European fund management evolves
Some of the most radical changes in the roles and responsibilities of Europe’s investment professionals will arise from the shift of institutional assets from internal to external management. Last year, slightly more than 40% of institutions brought a new manager on board – a level of activity consistent with that of 2001, 2002, and 2003 but significantly short of the 53% of continental European institutions that hired a new investment manager in 2004.
Institutions’ expectations for future hires also declined in 2005, a possible indication 2004 turnover was something of an aberration. In interviews conducted in 2003, 55% of continental institutions said they planned to hire a new investment manager in the coming year, a prediction that was borne out by 2004 results.
That momentum also clearly affected institutional expectations for 2005; in interviews conducted in mid-2004, half of respondents said they planned to hire a new manager in the coming year. Actual hiring was lower in 2005, and in more recent interviews, less than 40% of institutions said they planned to hire in the coming 12 months. Again, hiring expectations were down especially sharply in France, Germany and Belgium, and more mildly in Scandinavia.
Several factors combined in 2005 to bring turnover levels among the continent’s institutional asset managers back down to more sustainable levels. First, some of Europe’s investment management institutions, including some of the largest, have yet to recover entirely from the market convulsions of 2000-2002. Indeed, certain managers have substantially lost assets under management. Rather than make the investments necessary to restore these franchises, some financial conglomerates on the continent and in the UK are deciding to concentrate on other businesses.
This observation helps to explain the decline in asset manager solicitation activity in 2005. Overall, continental institutions received an average of 13.7 solicitations in 2004, but estimated that they would receive only 11.6 in 2005. In addition, many European institutions have yet to commit to a firm move back into equities after taking profits during the market recovery of 2003 and 2004. While the relatively strong performance of European equities this year has encouraged institutions to shift assets back into equities, the move has not been so pronounced as to require the hiring of a large number of new asset manager.
While the 2004 continental asset manager-hiring boom appears to have run its course, the average number of external managers employed by institutions has continued to rise, from an average 9.1 per institution in 2003 to 9.6 in 2004 and 9.8 in 2005. With this increase in the use of external managers, Europe’s pension executives are devoting more time to managing portfolios of managers as opposed to portfolios of money.
Managing money internally requires one set of skills, but overseeing an entire portfolio in which shares of assets are managed by different external firms is a different challenge entirely. The latter task is largely one of understanding how the risks and returns associated with the styles and objectives of each manager, aggregates to create the risk profile of the fund as a whole.
As such, the role of internal fund professionals becomes focused on establishing objectives for each separate portion of the overall portfolio, selecting managers whose strategy and capabilities can meet those objectives, and monitoring these managers not only for performance, but also to ensure that they are adhering to agreed-upon strategies.
And what investment strategies are most in demand among Europe’s institutional investors? In interviews with Greenwich Associates, Europe’s institutions have been saying for the past three years that they plan to reduce their holdings of cash and government bonds, and shift into equities.
As a group, they have not followed through. Government bonds, which represented 27% of these institutions’ assets at the end of 2002, represented 29% at the end of 2004; cash and short-term investments, which represented 7% in 2002, still represented 7% of continental institutions’ assets in 2005, and equities have been flat at 22%.
The situation is similar in higher-alpha investments such as hedge funds and private equity. Many institutions have been talking quite forcefully about venturing further into these asset classes, but in practice most have continued to dabble. Allocations to hedge funds and private equity have remained flat at about 1% of assets for each of the past three years. And now that hedge fund returns have fallen off, the proportion of European institutions planning to start using hedge funds has dropped from 19% in 2004 to 8% in 2005, and the proportion expecting to hire a hedge fund manager has fallen from 23% to 8%.
Corporate bonds, which in past years were also expected to attract new investment dollars, are now being viewed with some ambivalence by continental institutions. The proportion of institutions that plan to reduce their corporate bond allocations is now equal to the share of investors planning to increase them.
Further, the proportion of institutions reporting to Greenwich Associates that they plan to start using corporate bonds in coming months decreased from 5% in 2004 to just 1% in 2005, and the proportion planning to hire a corporate bond manager is down from 6% to 2%.
While European institutions have been slow to increase their equity allocations, they are making some careful changes to their investment strategies, and in some cases, to their overall asset mixes. Among the notable trends revealed by Greenwich’s most recent European investment management research are:
❑ Continental institutions are paying more attention to real estate as an asset class. The proportion of continental institutions reporting to Greenwich Associates that they hired a fund manager for real estate increased from 4% in 2004 to 11% in 2005, and the proportion expecting to hire one has jumped from 4% to 13%;
❑ The replacement of plain-vanilla balanced mandates with a variety of new balanced products is reviving interest in balanced management in Europe. Balanced managers are now being used by a third of major institutions on the continent, but of these institutions 56% are using the traditional ‘basic balanced’ mandate. Approximately 25% of the institutions in this group are employing balanced mandates with tactical asset allocation features, and more than 15% employ balanced mandates with absolute return features. Another 10% are using balanced mandates with guaranteed return or principal protection features;
❑ A small but significant number of European institutions are starting to adopt specialised products, such as CDOs, CLOs, and CMOs, that are perceived as having the potential to generate incremental returns with only a minimal increase in risk.
While only 5% of pension funds and insurance companies have been using these instruments up to now, another 3% are planning to start and 2% expect to hire managers specialising in the area in the near future.
Markus Ohlig is a consultant at Greenwich Associates based in Greenwich CT