GLOBAL – The low-return environment which looks set to continue for the foreseeable future will see investment managers having to change the way they structure their portfolios, says PIMCO finance director Lee Thomas.

The 20-year bull market in both bonds and equities is well and truly over, and Thomas is looking at returns on equities going forward in the region of six percent, and bond returns of around three percent.

Speaking in an interview in London today, Thomas said: “Returns are going to be lower, so alpha is going to become much more important. I think that’s what people’s intentions are going to be focused on – how to outperform these markets.

“The last 20 years you haven’t had to outperform, you’ve just had to ride the markets, and so alpha was not that important. But now it is and that is going to lead to a lot of changes in the investment management industry.”

Thomas believes that the current process for constructing portfolios does not concentrate enough on producing alpha, or market outperformance, and that this process will gradually change.

At present, when constructing overall portfolios for pension funds, the structure tends to focus firstly on asset allocation, and alpha generation is only a secondary consideration.

Says Thomas: “The way you form a portfolio today is to divide the universe up into investment styles, and that is considered to be the most important decision – how much are you going to put into equities versus bonds etc. Then you choose the managers, and the alpha part is just an afterthought, where it would be nice if you could get a little bit more.”

Thomas sees a change in this process so that generating alpha becomes key. This would mean designing a process where all alpha bets are optimised. “At the moment alpha bets are just the sum of all the different bets being taken by different managers in an uncoordinated way.

“Managers don’t often know who other managers are, and are acting independently – this goes against portfolio theory. The ultimate structure starts with an alpha portfolio, and then trying to optimise it.”

The route manages will take, Thomas says, will be either ‘revolutionary’ or ‘evolutionary’. The latter path will be more common, where specialist managers become broader, and clients give them permission to do so, so that eventually the manager has so much latitude that they can put together a portfolio selecting all different asset classes. The revolutionary way, says Thomas, would be to ditch specialist managers, hire a generalist manager and expect double returns from them by letting them decide how to invest.

But creating alpha is not easy, warns Thomas. “Alpha is a zero sum game. So half will have positive alpha, and half will produce negative alpha. Investment managers will have to demonstrate they can add value. Those that don’t will have business difficulties.”

PIMCO is part of Allianz Dresdner.