A shift away from traditional asset classes and into alternative products is resulting in billions of dollars in outflows from the industry’s largest mutual funds.

Seven of largest asset managers reported a record $50 billion in combined redemptions during the third quarter of 2016, most of which were from active funds, according to Bloomberg News. As a result, Brad Morrow, the head of research for the Americas at Willis Towers Watson, suggests that the industry is on the heels of massive consolidation. 

“You’re going to see niche players with competitive advantages … implement interesting strategies for portfolios, but I think who will be hit hardest are the more traditional managers that don’t have the size, scale, or operational efficiencies to maintain lower costs,” Morrow said in an interview with Money Management Executive. “It is going to be a tougher world for those.”

This is an edited version of the conversation.

What are some of the challenges causing recently reported record outflows from the mutual fund industry?

Since the financial crisis we have seen assets rising. It has also been very difficult to find returns. I think now you are seeing more asset owners continuing to try to implement diversity.

They want more and more exposure to diverse baskets, diverse portfolios and diverse return drivers. They are now looking beyond the traditional equity and fixed income routes to find anything that’s not correlated to the underlying return drivers that are equity and credit. So they are looking in more diversifying strategies.

You are seeing more and more move to alternatives and things that will provide that diversifying exposure. It takes more governance to do that, so we are also seeing more asset owners making sure they have the proper governance in place to make these moves and craft these types of portfolios.

Whether that’s adding to staff or delegating in certain areas, they’re doing that.

What does this mean for the traditional asset manager?

I think that’s making it tougher. You’re going to see some consolidation. 

Fees are coming down as the asset owners are also trying to find better and more efficient ways to access market exposures, or market beta — be it through smart beta or passive — and I think that’s going to continue to put downward pressure on fees for the traditional asset managers.

Morningstar data shows most of the industry's largest mutual funds had negative five-year net flows. What are your initial thoughts?

It mirrors what we’ve been seeing and talking to our clients about with the shift towards more diversity.

With this shift out of the traditional asset classes, we are seeing a focus on things that either have lower fees for market exposure or more complex that have different return drivers. These are often times smaller asset classes with more niche ideas.

That’s the more historically traditional path that people are trying to diversify away from because they have seen in the past that, like during the financial crisis when the portfolios took a serious hit even though some of them thought they were diversified. When they saw their portfolio they were really exposed to a lot of the same return drivers. Even if they were defined as different asset classes, they acted the same.  

Right now they’re trying to find different exposures that truly diversify their portfolio.

What have been some of the methods managers have moved into alternatives?

Everybody is struggling and trying to find yields and trying to find returns. Asset owners are obviously struggling to match or keep up with their liabilities, and there’s been a lot of de-risking going on.

So, there has been a pretty big change in the market over the last few years. We’re seeing clients that are adding managers and adding strategies, as opposed to consolidating into the major categories, and I think you’re just going to continue to see that now. They are also finding different ways to outsource these strategies. That is why you have seen pretty big growth in the outsourced CIO numbers over the last number of years too. That has grown pretty dramatically. It’s a way where if you don’t have the governance in place, and you’re not as nimble as you would like to be, to be able to add some of these strategies and maintain and monitor them.

Outsourcing is a way to do that.

Do you see this shift as a marketing challenge for managers and their clients?

We’re looking within their portfolios and seeing how they can try to meet their objectives and everybody sees how hard it can be.

The natural way to do that will be to diversify the portfolio yourself, and determine whether you have the governance in place. If it’s happening with your portfolio, you can bet it’s happening across the industry.

What types of products are best suited for the current investing environment?

We still see people looking at private equity, or on the other side of the continuum, even at long/short equity are areas.

Some of the real assets are continuing into real estate and other types of hedge fund strategies within the diversifying strategies. Even for just the broad market exposure we are looking at the smart beta approach for more ways to get to low cost market exposure.

There are a lot of things we see clients moving forward.

Can you discuss some of the challenges managers face developing hedge fund strategies? 

Hedge funds in particular are a difficult because the term hedge fund is used in so many ways. It has become a term for an asset class, which in truth it is lots of different strategies that are called hedge funds. Depending on what you’re trying to accomplish with your portfolio, they may or may not be useful or applicable.

There are a number of different systematic strategies that can be used in place of them or may be a form of smart beta to get different market exposures. The problem is the vernacular of saying hedge funds, which is synonymous in some ways with high fees, especially when across the asset class called hedge funds. If returns don’t look so good, it gets hard to justify having a discussion about what hedge funds are and what they cost.

What you hope is in the time of a market downturn they would also hold steady and maybe give them an absolute return to help them with the portfolio. But to be in that asset class, at that time, you would’ve had to survive and maintain your exposure when the market was going up. Then people would question why you even had those in the portfolio at all.

What do you anticipate the long term impact of large amounts of money leaving these products will be?

I think you’ll see consolidation. I think you’re going to see niche players with competitive advantages … implement interesting strategies for portfolios, but I think who will be hit hardest are the more traditional managers that don’t have the size, scale, or operational efficiencies to maintain lower costs. It is going to be a tougher world for those firms.

Those low cost producers that will be able to innovate will get some market share. Like I said, I think we will see some consolidation in certain areas, especially with traditional managers where market exposure can be gotten cheaper, versus other areas where value can be added and they can provide net positive return, net of fees, with good diversifying underlying strategies.

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