Hug it Out: Signs of Resolution in The Passive vs. Active Management Debate?

Like the Hatfields and McCoys (or “tastes great-less filling”), it’s seemingly raged forever, but will the active vs. passive be resolved on its own? It appears to be one of the conclusions drawn from a new report from market research firm Hearts & Wallets.

The report, titled The State of DCIO Distribution, finds that products like target-date funds, as well as an “intense” focus on lowering fees, are making it tough for active managers in the 401(k) space, particularly in the $3 trillion defined contribution investment-only market.

It comes on the heels of a another recent report from Morningstar that found the Department of Labor’s fiduciary rule, and its impact on 401(k) advisors, could send $1 trillion in new assets to passive products.

Overall, Hearts & Wallets finds that the defined contribution market is strong and growing on its surface, with positive net sales for the majority of firms surveyed, but considerable turmoil lurking just underneath. In the first half of 2015, 70 percent of the 30 asset managers surveyed recorded positive net sales. This is a marked improvement over full-year 2014, when only 54 percent of managers had positive net flows. The study notes, however, that 2014 was “a historically bad year.”

DCIO sales improvements have not reached levels seen prior to 2013, when 80 percent or more of managers regularly produced net sales “in the black,” but the fundamentals underlying DCIO growth remain solid. Hearts & Wallets projects the DCIO market will grow from $3 trillion (47 percent of the DC market) today to $4.1 trillion (51 percent) in 2020.

“There remains a great opportunity to manage the workplace savings of millions of Americans via a dedicated DCIO sales and marketing effort,” Chris J. Brown, Hearts & Wallets partner and co-founder, said in a statement. “Today the stakes are higher, product requirements stricter, and sales more difficult to earn.”

Obstacles to Growth

Asset managers competing in the $3 trillion DCIO market face mounting challenges from the growing role of target-date products, and most importantly, intense and growing pressure on portfolio expenses. The demand to cut expenses is driving business away from actively-managed portfolios and into passively-managed ones and promises to play an even greater role in future product selection.

When asked about their plans to include a range of asset classes in DC plan investment menus in the months ahead, leading plan intermediaries (also surveyed) favor replacing actively-managed domestic equity offerings with passive ones. For example, one-third of mid-tier consultants surveyed plan to increase DC plan placements of passively-managed large cap U.S. stock funds, vs. just 14% who plan to increase placements of similar actively-managed offerings. More than three in five asset managers say downward pressure on management fees has negatively impacted DCIO sales at their firm in the past year, while less than one in 10 say the impact was positive.

“To really compete in the DCIO market, portfolio fees must be kept at or below median simply to make it past initial screens,” Brown said. “And that is only the price of entry.”

How Low is Low?

When asked to define low expenses, nearly half of retirement advisors surveyed, who this year support an average of 33 DC plans with nearly $60 million of assets, said an expense ratio in the lowest 25 percent for its category. Another 21 percent said the lowest 10 percent, suggesting only passive products will suffice for these advisors.

Low expenses are also crucial for success in Target-Date offerings. When asked to rank more than a dozen attributes in terms of importance when selecting a Target-Date option for a plan menu, low expenses was among the top 3 among both retirement advisors and mid-tier consultants—a highly sought after intermediary segment, because their focus on employee benefits means big DC plan opportunities. This year’s mid-tier consultant survey respondents manage more than 100 plans and $1 billion of DC assets, on average.

When asked which firms are their preferred Target-Date providers, these DC plan intermediaries overwhelmingly selected low-cost providers American Funds and Vanguard Group. The competitively priced Smart Retirement Target-Date series from J.P. Morgan Asset Management is also a popular choice.

Distribution Challenges

The report identifies another area of difficulty for asset managers, one they can improve without the help of an intermediary. The issue is overlapping coverage, and subsequently added costs of compensating sales forces for a business that is, at its essence, a hybrid of retail and institutional sales. For example, the average DCIO manager covers DC plan intermediaries within Morgan Stanley with four salespeople, including members of the retail and DCIO units, while an additional two employees support the home office. When a Morgan Stanley rep generates DCIO sales, more than five employees, on average, are being compensated for this business, thereby eroding profit margins. DC specialist firms, such as CAPTRUST and 401(k) Advisors, present similar challenges.

“Going forward, asset managers must improve their ability to track sales, identify only key influencers for compensation, and stop paying every link in the chain for each dollar of new assets brought in,” Brown said.

Sales tracking support staff and/or software is the top investment priority for 2016 at 30 percent of managers surveyed. More can be done in the field, too. Only 10 percent of plan intermediaries say they proactively contact DCIO managers when their product(s) are included in a plan menu. More can be done to make it easier for intermediaries to report this information and to encourage them to do so regularly.


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