Asset management is a relatively young industry, which has become increasingly popular over the past 20 years. Rising incomes and demographic changes in the developed economies has meant more opportunities and a greater need to save. Likewise, a greater need for professional management has emerged in the wake of the rapid development in financial markets, which offer investors choice, but at the same time require a more sophisticated approach. The combined evolution of increased savings and efficient financial markets was the catalyst for the exponential growth of the asset management industry.
Asset management is built around three concepts: financial theory, efficient financial markets and regulation. A number of developments over the past 10 years are now challenging the underlying assumptions of these concepts. Such fundamental developments mean that both practitioners and users of asset management skills are being forced to reconsider their behaviour – a step which could lead to a totally different approach to the business in the years to come.
The major catalyst for the development of financial theory concerning asset management was the advent of advanced calculation methods. With the development of computers, it is hardly surprising that back in the 1950s, the fundamentals of the Modern Portfolio Theory were established. Markowitz’s Modern Portfolio Theory (MPT) created a scientific environment in which investors could make rational decisions based on quantified assumptions. The two basic factors in investment decisions, – expected return and risk – can be quantified for each investment and combined with the personal preferences of each individual in order to build up the optimum portfolio.
This quantified approach taken by asset management shaped the framework for investors and asset managers for generations. Within this environment, two interesting characteristics of assets and markets emerged. First, rational investors and efficient markets meant that more risky asset classes (statistically defined as asset classes with more volatile prices) delivered, on average, a higher return as a logical reward for the risks taken by investors.
Second, and more importantly, as the investment horizon increases, so risk or volatility seems to decrease. The chart illustrates this phenomenon in the past evolution of Belgian financial markets.
The same pattern is evident in almost all developed financial markets.
For a one-year horizon, the equity risk is more than three times the risk of bonds. Equity risk appears to be 50% lower for a five-year horizon and over ten years, the risk of bonds and stocks is almost comparable, although equities still deliver a 3% higher annual return.
These observations suggested that rational investors should take into account two mechanisms:
o the longer the investment horizon, the more stocks should be included in the asset allocation since they deliver better returns without substantially increasing the long term risk.
o long-term equity investors should not be concerned by short-term volatility.
These two assumptions were welcomed by asset managers, institutional investors, financial advisers and consultants as they rationalised their activity and facilitated the commercial development of their services.
The time was ripe for the birth of the so-called equity culture. For decades the theory and additional comments seemed to be borne out by markets behaving more or less as predicted.
However, difficulties arose in the form of the so-called equity risk premium. Based on rational behaviour, the historical risk premium on stocks was too high to be explained. There were two possible explanations: 1) Investors’ expectations were too pessimistic (in other words, not rational) or 2) too many unforeseen factors came into play that made rational expectations systematically wrong. The equity risk premium puzzle was dangerous to the theory but, at the same time, was welcomed by investors and asset managers because the returns on equity investments were systematically better than could have been predicted.
But let us try to find another explanation for the equity risk premium. Let us suppose that the MPT was strong enough to influence investors’ behaviour and was pushing them more towards equities and causing them to be less concerned about short term volatility. As a result of this changing behaviour, increasing demand for stocks leads to rising prices and an increased historical risk premium. Also, long-term investors no longer change their investment strategy as they did in the past, thus reducing historical volatility. These two observations were so convincing that more equity investment seemed rational, thus creating a continuous upside pressure on equity prices.
As so often in human sciences, belief in a particular theory could well have the power to create an environment in which it is self-fulfilling for some time. Only when this process of self-fulfilling prophecy implodes or explodes is the theory questioned.
Not all economists assume rational behaviour on the part of investors; neither do they accept that risk is reduced over time. Samuelson was perhaps the first economist to raise difficult questions with his famous article about the fallacy of large numbers. Even if it is rational to invest more in stocks when the investment horizon increases, time does not eliminate risks. As stock prices are not mean-reverting, investors should never believe that time will help them to recover from losses. A downturn in the market does not necessarily increase the probability of a subsequent price increase: each day starts with exactly the same probability distribution. Furthermore, historical figures are not necessarily representative of the true probability distribution of returns. Financial markets cannot be tested in a laboratory; there is only one outcome, linked to a very specific situation and we will never know the ex-ante probability of this outcome.
More recently, the development of behavioural finance further undermined the assumptions of the traditional theory: human beings are driven by emotion, and cognitive bias prevents rational analysis.
Even if the behavioural finance approach does not necessarily mean that markets can be beaten, it clearly indicates that overconfidence, framing and other psychological factors cannot be qualified as rational under the definition of the traditional financial theory. Bubbles, hypes and crashes are not caused by rational behaviour in terms of risk-return probability.
