Exploiting uncertainty in investment markets
In the first in a series on a new study, Barb McKenzie, Neeraj Sahai and Amin Rajan argue that subdued asset growth is set to drive out mediocrity from the asset industry
A thick fog of uncertainty has descended over the investment landscape. The credit crisis is in the rear-view mirror but the industry grapples with intensification of the competitive landscape and investor concerns about liquidity and capital protection.
As a result, the asset management industry is developing new propositions and seeking better alignment of interests.
These are the main findings from CREATE's* 2010 global research, sponsored by Citi and Principal Global Investors, which surveyed 237 asset managers and pension plans in 29 countries with combined AUM of $29trn (€23.7trn).
This article reviews its main findings. Subsequent articles will examine in more detail four subjects: asset allocation, multi-boutiques as winning operational models, charges and fees, and fiduciary overlay.
The after-shocks of the recent credit crisis continue to rattle the markets despite their dramatic recovery in 2009. The policy action by the G20 was decisive and timely, staving off a worldwide depression. As an unintended outcome, however, it also left policy-makers with tough choices.
Central banks are walking a fine line between inflation and deflation in their next move on quantitative easing and governments struggle to find a balance between financial solvency and mounting unemployment as they tackle public debts spiralling out of control.
The global asset management industry is also adapting to the new environment. According to the report, two factors will promote organic growth in assets over the next drive years.
The key factor will be the recovery in the four main engines of the global economy: the US, China, Europe and Japan. Its impact, however, will be tempered by the massive debt overhang in the west.
The second driver will be the rising prosperity in emerging markets and growth in private pensions in the key fund markets.
The resulting asset growth will accrue alongside a significant rebalancing in the global asset base, as baby-boomers approach retirement, as defined benefit (DB) plans change their investment approaches, and regulators frame new rules.
But the amount of new assets in motion will be small and the fund pie will be noted for its subdued growth potential. Asset allocation will blend caution, diversification and opportunism. Liquidity and capital protection will top the client agenda and beta will absorb the lion's share of the new assets.
In addition, diversification, negatively affected by excessive leverage in the last decade, will undergo a strong revival, with distinct tools that immunise unrewarded risks, separate alpha and beta and isolate short-term opportunism from buy-and-hold investing.
In general, complex overlays will be shunned; they cost too much and do not deliver enough. Boring will be beautiful, as investment becomes more nuanced.
New twists and turns
In terms of asset classes, the study found that emerging market equities and bonds will top the charts; so will index funds, in response to a rebalancing from actives to passives. The reason for this is that the current disillusionment with actives is likely to persist. However, it could also vanish as fast as the spring snow for two reasons.
Firstly, the fog hanging over the global economy will drive a wall of unsophisticated money into the passives. This, however, will create price anomalies as market cap weightings carry concentration and momentum risks.
Secondly, the unprecedented speed and scale of the sell-off in 2008 has created a trail of once-in-a-life-time opportunities in distressed debt, hedge funds, real estate and private equity (secondary market).
This means that it may be the age of stock pickers after all. But it is rash to project the here-and-now into the future.
In terms of regional growth, the study found that Asia will hog the limelight, but it will not be the next gold rush just yet. It will be the first destination for asset managers from the west looking for new clients and alpha. However, their incursion will be a matter of more haste, less speed.
Legal barriers, the roller-coaster nature of the region's stock markets, momentum-driven behaviours of retail clients and the obligatory domestic focus of pension plans are all reasons for this. Local managers and banks will remain the dominant players.
In contrast, Europe will offer more fertile ground for expanding the client base. Its demographics favour private pensions due to its ageing population. Low returns on private savings favour mutual funds since returns on bank-channelled products are meagre. Its policy environment promotes a new ‘era of personal responsibility' and its regulatory thrust powers UCITS funds.
Furthermore, North America will be the third most important growth region. The continuing closure of DB plans will bring new money into the next generation of defined contribution (DC), target-date funds. Rising investments in equities and bonds by sovereign wealth funds will favour big US managers.
Not surprisingly, asset managers are more intent on cultivating their home patch than seeking new pastures - for now, at least. There is recognition that a more client-centric business model can attract a new generation of clients at home.
