Dawn of a new normal
In the first article covering a new global study, Jim McCaughan, Neeraj Sahai and Amin Rajan argue that what asset managers do next will decide their industry's fate
Like other crises, this one will pass. But its memory will long endure. Clients in all asset management segments have a new definition of what pain feels like. Once the worst is over, the old normal will not be the new normal.
The findings of a new global research survey, involving 225 asset managers and pension plans in 30 countries with €13trn AUM, reveal there will be a flight to quality, simplicity and safety: quality defined by consistent risk-adjusted returns, simplicity by transparency and liquidity of the strategies used, and safety by capital protection. Alongside that, there will be also periodic opportunism to capitalise on the current mispricing of distressed assets.
Clients know that safe liquid assets means low returns. Many are unwilling to buy into the risk premium story for the foreseeable future. The scale of recent losses is the immediate cause of the loss of investor confidence. But it had been eroding long before due to three reasons.
First, the buy-and-hold strategy was not working as equities were outperformed by bonds over a long period. Second, the core-satellite approach did not work either as actual returns diverged markedly from expected returns for most asset classes. Third, diversification did not work as excessive leverage ramped up the correlation between historically uncorrelated asset classes.
For defined benefit (DB) sponsors, these factors were not the only ones that hastened the pace of plan closures in every region. They also had to contend with new accounting and regulatory changes. These had inflated the deficits at a time when ageing western populations left inadequate time to plug them. Every asset class they were advised to follow has failed them. Sponsors' patience has been stretched to breaking point. Covenant risk is at an all time high.
In the future, mainstream asset classes will outweigh alternatives in client choices in the nascent recovery. There will also be periodic opportunism to capitalise on the dislocation in the primary debt markets, as well as the secondary buy-out markets.
That apart, each client segment will have distinctive pre-occupations, reflecting varying degrees of belief in the risk premium story.
DB clients will be drawn towards indexed and global equities, and investment grade bonds; with a slant towards opportunism.
In the English speaking world, defined contribution (DC) funds will favour equities in some areas and refined target date funds in others. In continental Europe, insurance contracts will continue to dominate DC choices. In Japan, the interest in DC plans will wither as zero interest deposit accounts are perceived as a better alternative.
Retail clients will be drawn into products that offer capital protection and tax efficiency, with periodic opportunistic forays into absolute returns or cash products. As the baby boomers head for retirement in all the OECD countries, loss aversion is set to grow.
Finally, high net-worth clients will venture back into the active long-only space as well as alternatives, with a strong opportunistic slant.
And so for clients, the new normal will be a story of "buy what you understand; understand what you buy". It is influenced by discontinuities in the investment landscape driven by six factors (see figure 1). In turn, these drivers are expected to reshape the future of the industry.
On the one hand are those demand-side factors that can cause a tipping point, accelerate change and commoditise the industry. On the opposite side are those supply-side factors which can reverse client sentiment, moderate the pace of change and revitalise the industry.
The final outcome will depend upon the relative strengths of these opposing forces.
Asset managers have taken modest steps towards attacking the sacred cows which have long sustained cost rigidities in global asset management. A variable cost model is emerging in which costs are linked directly to revenue via variable pay, slimmer product range and strategic outsourcing. Diseconomies of scale are under attack.
On the cultural side, these steps are being reinforced by enhancements in the senior executive gene pool, client service and incentive systems - with a hard-nosed approach to economies of scale and scope.
On the structural side, they are being enhanced by outsourcing front, middle and back-office activities to create a distinct craft focus at the investment end, customisation at the distribution end, and standardisation at the administration end. Independent and multi-boutiques are becoming centres of investment expertise.
Thus far, the scale of changes is modest, with more in the pipeline: the collapse of Lehman Brothers was the catalyst. With a clear strategic intent, what is now in the works can potentially blow away the old entitlements and entrenched practices that have long conspired against client interests and operating leverage. These changes may outlast the nascent recovery: the majority of asset managers expect regulatory pressures and fee compression to intensify over three years.
Beyond that, they also expect more systemic crises to occur in the next decade due to two factors: continuing economic imbalances between west and east, and inflationary consequences of the economic stimulus in the G20 countries.
Thus, the causes and consequences of the current discontinuities suggest three overlapping scenarios in the med ium term (figure 2).
At one end is a commoditised industry in which a client's investment choices are largely driven by capital protection, as has already happened in Japan: 34% of the survey respondents subscribe to this scenario.
At the other end is a vibrant industry in which managers put client interests first more than ever: 17% subscribe to this scenario.
In between is a segmented industry with a fragmented food chain and a distinct focus on different client segments: 49% subscribe to this scenario.
Under it, competitive pressures from the latest crisis will accelerate the decoupling of manufacturing, assembly, distribution and administration, with each of them emerging as distinct competences at the time when the production of alpha and beta are increasingly separated.
Whatever the likely outcome, there will be no return to business as usual. Equally, the future will not follow a pre-determined path. As in a game of chess, final outcomes will depend upon the quality of moves made by asset managers at each iteration, as subsequent articles in this series will show.
Asset managers need a new narrative on what they stand for and what they can deliver.
Jim McCaughan is CEO of Principal Global Investors; Neeraj Sahai is global head of securities and fund services at Citi; and Amin Rajan is CEO of CREATE-Research
* Future of Investment, available free at www.create-research.co.uk