first efforts at developing systematic approaches began almost a century ago, partly in response to periods of wild speculation and losses like the market crash of 1929. Our understanding of investment value developed around this time, and our modern understanding of risk and portfolio construction began in the 1950s. Chapter 3 also traces the development of ideas underlying index funds—initially conceived in academia in the 1960s—and, in response, the eventual development of systematic approaches to active management.

Chapter 4, on seven insights into active management, describes key concepts required to understand efforts to outperform. This chapter begins with the “arithmetic of active management,” the idea that active management is worse than a zero-sum game—that the average active manager will underperform. It then shows that the information ratio—the amount of outperformance per unit of risk—determines an active manager’s ability to add value for investors. It also determines how investors should allocate risk and capital to different active products. The chapter discusses the fundamental law of active management, which breaks down the information ratio into constituent parts: skill, diversification, and efficiency. This relationship can help active managers develop new strategies and provide some guidance to investors looking to choose active managers. Other insights cover the process of forecasting returns, challenges to testing new investment ideas, and understanding how portfolio constraints affect the efficiency of implementing investment ideas.

Chapter 5, on seven trends in investment management, turns the spotlight on current directions that will influence the future of the field. These trajectories include the shift in assets from active to passive investing, the increase in competition among active managers, the changing market environment, the emergence of big data, the development of smart beta, the increased interest in what I call investing beyond returns—that is, investing for non-return objectives, such as environmental, social, and governance goals, as well as to earn returns—and, finally, fee compression.

Chapter 6, on the future of investment management, applies these trends to the current state of investment management—theory and practice—to forecast how the field will evolve over the next 5–10 years. As noted previously, I expect investment management to evolve into three distinct branches, with each offering two styles of products.

The investment case for indexing is compelling. Successful indexing is all about delivering exposures as cheaply and reliably as possible. The ability to provide exposures cheaply requires scale, and indexing is already dominated by a few very large firms. Although things could always go wrong in investment management, nothing would systemically threaten indexing as an investment category.

The investment case for smart beta/factor investing is fairly strong, if not as strong as the case for indexing. Like indexing, these products attempt to deliver exposures as cheaply as possible. I expect consolidation over time. A small number of firms will manage most of the smart beta/factor assets. Several things could threaten this branch of investment management: poor performance over an extended period, severe poor performance over a short period due to large and correlated outflows, and a lack of investor understanding of expected dispersion across different smart beta/factor funds.

Pure alpha investing faces the most difficult investment case—I expect the average pure alpha investor to underperform—though there are reasons to believe that some pure alpha investors can succeed. Pure alpha investing is distinctly not about delivering exposure cheaply. Instead, it involves narrow and transient ideas that require constant innovation to replace old ideas the market comes to understand. Pure alpha is capacity constrained and expensive. The most successful pure alpha firms will be research-driven boutiques, possibly including boutiques within large asset management firms. Although plenty can go wrong with individual pure alpha products, I do not see systemic threats to this branch of investing.

To add an optimistic spin on the current level of disruption in investment management, which is unsettling for many people in the field, I believe that disruption can create great opportunities. The shifting boundaries between active and passive and dramatic changes in technology augur well for new types of products and new sources of information to help managers outperform. Today may not be a great time to be a 50-year-old investment manager, but as I often tell students and colleagues studying for the CFA® Program exams, it is a great time to be a quantitatively oriented 28-year-old entering the field.