IW's 25th anniversary: What does the future hold for the UK funds industry?

Adam Lewis revisits the defining events of the past quarter century and examines how they influenced portfolios, as well as identifying the key trends set to shape the next 25 years.

There is an old phrase that while history does not repeat itself, it can often rhyme.

For example, like the UK is having troubles with Europe today concerning Brexit, in 1995 - the year Investment Week launched - the market was still dealing with the aftermath of Black Wednesday in September 1992 after Britain crashed out of the European Exchange Rate Mechanism (ERM), the European Community's system for linking the values of currencies.

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Having hit a high of 15% in 1990, following the 1987 stockmarket crash, interest rates in the UK had fallen back to closer to 6%-7% in 1995, and just as they are today, it was the UK equity income managers attracting all the attention.

The star managers of the day included Jupiter's William Littlewood, Credit Suisse's Bill Mott and George Luckraft, now of AXA IM fame but then working at Carrington Pembroke (subsequently ABN AMRO and now Artemis).

Other high-profile UK names included Fidelity's Anthony Bolton and a young Neil Woodford at Invesco Perpetual.

It has to be remembered that in 1995 the savings schemes of the day were not ISAs, but PEPs (personal equity plans), which Darius McDermott, managing director of Chelsea - who joined the industry in 1996 - recalls not only had a £6,000 limit, but 75% of which had to be invested in either the UK, Europe or corporate bond funds; all from a single fund management house.

As a result, in addition to UK equity income funds being the favourite place to be, McDermott notes Europe was also very popular with the big names of the day; Morgan Grenfell's Peter Young (for younger readers, Google the name for what happened next), Roger Guy at Gartmore, Rory Powe at Invesco Perpetual and Richard Pease at Jupiter.

While the Western World was entering a five-year bull market to the year 2000, emerging market and Asia funds were having a torrid time following the Tequila Crisis in Mexico, which was to be later followed by debt crises in both Asia and Russia.

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Outside of finance, in 1995 South Africa celebrated a historic victory on home soil to win the Rugby World Cup and eBay (then called AuctionWeb) went live. 

Future trends

Fast forward 25 years, and much has changed and little has changed. South Africa won the World Cup again, income funds remain popular and the UK still has its problems with Europe.

So what can investors expect of the next 25 years? Will income still be king, or will everyone be invested in so-called megatrends, such as artificial intelligence and alternative energy? Meanwhile, will all funds be ESG-aware and will there still be a place for active funds? In this piece we attempt to take a peek into the crystal ball and see what the future holds for the UK funds industry.

1. The rise of alternatives

When it came to diversifying portfolios, the rules were much simpler 25 years ago. By making simple allocations across the spectrum of equities, bonds and other traditional asset classes, investors were able to create a formula whereby if one asset failed, the other would offset the loss.

For example, rising equity prices were associated with falling bond prices and vice versa. Stronger economic growth would boost corporate earnings and therefore share prices, causing interest rates to rise and undermining the appeal of bonds.

With this in mind, the notion was conceived that having a portfolio that consisted 60% of equities and 40% in bonds should prove an uncorrelated source of returns over most time periods.

Thinking outside the box with alternative asset classes

However, as a result of the aggressive monetary policy actions adopted around the globe in response to the 2008 Global Financial Crisis, the old school model of asset class diversification became severely challenged as everything seemingly correlated to one. That is, all asset classes fell in tandem.

As a result, in the last decade, alternative investments - such as commodities, private equity and private debt, property and absolute return funds - have grown in appeal, being touted as a possible replacement for fixed income funds.

Will this appeal grow in the years to come, especially with bond yields at record lows and if the market turns against credit?

"Traditionally, government bonds have been the best way to diversify a portfolio," said Victoria Hasler, director, research and consulting at Square Mile.

"While there is no reason to assume this will change in the future, the high valuations of government bonds do pose a problem for many investors."

As such, while Hasler argued alternatives have a valid place in investor portfolios, she said they are not, and never will be, high-quality government bonds.

She added: "Good absolute return funds, which can perform well in any market environment, can be an attractive option as a diversifier, but they often come at a hefty cost, and do not, usually, produce income."

Esty Dwek, head of global market strategy, dynamic solutions at Natixis Investment Managers Solutions, said the firm is noticing more investors want to move away from the short-term uncertainty of markets and look to the future with more confidence.

"Whether this is investing in thematics or megatrends, responsible investing, or just trying to pick those businesses or adding alternatives," she said.

"All of these are complements to your more traditional asset classes, meaning it is not one versus the other, it is one with the other to help with long-term diversification."

2. The role of ESG

Buzzwords have been and will always be rife in the funds industry. The past two-and-a-half decades have given us BRIC funds (and many other emerging market variants such as Chindia and CIVETs), 130/30 funds, Split Capital investment trusts and the technology funds dominating the end of the century, which carried names such as TechTornado and NetNet.

As we head into the 2020s, the acronym on many investors' lips right now is ESG, which for the unfamiliar stands for environmental, social and governance.

However, while for some ESG may feel like a relatively new arrival to asset management, Ryan Hughes, head of active portfolios at AJ Bell, said it has been around in "some form or another" for most of the last 40 years.

"However, it does feel like the pace of change is picking up speed and I don't think it is unreasonable to assume that in 25 years' time, every type of investment will have an element of ESG embedded in it," he added.

"ESG is, increasingly, something that investors expect their manager to consider," Hasler said.

"ESG should also not be confused with responsible investing; the former is a risk mitigation tool and is something that all responsible investors should be considering, while responsible investing is more about using investing as a positive force for change - be this through exclusions, sustainability or impact investing."

