By Tina Byles Williams, CEO and CIO of FIS Group

The investment management industry is at a critical juncture, and is experiencing major shifts that will likely result in significant change over the next 5-10 years, according to the CFA Institute, a nonprofit association of investment professionals.

Investment managers should not let market-driven gains in AUM and margins lull them into staying the course.

Such contentment will ensure that once-enviable operating margins will be savaged by changing market dynamics that will drastically disrupt outdated value propositions, operations and distribution models.

The CFA study last month concluded that investment firms need to adapt more quickly as we enter a new global investment era, or else they will find themselves in unwanted territory.

In a challenging environment, adventurous active managers can find opportunities in a few key areas.

1. Technology: both friend and foe

While technology enables low-cost investment substitutes for actively-managed strategies, such as smart beta products, it also presents an enormous opportunity for both investment managers and institutional investors to harvest greater insights and cost-efficiencies for their research, operating and distribution frameworks.

For example, sensing technology aggregates data provided by satellites, machine learning and artificial intelligence; this could radically reduce the time and resource cost of securities research, while simultaneously improving the scope and speed with which data is analyzed.

Technology could also enable asset managers to directly distribute investment advice and products more effectively and profitably, as well as improve the customer experience, which is crucial for client retention in a service industry.

For asset owners and investors, technology platforms may go beyond simply screening and analyzing investment products based on prior performance track records, to providing more inclusive and predictive selection methods. By systematically evaluating a multitude of risks, such platforms can efficiently build and monitor portfolios that comply with investors’ unique objectives and risks.

Impact on Traders

For traders, new technology could translate to dozens of known and unknown benefits and opportunities — however, it could also lead to potential drawbacks.

Behavioral science warns us about our anthropomorphic trading tendencies that lead to irrational pricing, such as herding, anchoring, conformation bias and overconfidence bias.

Human traders can hopefully capitalize on those “irrational” moments, by discerning patterns and understanding the market structure and drivers that underpin market bubbles or dislocations. At least anecdotally and in observing recent events of extreme market volatility, algorithmic and high frequency trading strategies seem to be growing contributions to market volatility. Theoretically, by evaluating patterns among a broader data set and more rapidly adapting to shifts in those patterns, algorithmic trading strategies could either greatly enhance human traders’ their capability or outperform them.

While there is scant data on the market relevance of algorithmic funds and trading strategies (particularly on a levered basis), by arbitraging price discrepancies, these strategies enhance price discovery and market liquidity.  However, because many embed similar algorithms that tend to close their positions when market volatility increases, they could also amplify volatility.  To the degree that their positions are highly levered (which is a worrying unknown at a total market level), these strategies could be epicenter of a systemic market shock, particularly in a world in which global markets have become increasingly interconnected.

2. Changing sources of growth

Revenues for asset managers have been buoyed by capital market appreciation, but soon, shrinking market returns and ongoing fee compression will severely hurt revenues and operating margins.

Furthermore, defined benefit pensions will shift from accumulation to providing income, and large pension funds are choosing to manage their own assets as opposed to hiring external managers. Thus, defined benefit pension funds will be a shrinking source of new money for professional money managers.

Multi-asset products that offer more customized asset allocation and fiduciary management services are progressively becoming the best sources for organic growth. For institutional investors, this trend toward customization will mean different buying dynamics and more expensive regulatory compliance. Both trends will boost the demand for multi-asset strategies that combine a variety of index-linked or quantitative factor exposures, active bets and dynamic asset allocation

3. Rethinking active managers’ value proposition

As a result of discouraging performance by active managers and cost pressures, investors are gradually moving towards low-cost options such as exchange-traded funds (ETFs) and index funds. This trend favors large investment firms that can best use scale to drive down costs, and poses a threat to active strategies that are easily replicated by indexed or enhanced index strategies.

This means that outside of private market strategies, the most compelling value proposition for active equity managers is in inefficient markets such as emerging markets, frontier and small- or micro-cap-markets that are not easily replicated by passive strategies.

Smaller, skilled managers have a competitive advantage in such strategies as the scale of large investment managers forces them into the most liquid and highest capitalization securities that do not always yield the greatest return and can be most vulnerable to liquidation pressures during periods of stress.

For example, for the five years ending December 2014, frontier markets products that exceeded $500 million in AUM underperformed their benchmark by 0.5% annually, while smaller products delivered 5.0% average annual excess, according to eVestment data.

Among international small-cap products reported in the eVestment database between December 2005 and June 2016, the cumulative excess return vs. the EAFE small-cap benchmark for products that were less than $1 billion was 2.7%; vs. 1.6% for their larger peers.

Capital markets are fundamentally changing and challenging many aspects of our industry’s decades old operating model. Today, the greatest danger for investment managers is to ignore the evolving world of asset management that we are currently immersed in.