IPE at 15: A future for investment management
Saker Nusseibeh and Zuhair Mohammed outline a vision for institutional managers
Over the past few years, we have seen extreme asset movements, markets ceasing to operate, several myths truly busted (the concept of risk-free assets is unlikely to be the same ever again) and politicians lining up to demonstrate that they can ‘control' economies.
Looking forward, what we see are Western markets delivering either zero or low growth over the next decade as these countries try to come to terms with their debt burdens. While some people believe that growth rates in the West will somehow be decoupled from those of emerging markets, we believe that, barring short discrete periods, emerging markets are reliant on consumerism in the West and thus they themselves will struggle to maintain their ascendancy.
Further, in such conditions politicians will play to popular opinion by trying to stimulate their economies using short-term fiscal tools. But, as in Japan, repeatedly using popular policies will lose credibility and almost assure failure. So while we will witness some economies performing in fits and starts and even forming break-away groups, eventually the low growth peloton will haul them back in. Hence we will see short ‘risk on' periods followed by corrections that regress longer-term returns to the low growth environment.
In this environment, we expect to see a number of forces bearing on the fund management industry and The 300 Club will continue to focus attention on aligning the interests of asset managers, investors and society at large.
The first of these is that with ‘spiky' returns, comes the desire to profit from the volatility through more active asset allocation. This it self could be implemented in a number of ways:
• Investors award shorter-term mandates that can be pulled at relatively short notice. Unlikely to be a front runner as this results in time consuming and costly transitions. Similarly, it requires the underlying asset to be relatively liquid.
• Investors offer the manager greater freedom to invest defensively, should the manager see fit. Has been tried before and failed, so not considered further.
• Investors hire a fund manager to provide an overlay facility that allows for asset allocation changes. This is a feasible solution and may represent an opportunity for the larger fund management houses that have begun to re-hire those asset allocation teams that they fired post the balanced-fund era. Boutique fund managers will find this a harder challenge, so they may opt for the last option.
• Investors insist fund managers offer an overlay facility within mandates to remove market beta under certain circumstances. This may not be entirely at the fund manager's discretion, with some mandates offering ‘dual control' to the client. These mandates will require more complicated investment management agreements (IMAs) but we have already seen some mandates integrate derivative overlays into their portfolio construction. Provided they are used correctly and understood fully, they can be a useful tool.
The second force relates to equitable distribution of the spoils between clients and fund managers. Over the last three decades we have seen active management charges remaining relatively stable in the core asset classes, despite returns beginning to tail off.
In the good old days of high single-digit/early-teen annual returns, the focus on fees was, at best, something to consider after the preferred fund manager had been selected. The pensions industry then evolved its thinking to focus on net of fee returns and, finally, what share of the alpha (the excess return above the general market return) the fund manager received. So whether the industry wants to focus on total return net of the total expense ratio or on the share of alpha in a low return era of austerity, fund managers must share in the cut-backs and fund management charges will come under pressure.
Much ink has already been expended on the merits of the newer, less-transparent asset classes where the share of spoils is even more biased towards the fund manager. We are already seeing the concept of ‘two-and-20' in the hedge fund space shift downwards, but there is further to go.
Similarly, the industry could improve the performance-related fee structures that are on offer. At face value they encourage alignment of interest but the devil is in the detail. All too often, we see structures that contain optionality whereby the fund manager effectively secures a ‘heads-we-win, tails-you-lose' position. Similarities with banking bonuses might seem harsh but let's face it - fund managers are smart people who are capable of recognising how to maximise their own wealth and not necessarily that of their clients. Again, it is not impossible to create performance-related fees that better align interests but we require persistent and co-ordinated pressure from the asset owners to bring this about.
The third force comes in terms of increased competition. If fund managers fail to react to the second force, we are likely to see clients adopt passive mandates (not necessarily market cap-weighted indices) to suppress costs.
Competition will also increase in the active management arena. As financial markets develop across the Far East, we can expect a new breed of active fund managers to compete with the well-established western managers. As newly emerged companies prepare to flex their corporate muscles by targeting companies in the west, local knowledge might offer some competitive advantage. Similarly, such fund managers have the benefit of hindsight when it comes to developing an efficient back office and they also benefit from lower staff costs.
The fourth and final force is that of alignment of interest. The majority of the fund management industry, with a few notable exceptions, has operated on the basis of ‘buyer beware'. At the extreme, this has amounted to no more than product pushing, regardless of the fit for the end users (pension scheme members). Such behaviour helped generate a desire for independent third-party monitors (consultants) to assist pension schemes separating the good from the bad.
Just as pension funds have demanded that consultants move beyond a passive role of providing the pros and cons of any activity and leaving lay trustees to decide the course of action, there is an opportunity for forward-thinking fund managers to step up to the plate and offer guidance to their clients and prospects. In its purest form, this has to go beyond ‘the most appropriate fund we have to offer' into what's best for the client's longer-term interest. We accept that such behaviour will work best when coupled to an equally forward thinking consultant, who does not feel threatened by the fund manager's well-intentioned contribution.
The reality is that clients are best served by proactive fund managers and consultants, even when their immediate commercial interests are not best served. However, if fund managers genuinely want to secure long-term commitment from clients, they will have to migrate towards this model.
The 300 Club aims to challenge the status quo in our industry by asking probing questions which, on occasion, means playing devil's advocate. Over the coming year we plan to issue papers addressing why standard industry theory doesn't work, whether as an industry we really put clients first and whether we are doing enough to change the trend for investors, managers and regulators to deal with issues in a compartmentalised way. Instead, we will advocate a more holistic approach, because many of our troubles can be traced back to the unintended consequences of (mostly) well-meaning actions.
Saker Nusseibeh is chairman and Zuhair Mohammed is a founding member of The 300 Club,a group of leading institutional investment professionals,which was set up in 2011
This article first appeared in the February issue of IPE magazine.