This client base, however, will be more professional, more heterogeneous and more demanding, according to the report. It will be increasingly populated by new segments, alongside a notable switch within the old.
Survey respondents estimate that asset growth will be dominated by significant rebalancing of existing allocations, with the volume of new money in motion remaining small. Only a third of assets will be fresh inflows, mainly from sovereign wealth funds, national pension funds/central bank reserve funds and DC and DB plans in Asia, Europe and North America.
The rest will be assets switched from wholesale packagers, DC plans helped by the closure of DB plans and outsourced insurance assets. As a result, competition is expected to intensify as money moves between geographic regions, asset classes and client segments.
Fund managers need to realise, however, that new clients will not mean business as usual. With a premium on liquidity, client money will be less sticky; their investment reviews more frequent; their service standards more onerous, and their due diligence more robust.
The report suggests that new clients will invest with asset houses that are organisationally stable, financially viable and prudentially ethical. Investment, operational and reputational risks will top their agenda.
Asset managers have turned the spotlight on their products, as well as service propositions, the study has found.
They are ramping-up expertise in asset allocation, product innovation and customised solutions and demanding products fit for purpose. In distribution, they are raising service quality and technical collaboration with consultants and fund platforms. The engine rooms of fund houses worldwide are changing.
To start with, there is new recognition that tough times can be the mother of invention. Asset managers are seeking new ways to satisfy their client's needs; and new tools are being used to develop product ideas and test them before new launches.
The second point of departure applies to the emerging service models. There are improvements in base line service standards for all clients. In addition, institutional clients are being segmented on the basis of their strategic importance to asset managers and offered a clear proposition based on their identified needs.
Fees and charges
The study further indicates that the ‘heads-I-win, tails-you-lose' fee structure is under the scrutiny of regulators, clients and their advisers. The latest bear market showed that some 80% of asset managers had been paid too much. They were outperformed by the indices they were tracking.
The survey shows that one in every two managers expects to implement high-water marks that ensure a performance fee is paid only when a fund exceeds the highest previous value reached by its cumulative returns.
Also under consideration is rolling multi-year performance fees that discourage excessive risk taking to hit a given year's target. Staff incentives, too, are becoming more merit-based. However, progress will be gradual. Guarding existing revenue streams remains a top priority after a 40% drop in gross revenue in 2008. Besides, blowing out the old entitlements is hard when they are hardwired into staff contracts.
Winning business and operating models
So what are the winning business and operating models emerging from the credit crisis?
Currently, 50% of asset houses operate as integrated producers. According to the study, the number will decline and multi-boutiques will become the dominant operating model among medium and large asset managers over the the next 10 years.
Creating a small company mindset in a large company environment helps to foster principles of meritocracy, personal accountability and leadership. Being more nimble and focused, boutiques will be better placed to meet client needs. However, multi-boutiques will co-exist with other models in the ever-changing investment galaxy of the 2010s.
Notably, none of them proved resilient in the face of the two savage bear markets of the last decade - including the long admired partnership model.
That small band of asset managers who suffered least during the credit crunch had one magic bullet: a clear financial and non-financial alignment of interests with their clients, supported by operational excellence.
Accordingly, outsourcing of non-core activities is becoming a cornerstone of excellence. Strong in back office, it will spread to a number of high value-added activities in the middle office.
Outsourcing will ensure that asset management remains a quintessential craft business, but with a professional overlay of skills and infrastructure to exploit the opportunities created by the crisis.
In the process, new forms of alliance will deliver higher operating leverage as well as a raft of checks and balances that rank high in clients' due diligence.
Unsurprisingly, the study also found that a fiduciary overlay will differentiate winners from losers in the global asset management market.
Success will require asset managers to exercise a ‘duty of care' in delivering five things: consistent returns, a deep talent pool, superior service, a value-for-money fee structure and a state-of-the-art infrastructure.
These factors have always mattered. But in the post-crisis world, their delivery requires a decisive shift in asset managers' role, from distant vendors to close fiduciaries, from product pushers to credible innovators.
Without it, clients will end up with the worst of both worlds - much pain and little gain.
Barb McKenzie is COO of Principal Global Investors; Neeraj Sahai is global head of Citi securities and fund services; Prof. Amin Rajan is CEO of CREATE-Research
*Available free from firstname.lastname@example.org