Slowly Melting Ice Cubes

How to survive the commoditization of the asset management industry

“Phil, I’m a melting ice cube”

I was having lunch with a friend who holds a senior position at a large, dull asset manager.

“Nothing works anymore. Nothing. Not on the portfolio side and not on the distribution side. We’ve been surviving on rising market price levels, employee attrition, and the inertia of soon-to-be-retired advisors who’d rather make their tee time than consider a change of fund manager.”

As someone who has been in the industry for more than a minute, the only thing I found shocking about this was his honesty.

The lunch was a bit of a fishing trip for him. “Fact-finding” if we are being kind, idea-theft if we are being paranoid, and for me, a chance to share my vision and explore a potential distribution partnership. These types of lunches are routine.

But this one got me thinking. Most melting ice cubes don’t know they are. What do you do in that situation? Try to melt more slowly? Try to reinvent yourself as something you aren’t?

What would I do? What would you do?

Warren Buffett has talked about the idea of melting ice cubes. It is the counter-weight to having a durable competitive advantage or a wide moat.

I’ve spent the better part of the past year exploring durable competitive advantages and wide moats in real estate. We’ve identified quantitative factors that provide durability in real estate.

Melting ice cubes are the counter-weight. Melting ice cubes are the anti-moat. And legacy asset managers are slowly melting ice cubes. Here is why, and here is what they should do about it.

Fund Commoditization

Vanguard did it again. Vanguard just announced that it will be reducing expense ratios by 20% on 87 funds. The fee pressure in asset management has been relentless, and efficiencies achieved from scale, AI workflows, and modernized blockchain systems are only going to increase its velocity.

Source: Morningstar. Data as of Dec. 31, 2023.

You can be in the business of selling low margin products at scale, or you can sell high margin products at a premium, but you aren’t going to retain scale and margin by selling the same products as everyone else.

The commoditization of funds is not just an issue of price point. The lack of IP protection means that any disclosed (systematic) strategy can simply be copied by anyone else at any time.

I’ve seen lifelong subject matter experts in areas such as robotics and AI launch funds, only to see allocators choose index funds from larger firms where the index provider is doing security selection by filtering for keywords in the company descriptions. That’s not an exception, it is the rule.

And if you have discovered a cool new factor or process, it’ll be copied too. It’s happened to me.

I’ve heard of stories where asset managers monitor the portfolio constituents that users enter into portfolio tools, and then launch copycat funds when they get to a critical mass. I’ve heard stories of wirehouse gatekeepers asking issuers to launch copycat funds so they don’t have to approve an upstart issuer who has a fund their advisors are asking for.

None of this makes asset management a bad industry. It doesn’t make this game a bad one to play. It just makes it more challenging. This is, quite obviously, an industry in transition. The industry, quite obviously, will look entirely different in ten years. The industry, quite obviously, is begging for disruption.

Pricing Power

Six years ago, Ben Hunt wrote an astonishing series of articles on pricing power in the asset management industry. Those articles led to some deep conversations with Ben about the future of asset management and markets. What Ben wrote was so prescient and insightful at the time, and remarkably, what was true then is even more true, prescient and insightful now, after six years.

Ben shared three key insights:

1. Client Ownership

“Pricing power in a services-based industry goes to whoever owns the end client relationship.”

This is why every asset manager wants to go direct. This is why brokerages can extract rents from issuers, who are powerless to do anything but grin and bear it. This is why Wirehouses can charge for shelf space or data costs or whatever euphemism they are going with these days. Whoever owns the end client relationship holds all the cards. And that ain’t the asset managers.

2. Intellectual Property

“The usefulness of IP in preserving pricing power is much less a function of the better mousetrap that the IP helps you build, and much more a function of how neatly the IP fits within the dominant zeitgeist in your industry.”

If you want the end client to ask for your fund - or better yet, if you want people bragging about owning your fund at a cocktail party, you better have some strong IP. And it’s not about your multi-factor approach or the way you’ve incorporated complex modeling and AI into your models. It’s about having a secret. It’s about having something no one else has, and no one else is capable of doing. That could mean a lot of different things. It could be the judgement of an active manager, and it could be data sources that you were the first to get to. Just make sure it is protectable. And make sure you can wrap it into a story that fits into a tweet, and resonates. I know, I know: easier said than done. But a worthwhile pursuit nonetheless.

3. Government Collaboration

“Capital markets are being transformed into a political utility”

Read the sentence again. And then again. Write it on a post-it and stick it to your monitor. Remind yourself constantly. Because this time is, in fact, different.

The animal spirits that used to drive markets have been replaced with the sober prudence of Federal Reserve middle managers with two-dimensional models, unlimited capital, and an inability to abide a 5% market pullback.

The Fed is intervening in markets at an increased velocity and decreased efficacy. Which has led to a market driven by flows, which are driven by narratives. And you aren’t going to measure flows and vibes with a valuation model.

