US managers face new challenges
“Never in 39 years in the industry have I known what our clients need more clearly than I do now,” says John Casey, chairman of Connecticut-based Casey, Quirk and Associates (CQA). “But how you do it is the question. We’re seeing a lot more urgency – the answers are not that obvious.”
CQA has identified six global drivers that are shaping the current challenges and the opportunities for investment managers. In its view, the needs are consistent internationally – that is, firms in the US are facing the same issues and the same problems as their competitors in other countries.
The key industry drivers are:
q Industry maturation: slower growth, increased competition;
q Retirement systems challenged by returns, demographics and underfunding;
q Retirement risk and investment decision power shifting to the individual;
q Lower expected returns forcing investor mindset shift;
q Proliferation of open and guided architecture;
q Vulnerable competitors.
The big picture – and the issue at the forefront – is continued low expected returns globally, exacerbated by the fact that bond rates are at historic lows. The expected five-year return of a 60/40 portfolio (60% US equities and 40% US fixed income), for the period ending 31 December 2010, is only 5.7%. Compare this with average long-term return assumption of 8.5% and you see where the problems lie for US investment managers.
CQA contrasts the ‘wind-at-your-back’ years from 1970 to 2000 - when big inflows into the defined benefit (DB) market as well as mutual funds combined with great equity and bond bull markets - with the current ‘shift-to-a-headwind’ period, with slower asset flows into the industry in a more normal return environment.
These lower returns are forcing an investing mindset shift, according to CQA. “The old investment framework is proving to be unnecessarily constrained,” says Yariv Itah, director of CQA. “Investors are getting out of liquid securities, not just to get into hedge funds, but they are looking at a much broader range of investment possibilities.”
There is a distinct move away from the dominant paradigm: long-only management; no derivatives or leverage; only marketable securities; flat, asset-based fees; and management oriented to benchmarks and relative performance. Instead, alpha/beta separation increasingly is the framework for building a portfolio, pension funds are adopting non-traditional and customised benchmarks, and they are negotiating incentive fee structures with their external investment managers.
In this drive for returns, pension funds are looking to expand their investment horizons and as a result they are making new and broader demands on their managers.
Rather than relying on domestic equities and bonds with a relative return orientation, US investors are showing increasing interest in adopting an absolute return orientation and in looking at a range of opportunities. To start with, US investors are becoming increasingly international in their outlook and many have been moving pretty aggressively in this direction for some years. This is not just an American trend, it is evident in most national markets internationally. In addition, areas like hedge funds, real estate and private equity are all now accepted classes and are no longer considered ‘alternative’.
Some of the most forward-thinking of large investors - particularly some of the endowments and foundations - are also looking outside the traditional lines for investments that will provide higher returns, for example at second-hand insurance contracts or project and infrastructure finance.
Overall, foundations and endowments demonstrated higher returns in 2005 compared with corporate and public pension plans, according to the Northern Trust Universe, which covers a range of 300 US institutional investors. They returned a median of 8.2% for 2005 as opposed to 7.8% for corporate and public plans. Some of this is due to a smaller exposure to fixed income and at the same time a greater willingness and ability to venture into newer and less traditional asset classes.
When investors start to think broadly, they also have to look around for investment management, and for advice. “Institutional investors are looking pragmatically at doing business with those who can help them the most,” says Kevin Quirk, CQA managing director. “It’s a less orderly process. ‘Orderly’ only works well in a bull market.”
As investors look outside the traditional investment lines, the winners will be those forward-looking firms that can think outside the box.
“It will be a race between two groups of managers,” said Itah. “There are those who are constantly looking out for the next idea that nobody has heard of yet. And there are those who are running right after the first guys and figuring out ways to commoditise those opportunities in ways that allow big investors to get in.”
Expertise will need to be drawn from a wide range of fields, including the financial engineering expertise of investment banks or the skills insurance companies use to manage their general accounts. In fact, CQA believes that competitors to traditional asset managers may emerge from the insurance and investment banking industry. “The ‘complete firm’ of the future will likely represent a convergence of core competencies from leading traditional and alternative managers” maintains Casey.
All this means that the traditional asset management industry is being pressured on many fronts. Not only are capital markets causing managers to duck and dive in their hunt for returns, but the increasing trend for remuneration based on performance-related incentives means that the balance of power in the investment management industry is changing.
The big losers are going to be mediocre manufacturers who have been sheltered by their distribution organisations, as well as local players who have been sheltered from overseas competition.
The big winners will emerge from those firms that have quality manufacturing with limited distribution capabilities, from the top tier of foreign managers and from those investment managers who have strong distribution but up to now were limited in their investment offerings.
And the changes will be by degrees: a significant group of today’s top competitors will change form dramatically. And while there will be big opportunities for the highest-quality managers to take market share, some of the perceived high-quality firms will face capacity issues.
And as investors look to broaden their range, it is not just the managers who will be facing heightened demands from their clients. “The demand for education is very high,” notes Casey. “Many funds are not at all confident in their consultants’ ability to understand new areas.”
To confront the challenges of the current investment environment, investors will also have to reassess their views of risk. “There are a lot of artificial ideas in place, a lot of misperceptions of risk,” said Quirk. For example, derivatives were originally created to manage risk but today they are considered a higher-risk option. “You can afford these ideas in a bull market, but we don’t have that luxury today.”
Regulatory changes could also encourage a reassessment of risk. If the Financial Accounting Standards Board adopts proposed new rules for mark-to-market accounting for pension funds, it will be huge catalyst for change. In fact, even just reports about it have generated significantly increased interest in asset liability management and in using leverage, shorting, or derivatives to manage asset liability mismatches.