Even George Soros further undermined the theory with his concept of reflexivity. While traditional economists accept temporarily irrational fluctuations of markets within a rational and stable long-term trend, Soros points out that such fluctuations are sometimes so powerful that they reshape the whole environment and alter the course of the long-term trend. Suppose that for an irrational reason, investors suddenly become concerned about the quality of the banking system. As they sell bank stocks and bonds, prices fall, thereby increasing the cost of funding. This could lead to a real problem in profitability and to destabilisation of the banking sector. In other words, irrationality will not automatically disappear but will sometimes be powerful enough to change the direction of history.
Finally, chaos theory, although relatively unsuccessful in financial practice, nevertheless indicates that insignificant events can change the very foundations of an economy: a butterfly in Europe that can cause a hurricane in Brazil.
The growing size and power of financial markets has totally changed the nature of their relationship with the “real economy” of production and trade. Whereas financial markets were originally a derivative product of the real economy, their size today exceeds that of the underlying economy. With a stock market capitalisation of over 150% of GDP in the US, even after two bad equity years, it is clear that fluctuating stock prices can have a huge impact on consumption and investments. Indeed Keynes himself warned against this evolution of dominating speculation on large financial markets.
Two other observations can be made about the current situation of financial markets.
First, research by Shiller and Campbell clearly pointed to the strong overvaluation of stock prices, based on long-term analyses. Even Greenspan had doubts about irrational exuberance when, in 1997, the S&P stood at a level of about 700. By 1999, it had doubled. The significant correction since 2000 leaves the S&P at a level way above that of 1997. This at least indicates that stock markets are still expensive in terms of long-term historical valuation levels.
The second observation concerns Japan. Considered as the most powerful economy in the 1980s, and an example to be emulated by the rest of the world, the Japanese economy entered a downturn in 1990 and one from which it has yet to recover. The Nikkei has since lost 75%, while interest rates stand at zero. This alone shows that long-term investors should never think that time will solve their problems and proves that mean reversion is not a characteristic of stock prices.
Regulators and supervisors are becoming increasingly aware of the risky environment of financial markets. The bubble of creative bookkeeping, starting with ENRON has done nothing to reduce their concerns. Little wonder, therefore, that there is increasing pressure on financial professionals to be more transparent and provide greater protection through increased own capital. The implementation of IAS, based on a generalised mark-to-market approach, together with capital adequacy rules for the financial sector defined in Basle II are clear examples of this evolution.
On top of that, the ENRON debacle is leading to more control on financial reporting and a focus on more transparency for all listed companies. Earnings management should be totally excluded and annual accounts should exclusively reflect the economic reality.
This new wave of regulation is having no small effect on the behaviour of a number of institutional investors. The general mark to market principle and more transparency will make short-term volatility of investments more openly visible and this could well shift the focus of investment strategies from long-term return to short-term stability as higher volatility increases the cost of capital. This is clearly the case for insurance companies but pension funds and their promoters, too, have to change their strategies.
Asset management is built around a number of assumptions generally accepted by asset managers and investors. These assumptions are challenged by a number of developments:
o Even in the long run, investments in stocks do not necessarily lead to a risk premium, since equity markets are not mean-reverting and markets are driven by powerful emotions;
o the evolution of financial markets clearly demonstrates this emotional dimension, which can last for years, leading to irrational exuberance or the opposite. The example of the Japanese stock market in the 1990s illustrates what little control investors have over risk, even in the long term;
o for many institutional investors regulation makes long-term strategies more difficult and more costly, and will force them to change their investment behaviour.
The influence of the above-mentioned simultaneous developments on asset management practice should not be underestimated.
First, the construction of the asset management process around a strategic asset allocation based on a long-term benchmark could well be challenged if the belief in a long-term risk premium for equity investments disappears or if the long term becomes to long. A totally different approach to asset management could be the control of downside risk combined with more freedom of movement for the asset manager. Indeed, this approach comes close to the already well-developed VAR analysis generally implemented by banks. Asset managers, consultants and pension-fund managers have to rethink the whole environment and way in which portfolios are constructed.
Second, as an increasing number of institutional investors become focussed on downside risk or VAR, they will move more towards the hedge fund business. The challenge emerges of combining long-term strategies with short-term risk management.
Third, if more and more investors become less convinced of the feasibility of a simple long-term equity investment, it could well undermine the equity culture and the market valuation.
The increased use of hedging techniques in order to limit downside risk could even increase market risk: selling when prices go down and buying when prices go up are traditional methods to control downside risks. As far back as October 1987, hedging techniques were causing stock prices to plummet uncontrollably – a situation that could only be stemmed using draconian measures like shutting down computer systems.
In reality, things will not deteriorate as described in this article because there is time to gradually adapt strategies and tactics. But even if the consequences are only half as significant as we imagine, the impact on the asset management business will be huge and the players should be well prepared with new products and new strategies.
Freddy Van den Spiegel is chief economist at Fortis Bank in Brussels