Over the last cycle, one of the key trends driving equity markets has been value vs growth. We’ve in fact written about the subject. Very few articles go beyond the result (factor decomposition of security behavior) to the cause (underlying company dynamics). Putting aside macroeconomic rationale, one of our core beliefs driving this company-specific phenomenon is the economic dominance (and corresponding stock performance) of platform companies. These companies incorporate network effects in their business model. This paradigm shift is epitomized by “FANG” security price behavior and is described as a momentum effect. While momentum as a factor describes the security behavior, the underlying economic force behind company-specific operating performance is one of increasing return with increased scale.
The classic example is Google, the global leader in internet search. Google has created a business that self-propagates its competitive advantage through the data it collects from usage. Because its product was built in a way to incorporate the exponential scaling of the internet through relevance algorithms, it drew increasingly valid results as the internet grew in scale, which brought it more users given the friction-less nature of its digital offering. The exponential increase in usage allowed it to collect more data, which allowed it to further entrench its dominance in content relevance (both search and ad). The cycle is virtuous once tipped into motion.
Professor W. Brian Arthur wrote about this phenomenon long before Google, while he was living in Silicon Valley in the 1980s. In his paper, On Competing Technologies and Historical Small Events, Arthur discusses how a transformation in technology creates oligopolistic structural rigidity in these companies, where winner-take-all dynamics flourish and “marginal inducements” to dislodge incumbents may prove “ineffective”. To be dislodged, or disrupted, is a central tenant of classical capitalist theory, best exemplified by the works of Christensen and Schumpeter. The lack of dislodging of these self-propagating firms has even driven a new school of Antitrust philosophy. Arthur’s then radical, but increasingly relatable, thesis points out how traditional supply-demand dynamics and competitive theory cannot slow down the “increasing return” phenomenon.
Increasing Returns in Asset Management?
While this is a fascinating phenomenon in its own right, this blog piece is an exploration on whether or not this dynamic is applicable to asset management. Asset management seems susceptible to the same dynamics at play with platform companies. A common thread across these platform companies is information / software distributed through internet business models. Like internet companies, there is near-zero marginal cost to scale with asset management firms. Up-front costs (staff, office space, compliance, technology) represent the bulk of capex for an asset manager, while marginal-cost is largely a function of sales/marketing, and client service. One would think that an asset management firm that could engender a network effect would set itself up to be a dominant powerhouse.
What we see is a bi-furcation of behavior across active and passive management. The active management space is extremely diffuse. Take the hedge fund space, with some $3 trillion+ of assets under management across 8,000+ funds. Any measure of industry concentration, such as HHI will paint the industry as fractured. The classic example of a hedge fund is akin to a garage band: a few nerds in a closet hoping to produce abnormal returns, selling a compelling story to ultimately scale their business.
This is in stark contrast to the passive management space, which has consolidated at an extraordinary pace. The top 3 ETF providers (BlackRock, Vanguard, and State Street) control in excess of 80% of the assets under management across all ETFs. This is breathtaking concentration more akin to FAAMNG companies than hedge funds. What are the dynamics leading to scale / consolidation in one business line and balkanization in the other?
Scale Dynamics – Active Management
Active management is predicated on delivering alpha to clients. Alpha is most commonly thought of as zero-sum, as it represents an inefficiency in the market that can be arbitraged by clever participants. Some argue that this means there is dis-economies of scale in active management, but the link seems tenuous. Sure, there is academic research behind the size of firms and their ability to deliver alpha, but one could argue that a successful firm can engender Matthews effects in terms of talent, technology, and competitive edge.
What’s missing for the active manager, that is present for a platform company, is a true two-sided market-place. Does a hedge fund’s process and performance become more effective with each additional LP? Does it behave the way that Google’s search algorithm becomes refined? Is there a network effect across the scale of clients and assets under management the way a Facebook grows more entrenched the more people use it? There clearly isn’t, which is why active management is more akin to a traditional business dynamic. Ken Griffin, who runs a rather successful hedge fund, points to the behavioral problems of added scale, as human psychology is impacted by increased risk taking. Scale begets added competition, and the competitive advantage of differentiated talent induces said talent to leave and start their own competing firms. A perfect example of this dynamic was the rise of high-frequency trading. This new subset of asset management drew abnormal profits that brought intense competition, consolidation, and dynamic reorganization. This ultimately has arbitraged away much of its profitability.
Scale Dynamics – Passive Management
On the flip side, passive management has seen dramatic consolidation, with winner-take all dynamics. Shockingly, had Vanguard not been reticent to enter the ETF market in the early 1990s, today’s industry concentration may be even more tilted. The key driver of scale / consolidation has been the commoditization of the product ETFs sell: beta. Because beta is defined by an index, and that index formulation can be clearly understood by an investor in a passive ETF, the consumer is buying a rule-set which is mechanized and ultimately commoditized. The mechanization of that rule-set allows for scale dynamics, namely, a larger purveyor can deliver lower cost while maintaining profitability, choking out upstarts. This of course drove a race to the bottom on ETF fees which reached its logical game-theory conclusion: the zero fee ETF.
But are passive ETF providers like platform companies that engender higher operating returns with greater scale, or are they simply scale-providers of commodities who will have their profits arbitraged away by commoditization? For Vanguard, it almost seems defeatist as the firm is structured as a mutual. State Street, the #3 is more of a true conglomerate, with a substantial portion of their business directed towards investment servicing / custody. This leads us to BlackRock, the leader in ETF scale and the only platform aspirant in the passive space. BlackRock continues to win net inflows, while providing extremely low cost and pioneering services in risk analytics, smart beta, and machine learning. What sets BlackRock apart is its ability to differentiate its ETF offering beyond commoditized low-cost beta, embedding services such as risk-modeling and then cross-selling higher margin systematic active offerings. The cross-pollination can act as a flywheel, where entrenched ETF distribution offers a channel to promote risk-modeling, which allows for an up-sell of higher-margin active products and services.
But this isn’t a true platform company. There isn’t a two-sided marketplace. BlackRock ETFs are still consumed through brokerage platforms, traditional RIAs, and robo-advisors. Their products do not differentiate as a function of their scale. They continue to operate in a semi-efficiency, given their scale is driven by the low cost. For BlackRock (or for any asset manager) to truly make the leap would require an ability to leverage data capture in a way that creates virtuous competitive differentiation. This is still a tough game to crack in asset management, so don’t hold your breath for BlackRock to be the next Google.
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