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For Hasler, the journey of ESG integration is an "obvious and logical" one and she argued it seems likely that at some point in the future - whether that be in two years or 20 - ESG will simply be a hygiene factor considered by all managers. Whether the same is true of responsibly invested funds, she added, "remains to be seen".

Jens Peers, global CIO of equities and fixed income at Mirova, an affiliate of Natixis Investment Managers, noted how several years ago, many thought sustainable investing was "for hippies" and not an area in which investors hunt for returns. More recently, he added, this has all changed.

"In areas like Europe, ESG investing has become much more mainstream," he said.

"Firstly, performance has been good, while high-profile examples of companies with poor sustainability practices - such as Volkswagen or BP in the Gulf of Mexico - have shifted the mindset of people in general."

In terms of the evolution of ESG, Peers does not think there will be a definitive ‘ESG portfolio' because there are so many different approaches possible.

He explained: "Today, for pretty much all asset classes, investors can find strongly performing ESG funds for their portfolios.

"So it is not just a question of do you want to find a place for ESG in your portfolios, today you can do it for your whole portfolio."

3. What next for active?

The active-versus-passive debate is one that has rolled on for much of the last 25 years, but 2019 was a particularly tough year for proponents of active management.

However, while investment and managing director at Iboss Chris Metcalfe said last year was one of soul searching for the active management industry, he added the same has been true for much of the last decade.

"Even before the high-profile sacking of former GAM director and bond manager Tim Haywood and the suspension of the Woodford Income fund, the knives were out for the active manager fraternity," he said.

"Often seen as managers of poor value and underperforming funds, the question is endlessly asked, ‘why bother with active management at all?'"

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Conversely, Metcalfe said Iboss sees this negativity as a potential source of positive returns.

He argued: "The opportunity set for adding value though real comparison work at a granular level is easy to demonstrate, especially within an industry that increasingly relies on broad sweeping statements.

"As a small boutique manager, the success of our company will be based on our long-term results and our predominant use of actives is based on our own empirical evidence."

On this basis, Metcalfe accepts there is much evidence that in a number of cases a passive alternative does offer better cost-adjusted returns than an active one.

He said in areas such as US large cap, global property shares and  UK shorter-dated bonds, the evidence largely favours passive vehicles.

However in areas such as global emerging markets, Asia and Europe, research from Iboss shows its selection of active managers can significantly outperform.

"We hope the high-profile problems of a small number of active managers will lead to a keener focus on results and how they are obtained," he said.

"Hopefully, most managers, investors and the media can steer clear of some rather lazy labelling and name calling which just stifles the proper, very necessary, debate."

For Square Mile's Hasler, the saddest fallout of the Woodford saga is the way in which it has led to a lack of trust from some retail investors.

"The worst possible outcome, for many investors, is they get spooked and pull out of financial markets altogether," she said.

"There are some positive initiatives at the moment in terms of things like clarity of objectives, fee reductions and ESG, which could help restore trust, but these will need to be taken seriously and communicated well if active management, as an industry, wants to rebuild its reputation."

While one so-called ‘star' fund manager saw his star fade in 2019, Hughes said looking forward 25 years he still expects the star manager concept will be alive and well, not least because of how investors like to humanise investing and put a face to performance.

"There is a bigger question though around how many funds there will be in 25 years' time," Hughes added.

"We have seen the universe grow over the years but I for one would love to see asset managers really focus in the future and stick to areas where they are genuinely world class, rather than having a plethora of average-to-poor products."

4. Passive flows to increase

Against this background, the expectation is universally that passive fund flows will increase in the coming years, while closet-tracking active funds will also come under increased scrutiny. 

Hasler believes the rise of passives could lead to a form of ‘core/satellite' model in which core allocations are achieved through passives and satellite allocations to high alpha funds, markets, or outcome-oriented funds complete the portfolio.

"Predicting the future is hard, but if one thing is inevitable it will be the continued rise of passives, which will continue to put cost pressures on active funds," said McDermott. 

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"However, despite the pressure from fees, shareholder activism and the regulators, we still think that in the next 25 years there will be a place for good active managers in most people's portfolios."

Going further, Daniel Nicholas, client portfolio manager at Harris Associates, said in the next decade the more pressing issue will be that of closet index tracking. 

"Not all active managers are created equal," he said. "It is time to reframe the active versus passive debate and instead look at the issue of closet tracking, which is bad for the whole industry.

"This is when managers become so afraid of losing their job, from losing assets by underperforming in the short-term. They hug the benchmark but still charge an active fee. We would argue closet is the villain here, not indexing."

Metcalfe said that if one thing is certain, the next ten years will look nothing like the last decade. As a result, he said both fund managers and investors will need to be more discerning in terms of both where and how they chose to invest.

"As human beings we are always looking for patterns and no more so than in investments," he said. "We also know that clients tend to pile into popular funds, especially if those popular funds are shooting the lights out.

"Woodford Income was a good example of this, but we also see it with Lindsell Train and Fundsmith. The very large UK bricks and mortar funds which, after the M&G property fund suspension are back under the spotlight, amassed their considerable assets because they seemed to be almost ‘all-weather' funds.

"You only have to look back to 2007 to see this has not always been the case, with the ‘all-weather' fund being a misnomer in a single asset class."

Ending on a positive note, Hasler said the rise in responsible investing is a real opportunity for the funds industry. 

She explained: "It should allow good managers to shine but, more than that, it also gives an opportunity to be a positive force for change in the world and rebuild a somewhat battered reputation."