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BlackRock sends in the clones

John Rekenthaler  |  05 Apr 2017Text size  Decrease  Increase  |  

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The news that BlackRock sidelined seven of its equity-fund managers didn't make many front pages, but within the small world of professional money management it was a big story indeed.

The world's largest investment manager--Vanguard is the leading mutual fund company both in the United States and globally, but BlackRock runs more assets in all forms--swapped living, breathing people for stock-picking models. Fear the rise of the machines.

Said BlackRock CEO Larry Fink: "The democratisation of information has made it much harder for active management. We have to change the ecosystem--that means relying more on big data, artificial intelligence, factors, and models within quant and traditional investment strategies."

For those who don't speak investment jargon, Fink meant that fund managers no longer benefit from trade secrets.

Back in the day, corporate executives freely chatted with investment professionals, particularly those who held their company's shares and/or controlled a great deal of money. They would discuss their company's latest developments, as well that those of their industry. That information gave fund managers a significant edge on the rest of us.

That benefit is mostly gone. The SEC has tightened its interpretation of prohibited communications, so that executives have become more circumspect.

They can sometimes be tempted into disclosures, which is one reason fund managers still seek personal meetings, but the opportunities have diminished. Plus, blogs have largely supplanted the executives' industry updates.

Also, competition has increased. Although Fink's decision reduces the mutual fund manager count by seven, there are nevertheless more actively managed US stocks today than there were 20 years ago.

And as fund companies these days are more likely to name an investment team to run a fund rather than a single "star" manager, the number of official portfolio managers has grown at an even higher rate. These days, there are more rivals to beat.

The battle continues

Of course, switching from humans to algorithms doesn't eliminate the contest; as before, BlackRock must outdo its opponents to earn its management fees. The company hopes that by being earlier than most to embrace artificial intelligence, and being larger than all, that it will enjoy a competitive advantage.

That seems plausible. But even if BlackRock's change does improve its funds' returns, there remains the question of sustainability. Success breeds imitators, and imitators erode success. Winning investment management demands constant reinvention.

To summarise the first and most important lesson of BlackRock's announcement: The demise of the traditional portfolio manager continues.

Because of mergers and liquidations, there are fewer actively managed US stock funds today than there were last year; and now, per BlackRock's example, those that continue to exist might concede to clones.

That's bad news for stock-market junkies who wish to enter the investment business. Eventually, if enough funds convert, the level of competition will decline such that active managers will have an opportunity. But we are currently far from that point.

Doing it all

Another takeaway: It is hard to win across all asset classes. BlackRock is the world's largest active fixed-income manager and the biggest exchange-traded fund provider.

Each of those are huge endeavours. It took three decades, and intense focus from senior management, to build that bond-market expertise.

Winning the ETF asset battle was another struggle. Seeking excellence with actively managed stock funds might have been one ambition too far.

Indeed, when asked if a major fixed-income manager had ever accomplished that feat, Morningstar's research team demurred. Perhaps Franklin Templeton.

But the catch to that example is suggested by its name. Franklin did not create its stock-fund business--although it tried for many years--but instead bought that capability from a company that was already so established that it came aboard with equal billing. Franklin Templeton absorbed its purchase well, but a purchase it was--not a creation.

(The same cannot be said in reverse. Whereas Fidelity was once thoroughly average at running investment-grade bonds, it now is among the best. That change came completely from within. Unfortunately for Fidelity, as its bond funds improved, its US stock funds regressed, thereby preserving this column's thesis about the difficulty of succeeding with all asset classes.)

Stocks, not bonds?

The third point puzzles me. BlackRock's action suggests there is more opportunity for traditional active managers with investment-grade bonds than with US stocks. BlackRock, after all, did not remove its fixed-income managers. They, apparently, are still able to compete with index strategies. How could this be?

If the US stock market is so thoroughly researched that active management is much stymied, then what about investment-grade bonds? They are no less scrutinised; and, at the top of the credit ladder, they're simpler to analyse, because they mostly respond only to changes in interest rates.

As Morningstar's Jeff Ptak writes: "Supposing that one concedes that point (that the old method of security selection has become obsolete), why are bonds--where BlackRock has enjoyed greater success--any different?"

"Sure, there are some clear differences in how those markets are structured, how indexes are built, and so forth. But would BlackRock argue that someone should invest more in active fixed-income funds than in active equity funds because the former is the easier task?"

My guess is that BlackRock would deflect the question, by stating that it is happy with its fixed-income management but felt that its equity approach needed to be tweaked. My guess is also that if Jeff Gundlach of DoubleLine were asked a similar query, he would give a similar response.

Portfolio managers tend to talk about what they believe that they do well, rather than theorise about market structures. But it's true that there is more faith these days in active fixed-income management than in active US stock-fund management. It is hard to explain why.

Genetics

There's a certain poetic justice to BlackRock being the company to fire the warning shot at stock-fund managers.

In 2009, BlackRock acquired Barclays Global Investors. Fourteen years before that, Barclays purchased Wells Fargo Nikko Investment Advisors. And Wells Fargo ... launched the first index fund.

In 1971, Wells started the Samsonite Luggage Fund, at the request of the family that owned Samsonite. That fund held equal weightings of each stock listed on the New York Stock Exchange. (Vanguard created the first public index fund in 1975.)

"BlackRock: Putting investment managers out of business for almost half a century." No, I don't think that will do as a corporate slogan.

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John Rekenthaler is Morningstar's US-based vice president of research and has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

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