Not having as much fun
Investment professionals globally are facing the most challenging business environment since the 1970s. The abrupt halt to a 25-year bull market has exposed many of the industry’s excesses and inadequacies, particularly with regard to business management. In addition to the resultant pressures on expenses, senior industry executives must confront intense competition and ever-higher standards for success. As one chief executive officer states simply: “This business is not as much fun as it used to be, and may be becoming less so.”
As a result, many industry participants are contemplating fairly radical changes to their behaviour. In our experience, investment managers, their clients and their intermediaries began last year to profoundly rethink many of their long-held beliefs. Given the business environment, many have concluded that the riskiest strategy is not taking assertive action and deciding what is and is not possible.
Therefore, we believe that 2002 should be viewed as an important transitional year for the industry and several new ideas will become reality in the first half of the decade. Contemplation will give way to activity.
In this article, we describe six important concepts that are likely to be embraced over the next few years. We believe these concepts apply globally.
(Perceived) consolidation begets
Corporate owners can bring financial and managerial discipline to investment management affiliates. Unfortunately, a relationship with a larger financial services firm often also brings creeping bureaucracy and greater costs of complexity. Within this environment, operational focus and properly aligned financial incentives are critical elements of on-going success. Firms lacking these two critical attributes may well deteriorate over the next several years.
This presents a particular challenge for the investment management affiliates of large financial institutions. Most of these affiliates do not have the autonomy to insulate themselves from the frequent across-the-board cost-cutting exercises that occur within financial services firms. Also, it is difficult to create incentive-based compensation tied only to the longer-term performance of the investment management subsidiary. (As a result, many of these institutions have had to fuel the industry-wide escalation of annual cash compensation.) These problems are only exacerbated with the increased size and complications associated with a growth strategy consisting of acquisition and consolidation.
To foster stronger investment management businesses, larger financial services firms must consider separating from their investment management capabilities. (We chose the term ‘regurgitation’ for emphasis.) A likely scenario would be a separately capitalised firm in which the parent company retains a substantial equity stake, but where the remainder is purchased by or gifted to the employees.
We think the first large-scale ‘regurgitations’ will occur as early as this year.
Fixed income as a tactical, not
Most investors view a systematic allocation to lower-risk, lower-return strategies as the prudent part of a diversified portfolio. Historically, this allocation has been synonymous with traditional fixed income instruments, including treasuries, corporate bonds, and asset-backed and mortgage-backed securities. Unfortunately, relative to expectations, long-only portfolios using these fixed income instruments have produced lower returns with higher volatility. Many sophisticated investors are questioning their relevance to meeting liability needs, especially US pension funds who, for the first time in a decade, are in the process of asking their corporate sponsors for contributions.
In the future, we expect fixed income firms to rethink their organisations. They will do this to support products that integrate traditional fixed income securities with hedge fund strategies, real estate, derivatives, distressed debt and other portfolios producing strong returns and yields with low volatility. (Also, leverage may be employed judiciously.) In these products, an allocation to traditional fixed income instruments is not guaranteed; rather, these instruments will be purchased only when they have superior risk-return expectations relative to alternatives.
In addition to higher risk-adjusted returns, these new low-volatility products can be designed to better meet client liabilities. (Few investors have obligations that mirror the Lehman Aggregate!)
Distribution without boundaries
Historically, most investment distribution organisations have been structured according to products or vehicles. That is, different teams have been responsible for mutual funds, wrap products, annuities, defined contribution plans and separate accounts. In the light of still further divisions by asset class (eg, fixed income, long-only equity, hedge funds), clients and intermediaries have interacted with investment management firms on a fragmented basis.
This silo-based structure looks increasingly anachronistic to us as we observe how clients demand a more integrated approach to sales and client service. Consider the evolution of the wire-house broker. Firms like Merrill Lynch now require their private client relationship managers to effectively represent a broad spectrum of products and investment vehicles. (Previously, such firms tolerated de facto specialisation in one or two products.) In addition, these firms have created investment product gatekeepers that are taking a more holistic view of managers. Serving these critical intermediaries will require greater coordination on the part of investment management firms. Institutional investors are similarly asking for managers to integrate or customise their capabilities in a solutions-oriented manner, not simply represent individual products.
