A Long Tail Strategy for Asset Managers

Do robo SMAs create a market for niche investment strategies?

Recently I bought a little plastic replacement part for my eight-year-old dishwasher. It’s not sold at local hardware stores, but I found it on Amazon. In terms of sales volume, this obscure item is surely a substandard performer for Amazon, but it turns out that these small sellers are big business, in aggregate. This is the idea of the “long tail,” which was popularized by Chris Anderson in an October 2004 Wired magazine article. Anderson notes that “The average Barnes & Noble {store} carries 130,000 titles. Yet more than half of Amazon's book sales come from outside its top 130,000 titles.”¹

We — and a few asset management firms we’ve been talking to — have been wondering: is there a long tail strategy for asset managers? Is there, cumulatively, high demand for niche investment strategies?

Here’s what’s behind the question. A long tail strategy is only possible if you have some way to cost-effectively deliver niche products. As long as there are high fixed costs for each item, you’ll face a vicious circle of high prices leading to low demand, leading to higher prices, leading to lower demand, etc. We see something like this in asset management. Mutual funds and ETFs have fixed costs, which forces small mutual funds and ETFs to have high fees, which lowers demand, which requires higher fees, etc.

But separately managed accounts (SMAs) have the potential to fundamentally change these economics. SMAs backed by robo-technology (what we’ve called “robo SMAs”) greatly reduce the cost of launching and managing small AUM strategies. In principle, niche strategies could be priced on par with larger strategies. The question at hand is, if you did this, would there be demand?

You might be tempted to note that there’s already over 5,000 ETFs — niche enough — but the top 20 are getting more than half the inflows.² If thousands more strategies were newly made available, would that make a difference? But this objection misses the point. One of the primary reasons that the top 20 ETFs get so much of the inflow is that they are so inexpensive, with an average fee of 7 bps — 41 bps cheaper than the average ETF.² The question being asked is not whether there’s a large aggregate demand for high-priced niche investment strategies, it’s whether there would be a large aggregate demand for low-priced niche investment strategies. And that’s what “robo SMA” technology makes possible.

So, is there large aggregate demand for boutique strategies? Does a long tail asset management strategy make sense?

The Case for No

The case for “no” is that it’s not really clear that there is a need for ever more esoteric stock selection strategies aimed at outperforming everyone else. When it comes to books, we can all have our own idiosyncratic interests. But do we all have our own philosophy of investing? The idea of a long tail is that, say, half of all sales can come from niche products. But is there any reason for the average investor to have half their investments in long tail “micro strategies”? By definition, not everyone can beat the average (though a lot of self-directed brokerage firms are pretty much founded on the opposite premise), so, measured by average performance, it’s hard to see how micro strategies would be helpful.

The Case for Yes

The case for “yes” is that while individual investors may not need their own strategy for beating the market, they can nevertheless benefit from niche — even one-off — strategies. The two main reasons are:

1. Risk customization: If you or your spouse work for Exxon, or even if you just live in Houston, you already have exposure to the fortunes of Exxon and the energy sector. It may make sense for you to reduce exposure to Exxon — or the whole energy sector — in your investment portfolio. Or if you have ownership in a Real Estate LP, you might not want to have additional real estate exposure. These are examples of risk customization, modifications of investment strategies not to beat the market, but to complement an investor’s outside risk exposures.
2. Social criteria preferences: Independent of their end goals, investors may preferentially invest in companies with superior environmental records for their industry or avoid owning companies with poor employment practices. These choices may not directly improve investment outcomes, but that doesn’t make it wrong or unwise. For some investors, adhering to social criteria in their investments is a goal in itself, along with retirement and charitable giving.
   
   

If you view customization of this sort as creating a new product, then, in principle, every investor could have their own slightly different investment product, reflecting their own outside risk exposures and their own social preferences. It’s the ultimate long tail — an entire market made up of one-of-a-kind products. On top of this, tax and expense management further individualize each investor’s strategy. What each investor owns will be “path dependent” — a function of each unique history of deposits, withdrawals and security selection, as well as their particular tax rates and commission schedule.

So where does that leave us? Is there a long tail strategy for asset managers? If we include customized portfolio management in our definition of long tail products, there’s good reason to say the answer is yes. But there’s a problem. Customization of the sort we’ve been describing isn’t really an asset management product in the ordinary sense. It’s a service, one that’s best implemented by an overlay manager, someone who has a holistic view of a client’s entire portfolio — not an asset manager creating one-off models. This would seem to leave asset managers out in the cold.

Unless the asset manager is the overlay manager. And that’s exactly what we think will start to happen. We see asset managers expanding their offerings to include asset allocation, outsourced overlay and customization. This will enable them to economically offer niche investment strategies and personalized portfolios (see Asset Managers Pivot to Sell Solutions, Not Just Product, Robo-SMAs Will Replace Mutual Funds and Q&A: Robo SMAs Will Replace Mutual Funds).

So, is there a long tail strategy? Yes. Yes, there is.

For more on this topic, check out Asset Managers Pivot to Sell Solutions, Not Just Product.

¹ https://www.wired.com/2004/10/tail/. The piece is now 14 years old, but still worth a read. Anderson elaborated the concept in his book The Long Tail: Why the Future of Business Is Selling Less of More. You can read a critique by Anita Elberse published in the Harvard Business Review and Anderson’s response.

² https://insight.factset.com/cheap-and-transparent-etfs-dominate-in-first-half-of-2017