As institutions continually question their approach, fund managers have had to adapt to a client base that rejects the traditional assumptions. Bee Ong talks to Russell CEO Andrew Doman about meeting this challenge.

Long before emerging markets became global investors’ mantra, Andrew Doman had started moving his personal assets into these markets, as he anticipated that developed markets’ ageing populations would have an effect on asset values and returns.

Indeed, some theories suggest that the 1990s surge in equity prices was partially attributable to baby boomers saving and investing for retirement. According to this argument, the boomers’ retirement in the coming decades will sharply depress markets, as they liquidate their assets for retirement spending, while the next generation is too small to fill the gap. This demographic phenomenon can also affect government debt and tax revenues in future, as well as real rates of return. 

Doman, the new CEO of Russell Investments, is trying to make the point that investors need more sophisticated ways of assessing the markets, which takes into account a more holistic set of factors. “The old assumptions that drove strategic asset allocation need to be reworked. Many of these were based on the efficient frontier, which was built on certain assumptions regarding expected returns. For example, one assumption was that equities can return 6%, but will that be possible in the future? The market events of the last two years, when every asset class was correlated, shows that these assumptions were naïve. We need new models and approaches,” he remarks.

The Yale endowment model, on which many of Asia’s sovereign funds and endowments are based, is largely built on the supposition that alternatives are uncorrelated to listed equities and bonds. But market behavior during the perfect storm has proved this to be erroneous.

What new models and approaches will institutional investors need to address today’s more complex markets? Russell and other leading-edge institutions such as EDHEC are in the midst of researching the conundrum.

It is one of several innovations that Russell thinks investors need currently. The US-headquartered firm is today focusing its creativity on investors’ new demands. “Many institutional investors are questioning the decisions they made in the past and they are demanding fresh strategies, including new product structures and more manager research,” Doman says.

He discerns several trends among institutional investors. One is the realisation that, although they have long investment horizons, they need to time markets and perform tactical asset allocation to some extent. “Most institutions don’t have an infinite time frame, and many didn’t do enough market timing. In the US for example, defined benefit portfolios are dependent on interest rates and as a result, shortfalls can vary significantly from year to year.”

Pension funds, non-profits and endowments, which sometimes rely on investment returns to fund operations and liabilities, are particularly sensitive to short-term vacillations. A Russell research report investigating whether a 6% real return will be available to non-profit investors in the future concluded “kinda sorta”. From 1926 to 2008, a portfolio of 60% equities and 40% fixed income returned 5.4% in real terms, after adjusting for US inflation. But even though the portfolio approximates the 6% hurdle rate over the long run, “a prolonged period of depressed returns over the intermediate term would seriously undermine the program. So it is necessary to look not only at the long-term averages, but also at shorter periods,” the report says. Of the 79 periods (each period is five calendar years) in the study, the portfolio failed to reach the 6% target rate in 41 periods. When divided into 74 decade-long periods, the portfolio underperformed the 6% hurdle in 34 periods.

Long-term investors’ short-term requirements are growing shorter. “Some mandates are awarded on an annual basis now,” Doman observes. Mahendran Nathan, Russell’s chief executive for ASEAN, India, Hong Kong and Taiwan, remarks, “Institutional investors want a high level of engagement with their advisers. In fact, some clients want to review portfolios every month, while in the past, they might have made reviews annually. The market environment changes very quickly these days and clients need to know whether their bets are going in the right direction and if risk is being managed well.”

It all comes back to a basic question: How competent is the fund manager? “We see increasing rates of switching of advisers and a demand for deeper research into fund managers in specific countries such as China. The need for due diligence on managers has increased, especially post-Madoff. Investors need to know about the fund manager’s operational procedures and internal controls, not just about their performance track record,” says Doman.

Some institutions’ trustees are also embarking on soul-searching, he adds: “Many trustees say ‘we’ve been bamboozled by the markets. Are we better off delegating investment management responsibility to experts who can handle the investment process end to end.”

Nathan thinks that many smaller institutional investors with fewer than US$5 billion may benefit from outsourcing their trustee responsibilities. For example, a typical institutional fund in Asia is relatively small; all three of Singapore’s public university endowments are under US$3 billion each in assets.

Russell manages US$179 billion globally, of which 80% is institutional and 20% retail. The group expects Asia regional assets under management expected to quadruple in the next four to six years. To address the new demands, Russell’s recent inventions include an enhanced asset allocation strategy based on 114 pairs of assets to be used in high-conviction situations; strategies to add some defined benefit advantages into defined contribution pension plans; and an active ETF being tested in Australia, which allows for shorting specific ETF components to add alpha.