(Bloomberg) -- The merger of Scotland's two largest money management companies is the biggest attempt yet in Europe to defend the old-fashioned business of picking stocks and bonds in the intensifying battle against cheaper, better-performing funds that track indexes.

Standard Life's $4.7 billion deal announced on Monday to buy Aberdeen Asset Management will cut costs, improve earnings and make it easier to attract and retain clients by offering a broader range of products, they said.

For the industry, it underscores the biggest challenge to its model for decades: larger "passive" funds drawing customers while more expensive "active" managers who use research to select investments are losing them. Schroders CEO Peter Harrison last week called index funds the "big bogey" and companies have to come up with ways to counter them. Both Standard Life and Aberdeen are trying to staunch an outflow of funds and are banking on investors returning to active managers to eke out better returns.

"The jury is out on whether it can stem the tide," said Colin McLean, founder and CEO of Edinburgh-based money manager SVM Asset Management. "Mergers give the opportunity for cost cutting and some rationalization, and help share some of the other costs. But I'm not sure that it necessarily helps win more business back from passives."

PASSIVE THREAT

The U.K. fund industry oversees about $8.6 trillion of assets, making it the biggest in the world after the U.S., and the pressure to reduce costs is coming from regulators and politicians as well as competitors in the world of low inflation and interest rates.

The hook-up would create a company with $808.91 billion of assets and make it Britain's largest active manager. Now it has to contend with changing market forces.

"We are operating in an environment where major headwinds continue to buffet the savings and investment market place and therefore affect the asset management industry," Standard Life CEO Keith Skeoch said on a conference call to discuss the transaction. The investment environment has "increased the client's need for active management," he said.

In Europe, Morningstar figures show index-tracking investments account for about 15% of the market, though the trend in the U.S. suggests it will keep rising. Passive funds are likely to overtake their active counterparts in the U.S. by 2024 at the latest, Moody's Investors Service said last month.

In the background, new European regulations are estimated to add an extra $2.1 billion in technology costs alone this year. In response, active managers are introducing new strategies including securitized credit that index trackers can't replicate to maintain their fee income.

LAGGING PERFORMANCE

First, they have to improve performance and beat indexes, according to passive investment specialist Vanguard. Its research showed 64% of active equity managers and 73% of bond managers globally trailed behind their benchmarks over the 15 years through 2016. Vanguard's chief investment officer, Tim Buckley, said in an interview last month there would only be a revival in active management if costs fell.

"Fund management groups are adapting to a slightly different world, where passive funds have made great strides," said Laith Khalaf, a senior analyst at Hargreaves Lansdown. "It makes sense that bigger is sometimes stronger."

Standard Life's offer values Aberdeen in line with its market value before the talks were disclosed March 4. The deal will boost revenue, cash flow and earnings, the firms said in their statement.

If completed, it would be a further consolidation of the industry locally and globally. Aberdeen bought Scottish Widows Investment Partnership from Lloyds Banking Group in November 2013 and a combination with Standard Life means Scotland's three largest money managers are set to become one in less than four years.

Elsewhere, Japan's SoftBank last month struck a $3.3 billion agreement to buy alternative-asset manager Fortress Investment Group. Janus Capital and U.K.-based Henderson are reducing costs and broadening their product mix after agreeing last year to merge and create a $320 billion money manager. France's Amundi agreed to acquire Pioneer Investments from Italy's UniCredit in December.

TOUGH TIMES

Aberdeen, which was formed in 1983 and is headquartered in the northeast Scottish city, has been hurt by weaker sentiment toward emerging markets and suffered outflows in the past three years, prompting CEO Martin Gilbert to reduce expenses and freeze salaries for higher-paid workers. Edinburgh-based Standard Life, whose roots go back to 1825, also saw its investment unit report outflows in 2016 after Britain's vote to leave the European Union and Donald Trump's surprise victory in the U.S. presidential election.

"Everyone is facing headwinds, and if they don't know it, they have problems," Martin Davis, CEO of Edinburgh-based fund manager Kames Capital, said in an interview at his office before Standard Life's talks with Aberdeen were disclosed on Saturday. "We've had an extraordinary political environment, we've had a volatile market, and we have a regulator that's focusing on the asset management space and baring its teeth."

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