In the future, investment distribution organisations must erase the traditional boundaries that have fragmented their efforts and organise instead by client segment. There is already evidence of such a trend; for example in 2001, several firms integrated their defined contribution (DC) and defined benefit (DB) sales efforts. Some retail-oriented firms are integrating their wrap and mutual fund sales teams. Ultimately, the optimal organisation will probably have all distribution efforts coordinated, perhaps by a single individual. We believe this to be true because the professional standards for serving each client segment are converging rapidly, and it is necessary to have a structure with the authority to enforce these firm-wide standards.
Clearly, the goal of integrated distribution is challenging. It requires highly trained sales and client service professionals, resources dedicated to assuring seamless coordination, and a culture that fosters teamwork, not fiefdoms. However, as the industry’s economics are increasingly driven by retention and cross-sell (not gross sales), addressing these challenges is critical.
Alternative investments are
We hope that in this and subsequent years a majority of sophisticated investors come to view ‘alternative investments’ as a systematic, integrated component of their portfolios and a substitute for, not simply a complement to, long-only fixed incomes and equities.
As we wrote in our 2000 report, Success in Investment Management, this acceptance will require years of education and better marketing. However, ‘traditional’ managers must recognise that the transition is occurring and make the proper adjustments either to integrate with alternative investments or to develop such capabilities themselves. In a few years, will a long-only portfolio of marketable securities managed for a flat fee be considered a niche product offering? (Here, long-only management may be the new alternative investment class.)
Efficiency energises true talent
Contrary to previous opinion, barriers to entry into investment management are decreasing; it is difficult to impede a talented professional from seeking a more pleasant and productive work environment. Unfortunately, for many organisations, their increased size and bureaucracy have encumbered, not leveraged, the skills of their most talented investment and marketing professionals. The industry’s senior executives usually identify ‘loss of key personnel’ as their most pressing issue.
Over the ensuing years, we expect leading firms to conduct explicit ‘efficiency audits’, particularly in the portfolio management and research areas. It is, however, important to differentiate ‘efficiency’ from ‘cost-cutting’. The primary objective of an efficiency strategy is to transform a firm into a magnet for outstanding professionals; reduced expenses may (or may not) be a residual of this exercise.
The blurring of DB and DC
The current weaker capital markets plus the Enron debacle are exposing the inadequacies of many defined contribution plans. These short-comings include potentially misaligned financial incentives to sponsors that favour DC over DB plans and, perhaps most importantly, participants’ inability to take adequate responsibility for their savings (or a disinterest in doing so).
The need to provide improved employee benefits, the spectre of litigation, and potential legislative intervention will cause legislators, regulators, and plan sponsors to rethink the DC plan as commonly structured today (at least within the US). Future schemes are likely to combine greater fiduciary involvement, either by the plan sponsor or credible third parties, with benefit portability. (We believe the principle of ‘cash-balance’ plans may be a sound starting point, though the implementation of many of these plans has been rightfully maligned.)
Some of these changes will also cause investment managers to rethink the defined contribution market. The likely increase in pricing transparency for administrative services and the proliferation of ‘open architecture’ plans will call into greater question the economic attractiveness of a bundled service model (ie, combining a proprietary record-keeping capability with investment management services). As a result, over the next few years, we expect that several leading defined contribution providers will exit the record-keeping business. (A mitigating factor to this prediction will be if firms can create a link between their record-keeping capability and the systematic capture of funds ‘rolled-over’ when a participant leaves their employer.)
In conclusion, we expect the early years of the decade to be interesting and important ones for the investment management industry. If our six concepts become reality, there will be significant opportunities for managers to create value. We look forward to revisiting our predictions in IPE’s tenth anniversary issue.
John Casey is chairman and Christopher Acito is managing partner at Casey, Quirk & Acito, a strategic advisory firm that focuses on the investment management industry, based in Darien, Connecticut