Pimco shows asset managers suffer from low-cost indexing

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Pimco has had a uniquely challenging few years.

In the past three years, the $1.5-trillion asset manager has lost about $500-billion of its assets and fired its star bond-fund manager, Bill Gross. Now it is reducing its staff by up to 3 per cent, with its top executives saying in a memo, "The competitive demands of this industry require that we continually adapt and innovate to meet evolving client needs."

While Pimco faces some specific challenges, its latest move highlights a seismic shift among big investment firms globally. Active managers are under fire from investors who are scrutinizing whether human judgment is any better than broader indexed strategies and often conclude it's not.

"If you're an active manager with problems, people are punishing you much more than they used to," said Russ Kinnel, director of mutual fund research at Chicago-based Morningstar. "We're seeing more firms of all sizes under pressure. Even if things are going well, you may have a hard time keeping assets."

The result has been that headcount at big asset managers has levelled off and is starting to shrink, with the number of employees at big investment firms worldwide falling in the first quarter and poised to decline further in the future.

Managed assets are plateauing at the same time.

This is pretty unusual because big investment managers are cutting staff at a relatively benign time in the market. As a whole, the firms are not hemorrhaging assets. They're not experiencing broad-based persistent declines in stock or riskier bond holdings the way they did during the 2000 and 2008 downturns.

And investors have a ton of money to invest. It's just going elsewhere, namely to cheap index-tracking funds such as ETFs. Indeed, last year was a record year for ETFs, which attracted more than $350-billion in new assets globally, according to Greenwich Associates. But even a firm like BlackRock, which is a leader in the ETF industry, has trimmed staff. These passive funds don't pay a lot by way of fees, which is sort of the point.

Investors are losing patience with the promise of human stock and bond picking after active funds repeatedly underperformed passive ones. Intermediate-term bond funds, for example, have gained an average of 4.3 per cent so far in 2016 compared with a 4.8- per-cent gain for the Barclays U.S. Aggregate Index, Morningstar data show. Junk-bond funds have had an annualized return of 2.2 per cent in the past three years, compared with a 3.3-per-cent annual gain for the Bank of America Merrill Lynch U.S. High Yield Index.

AllianceBernstein's chief executive, Peter Kraus, blamed this underperformance in part on the size of asset managers, which he said had become too big for their own good. Earlier this month, he said active investment managers might have to shrink by as much as one-third, or $10-trillion, if they want to beat industry benchmarks.

Meanwhile fees are dropping rapidly, especially as it becomes harder to deliver reliable returns because of extraordinarily low bond yields globally. There's less return to go around when global sovereign-bond yields are an average 1.1 per cent, compared with an average 2.4 per cent over the past decade, according to Bloomberg data.

Higher fees can easily make the difference between underperforming or outperforming.

This backdrop isn't going away. ETFs will continue to dominate the landscape, and fees will continue to shrink. Vanguard Group, which has led the charge into cheap index-tracking strategies, said this week that it was prepared to lower fees even more. "I don't know what the theoretical number is," said Bill McNabb, Vanguard's CEO, whose firm employs about 15,000 people. "Revenue will have to come from somewhere. You've got to pay people to do things." During the next downturn, staff at active managers will probably shrink even more. There is an important role for human judgment, but it will most likely come in a much smaller, more specific form than the behemoth investing malls of yore.