Gone are the days of brilliant hedge fund managers that can use poker-playing skills to beat the market. Those same HFTs that once valued game theory are now technologists, top to bottom. Even David Einhorn is now buying based on value - but monetizing not through stock price corrections but through cash flow.

Meanwhile, Donald Trump just announced the launch of a sovereign wealth fund - a sovereign fund that will purchase shares of private company stocks. This is the transformation of capital markets into political utilities. This is BTFD. This is Number Go Up.

Should’ve stuck to passive

Innovation

You might think innovation is your best path forward. Results may vary.

It’s been more than a decade since the earliest adopters asked the SEC for permission to launch a bitcoin ETF. File a prospectus, they said. File a 19b-4, they said. Come and teach us about the asset. Get on these calls, answer these questions, for years.

The costs to these firms. The legal costs, the opportunity costs, I can’t even begin to calculate them.

And then, when the SEC was ready to give their approval, they walked Blackrock right up to the front of the line and approved Blackrock-come-lately right alongside those innovators. “Thanks for playing, suckers, now Blackrock is outspending you 100:1 on distribution. Attached is your most recent legal invoice, please send payment promptly.”

Microstrategy didn’t follow those rules, Microstrategy turned its company into an unregistered bitcoin debt fund. Grayscale didn’t follow those rules, Grayscale launched trust structures that might look and feel just like an ETF, but hey we never actually said “ETF”, and also don’t mind the massive discount and premium, and thank you for your 2% fees.

Both of those firms made hundreds of millions of dollars, while the ETF issuers sat in line watching with envy.

It wasn’t innovation that won. It was regulatory arbitrage. It was chutzpah. And it was inferior, not superior products that made the most money. So that’s a game you can play if you want to play it. It’s not a game I want to play, personally.

Zero to One

Peter Thiel’s Zero to One is one of my favorite business books. The book explores how to build a massive business by laying the groundwork for scale. When you distill it down to it’s essence, you get four key takeaways:

• Proprietary technology

• Network effects

• Economies of scale

• Branding

Proprietary technology in the asset management industry can be just that, and it can be the perception of such. We covered this when talking about IP, so I’ll leave it here.

Network effects are powerful, and inherent in the fund business. Bigger funds beget bigger allocations. Success creates FOMO. It took Ark two years to go from $25 million to $100 million in assets, and three years later it raised $5 Billion in a single year, and then grew to $50 Billion by 2021. Their message never changed, and it still hasn’t changed to this day. But the network effects have come, and they’ve gone.

Economies of scale are also baked into the cake. For funds that aren’t constrained by liquidity, the marginal cost to manage an additional dollar is the same at $100 as it is at a Trillion. Notwithstanding the time it takes to punch in extra zeros on a spreadsheet.

Branding is the big one. That’s the variable that is hardest to quantify. It is the most complex, the most mysterious, and the most overlooked.

Cult of Personality

Don’t think of it as branding. Think of it as building your cult of personality.

The Kamala Harris campaign spent over $1 Billion and relied heavily on sponsorships and traditional media. The Donald Trump campaign spent a fraction of that and instead talked to Joe Rogan and Theo Vonn and made memes.

There is an obvious paradigm shift happening. CNN barely cracks one million prime time viewers while Joe Rogan podcast episodes regularly break 10 million. The Washington Post has 2.5 million digital subscribers, a viral tweet can surpass 100 million views. And so on.

Media is increasingly decentralized and fragmented. And there are fewer media gatekeepers than there has ever been. In that there is massive opportunity.

The opportunity is not just to sell a fund, it is to set the narrative. Make no mistake: if you aren’t setting the narrative your competitors are.

Everyone looks at the wrong metrics on social media. They look at numbers. Likes, retweets, whatever. They don’t look at the quality of follower, or the resonance of message. Those are harder to measure.

I’ve had jokes go super viral, and they are forgotten by the next day. And I’ve been told that my writing has moved people to leave their job and pursue entrepreneurship. That’s a wide gap, wouldn't you say?

You want to know what has resonance of message? Authenticity does. And in this industry, it is in short supply.

You can’t fake it, you can’t outsource it or pay for it. And you can’t draw a straight line to immediate revenue. It just doesn’t work that way.

The bottom line is that in a commoditized industry, you have to build some kind of cult of personality to survive. You must be someone’s favorite asset manager. There has to be a reason for your target client to to ask specifically for your funds. You have to stand for something.

The days of asset managers in well polished shoes and a crisp tie talking about prudence and stewardship might still work on the last of the boomers, but it will not survive another generation.

If people aren’t bragging about owning your funds at a cocktail party, you aren’t going to survive the commoditization of the asset management industry. And if they are, you’ll go Zero to One faster than was ever possible before.