Manager selection in a volatile world (co-written with Amin Rajan)
This essay appeared in Investment & Pensions Europe in May 2013
When choosing managers or funds, there is a growing gap between what selectors say and what they do. Their rhetoric covers four ‘Ps’: philosophy, process, people and performance. But their practices too often focus on past performance. Though professional selectors aspire to make decisions based largely on qualitative factors, performance remains king.
As in institutional markets, in retail this gap reflects growing short-termism on the part of the end investor as much as the desire to minimise career risks on the part of fund selectors and pension advisers. It also reflects the pronounced shift from balanced mandates to specialist mandates that has been gaining momentum in the US since the early 1990s and in Europe in the wake of the 2000-02 bear market.
The gap has widened due to three fault lines in the investment landscape: the buy-and-hold approach has not worked as expected, as equities have been outperformed by bonds; nor has the bar-belling approach worked, as actual returns have varied markedly from expected returns for most asset classes; diversification has also not worked, as excessive leverage ramped up the correlation between historically low-correlated asset classes.
As a result, growing client demand for multi-asset strategies of various types is changing the complexion of both asset managers and the selectors who analyse them.
These developments suggest that although the past may be the best guide to the future, it is still a very imperfect one and less certain than ever.
The over-emphasis on performance in the selection process is all the more worrying, since empirical research shows that only a small proportion of managers beat the markets, after fees and charges are taken into account. The ones that do beat the markets lack persistency over time in their performance numbers.
Like alchemy, expectations of persistency thrive on the end investor’s wish to believe in impossible things. No wonder, the long-term relationship between managers and their clients has given way to brief affairs in the world of fast finance.
The winds of change
The 2008 meltdown has left investors on shaky ground. They need a high-touch approach that assures them that their asset managers understand the investment heartbeat of their end-investors as well as the subtle nuances of investing today.
Four messages stand out from the 2012 Principal Global Investors/CREATE Survey*. First, markets will remain in an era of prolonged volatility until substantial. deleveraging is evident on both sides of the Atlantic. Second, the volatility cloud still has a silver lining owing to exceptional opportunities thrown up by periodic price dislocations. Third, asset managers are re-orienting their business models to turn these market ructions into investment opportunities. Finally, a new form of diversification is emerging in which risk minimisation is more important than returns maximisation.
The survey respondents also identified factors that will differentiate winners from losers. These need to be factored into the manager selection process. They fall into three neat clusters.
The first cluster covers end-clients: 66% of respondents cite the importance of a deeper understanding of clients’ goals, challenges and risk tolerances; 66% also single out the importance of greater client engagement, and 59% caution against making unrealistic claims about returns.
The second cluster relates to investment capabilities: 54% cite managers’ track record on active management, and 53% cite the importance of the expertise that anticipates price dislocations within a multi-asset class framework.
The third cluster covers alignment of interests: 50% see the importance of co-investing that ensures that investment professionals also have a personal stake in the funds they manage; 44% see the need for low charges and high watermark fees, and 42% favour low charges plus profit sharing. At the very least, clients want to make sure that their managers eat their own cooking. The current skewed structure is akin to a call option that makes little sense after millions of investors lost billions of dollars in the two bear markets of the last decade.
These clusters underscore an important point: increasingly, investors are distinguishing between product alpha that is time dependent and solution alpha that is need dependent.
One is about beating the market, the other about meeting the goals of the end investor. The shift from the first to the second is now in progress. Alpha is too scarce and expensive. Liability matching is paramount due to ageing populations. In various guises, balanced mandates are making a comeback, as evidenced by the rise of fiduciary management in Europe and in implemented consulting in the UK.
In analysing multi-asset class strategies, fund investors must take a more holistic view of a manager and its capabilities. They must discern a manager’s skill in not only picking stocks but in making broader market allocation decisions.
Picking the wrong stock can have serious implications for an specialist fund but getting the overall asset allocation mix wrong can spell disaster for an investor. In 2008, many investors experienced just such a double-whammy.
Because it affects the whole portfolio, getting the asset allocation wrong can have detrimental implications. A way to manage that risk is to diversify the diversifiers – that is, allowing broader viewpoints into the asset allocation.
Ascendancy of multi-asset classes
Underlying much of the discussion about multi-asset investing is the changing role of managers and their selectors.
As balanced mandates were replaced by specialist mandates in the last decade, the role of the asset manager became increasingly narrow and distant.
A variety of professional intermediaries stood between managers and their investors. Typically through their unilateral control of asset allocation decisions, such gatekeepers ended up with undue influence on strategic asset allocation.
They were paid primarily to allocate to specialist buckets. This approach has been found wanting. The selectors do not have the expertise to assess asset class correlations in different volatility regimes in today’s turbulent investment landscape. Nor do they have the experience to do dynamic asset allocation – for many of them, that is synonymous with Russian roulette.
Not surprisingly, therefore, we are entering an era in which managers are being increasingly afforded the opportunity to make portfolio-level decisions within broader mandates covering different asset classes.
Today, investors are rightfully saying ‘Who cares if a fund manager beat the market benchmark by 100bps if the wider market is down 20%? We don’t want to be in that market.’
On their part, asset managers are demonstrating an expertise across asset classes, in line with their client needs. They are taking on broader responsibilities – in some cases, in alliance with the intermediaries; in others, instead of them. Balanced mandates are dead. Long live balanced mandates.
In the process, their selection criteria is being extended beyond four ‘Ps’ and take in the elements of the three clusters mentioned above. Institutional investors with clear liability benchmarks are the first to break ranks. Retail investors heading into retirement are following suit.
Co-written by Amin Rajan (CEO of CREATE-Research) and Roland Meerdter (managing partner of Propinquity Advisors).
*Market Volatility: Friend or Foe?