The end of an Era: 1992-2008
A new era for investment management is emerging. Complexity abounds, but it promises the potential to broaden business opportunities, create more stable revenue dynamics and provide greater client control. To understand where we are headed, we need to understand the ground we have covered. The following is a brief history of the era that has just come to a close.
Balanced strategies, once the only game in town, had been under pressure for years. Asset class and style specialization soon became the norm. With the help of computer enabled modeling tools and academic backing, the investment landscape grew in a well-defined pattern. In 1992, a one-two punch was thrown at investment managers: investment became about style.
Professor William Sharpe published his seminal paper “Asset Allocation: Management Style and Performance Measurement” in 1992.* This concise paper had a huge impact on the dynamics of the industry. In it, Sharpe argued that much of what dictates manager performance is due to manager style biases. His observations laid the groundwork for ‘style logic’ and had tremendous implications on the growth of passive index products. It led to the eventual proliferation of style buckets and the compartmentalization of investment managers into them.
Particularly in the world of institutional investors, this academic work gave investment consultants a strong upper hand in the establishment of asset allocation models, manager selection and implementation. Sharpe pushed plan sponsors to consider the importance of ‘style’ on an investment manager’s returns, demand ‘consistency’ from them and to distinguish a range of categories. His analysis and the related thinking that followed led to the increased indexation of investment management products. Consultants’ strength as intermediaries between asset owner and investor was cemented. A manager needed to be kept in check – not only to compare their performance versus peers, but to know whether they were ‘cheating’ by drifting away from the prescribed style.
The second blow to manager cross-asset class discretion was the Morningstar Style Box. Also debuting in 1992, the Morningstar Style Box was intended to be descriptive in nature, however it quickly evolved to become a prescriptive tool. Investment managers, through the intermediaries and fund boards who began using the tool, were increasingly told how they should and should not invest. Specialization, often driven by investor demand not manager initiative, came to the fore.
Changing Role for Investment Managers
It was a major driver in the erosion of control and powers of discretion they had once enjoyed over the broad asset allocation decisions they were making on behalf of investors. Investment managers now occupied one end of the value chain with investors on the other and intermediaries placed firmly in between.
Following these two developments, investors increasingly acted from the perspective that investment managers should not be the ones to decide between bonds and equities, or large and small, or value and growth, or U.S. and Asian equities – this was now the role of the intermediary adviser and investment consultant. These decisions were made through rigidly optimized strategic asset allocation models. In turn, products were increasingly designed and managed to fill the boxes. Unfortunately, the boxes were not designed to exploit managers’ best thinking.
Interestingly, this one-two punch corresponds with the rise of index strategies. The SPDR (S&P 500 tracking) ETF was launched in the U.S. in January 1993. And Vanguard, having launched as a firm back in 1974, started building business momentum in the mid 1990s. The low cost index approach was well aligned with the evolved views on the importance of style and asset allocation.
Power of the Intermediary on the Rise
The intermediary (as financial adviser, private banker and institutional consultant) soon gained influence and dictated the terms of engagement with end-investors. The investment manager who previously had enjoyed various levels of direct relationships with investors saw much of this erode.
At the time. the relationship between manufacturer (manager) and distributor (intermediary) was in fact symbiotic and welcomed. Each ‘partner’ had its unique role, or specialty, through which the ‘end-client’ benefited. The intermediary provided manager selection, investment policy decision making and asset allocation. The investment managers provided the cogs to the machine targeting the outperformance of benchmark market indices and peers. Managers gained AuM through strong relationships with intermediaries acting as conduits from end-investors. This is no longer the case. Over the last several years, those spigots of investor flows have been redirected – the intermediaries, now acting as investment managers themselves, are capturing more of the flows.
In an expanding environment, in which new markets are being developed and innovation is leading the charge, there is no sense in changing a model that isn’t broken – particularly when all parties feel as though their respective role is clear and that they are being compensated accordingly. Alas, such was the swan song marking the end of the era. Today, fee compression, ‘expanding’ business models, external threats and the failure of previous era asset allocation decision making has pushed relationships a new direction.
Cogs and Machines
Asset allocation is the most important decision made by or on behalf of investors. In the vast majority of instances, the decision to be in or out of equities trumps knowing which equities to buy. For the future of the investment management industry, the key question is who makes that decision on behalf of the investor to buy stocks at all?
This is a crucial question because it is the entity that controls the framework for asset allocation which, in turn, enjoys a stronger relationship than the entity that simply fits as a narrow cog in a machine. They also have a much greater impact on the performance of an overall portfolio composed of various asset classes. The large-scale investment management companies who will end up on top for the next 25 years are figuring out how to get the power to make broader decisions – how to be both cog and machine makers.
For specialists, narrowly focused in a particular style box (particularly in ‘efficient’ market categories), it is imperative to be absolutely exceptional to have a chance. Otherwise, if you stand in the middle of the road for too long you will eventually get run over.
The empirical evidence indicates as much. Asset managers with a run of the mill product hoping to eek out a small return above an index have a long and slow trudge ahead of them. Flows since the end of the last era have indicated as much: unconstrained, outcome-oriented allocation products have been winning the bulk of asset flows. Alternative products, many of which are a reflection of the trend towards removing constraints from investment managers, are now as much a net beneficiary of these changes as they have been a driving in the changing logic.
How Investment Management Companies Should Think About These Trends
Who is making asset allocation decisions on behalf of investors and what tools are being used to implement those decisions? This question should frame the decision making of investment managers developing a strategic growth plan. It dictates the dynamics of investor behavior and, in many ways, the evolving relationship between investment management companies and intermediaries such as wealth advisers, private banks and institutional consultants who are (re)emerging as investment managers themselves. Closer to the client (and with an urgency to expand margins as an incentive), they stand a good chance of taking market share in what is becoming a newly defined market.
One helpful way to think about the developments in the investment management industry would be to see them as a complex result of the ebb and flow of the role and power of intermediaries. The power of intermediaries over the last 20+ years has been driven by their ability to dictate the terms of engagement with investment managers by, amongst other things, ensuring that managers were specialists and therefore responsible for narrow groupings of securities in a particular asset class and style.
With the blowout of asset allocation results from 2007-2008, we have arguably seen the end to the traditional intermediaries discretionary super cycle. As is evidenced by the growth in market-derived products (smart beta included), there are plenty of ways to access the market and its various elements. The questions that remain are: which ones, when and at what weight?
Some important things to keep in mind:
1. Investment managers are increasingly competing against the intermediary conduits that helped feed them AuM over the last 25 years.
2. ETFs and Vanguard have killed the business model for middle of the road active managers – particularly in light of intermediaries increasingly seeking to ‘add value’ through asset allocation decisions.
3. The prominence of the standard “strategic” asset allocation model followed by a filling of the buckets of specialists is disappearing.
4. Asset allocation is the single most important decision not only for getting desired investment results but also because it also dictates the nature of the relationship with investors. This is the battleground between investment managers and intermediaries. Unconstrained, go-anywhere, benchmark-agnostic, multi-asset as well as outcome-oriented strategies are all the marks of broadening asset allocation decision making.
5. Investors are seeking more, not less, investment advice though that ‘advice’ may increasingly be (re)embedded in investment products. This is a big opportunity for investment managers.
6. Investment Solution = Control = Discretion = Fee Capture = Longevity of Relationship
* Sharpe’s paper, “Asset Allocation: Management Style and Performance Measurement,” can be found here: http://www.stanford.edu/~wfsharpe/art/sa/sa.htm