Barbell fees for fixed income investments

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The author is a vice president at Oliver Wyman and former global head of banks and diversified financial research at Morgan Stanley

A trio of recent records tells us something important about capital markets: that the “barbell effect” long associated with equity investing is now really showing up in bond markets. This change underlines how much the structure of the financial market is changing.

Investors poured nearly $190 billion into U.S. fixed-income exchange-traded funds this year through August, according to Morningstar, 50 percent more than this time last year. Last month Ares raised the largest private equity fund in history at $34 billion. And 13 major banks have formed partnerships with private lending firms to distribute their loans in the past year – up from two the previous year.

My guiding view was that investor flows would polarize into a barbell. At one end, investors would turn to passive funds and exchange traded funds to access benchmark returns cheaply and conveniently. On the other hand, investors seeking higher returns would increasingly allocate funds to specialist managers who invest in private equity, hedge funds and the like.

Traditional “core” conventional active managers, caught in the middle, would be pressured to adjust their investment engines, become more specialized or merge for scale, as I argued twenty years ago in a Morgan Stanley research note .

Barbell called. At one end, ETFs grew from $200 million in 2003 to $14.0 billion at the end of August, according to ETFGI. On the other hand, more than half of all management fees in the investment industry will go to alternative asset managers in 2024, up from 28% in 2003, according to Morgan Stanley and Oliver Wyman estimates.

The barbell effect is now turning investments into bonds. First, there is a radical change in credit allocations after 15 years of zero or negative rates. Investors are fundamentally rethinking the composition of their portfolios. Since the Fed began raising rates, the share of U.S. bond funds managed in ETF format has risen from 21 percent to 28 percent, according to Morningstar data.

Investors are demanding more for much less. Active bond ETFs have an average net expense ratio of 0.40 percent, undercutting bond mutual funds by 0.65 percent, according to State Street Global Investors. At the other end of the industry, top alternative firms are moving forward despite the indigestion in the private markets. The top six listed alternative players saw a whopping 21% net new money flow into their credit strategies in the year to June 2024, compared to just 1% for all traditional firms.

Second, public bond markets are becoming increasingly automated, allowing specialized risk segments or blends to be packaged into bond ETFs.

Third, banks around the world are under pressure from a range of new regulations, such as new capital requirements, leading to another wave of disintermediation. What we see is the reduction of risk in the banking system, where the banks allocate the riskiest parts of the debts and transfer them to the private credit funds, keeping the less risky parts of the lending themselves. As the new banking rules become clearer, teams are adapting. The flow of partnerships and risk transfer deals in recent months is likely to accelerate.

Fourth, private credit players are trying to lower their cost of capital to enable them to be relevant for even higher quality, investment-grade assets on banks’ balance sheets. Leading firms, taking the indulgence from Apollo Global, are becoming important suppliers to the insurance industry.

Together, these forces will have a huge impact on the structure of funding markets and banks and the way bonds are traded. For example, ETFs are increasingly becoming the primary source of bond liquidity.

For traditional asset managers, the pressure to adapt has never been more acute. For some, the struggle to maintain margins and assets will lead to intense cost cutting and more consolidation to increase scale. Many other offers are possible.

It also causes a Cambrian explosion of innovation. The tie-up between KKR and Capital Group to create one of the first public-private fixed income funds and the partnership between Blackrock and Partners Group to create mixed private markets portfolios are key to watch. So is the exciting deal between Apollo and State Street Global Investors to create a hybrid ETF that invests in both public and private debt. These mark significant bets on the integration of private credit.

No trend goes unchecked and there will be bumps along the way, not least from the credit cycle. But if the barbell becomes as big a force in bonds as it is in stocks, a huge change is coming.