Future of Investment:
the next move?
Author: Prof. Amin Rajan
First published in 2009 by:
CREATE-Research
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© CREATE Limited, 2009
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The findings and views expressed in this report do not necessarily reflect the views of Citi and Principal Global Investors. Whilst every effort has been
taken by CREATE-Research to verify the information, neither Citi nor Principal Global Investors and their affiliates can accept any responsibility or
liability for reliance by any person on this information.
Foreword
This report is a timely and systematic assessment of sentiment
in the industry. We at Principal Global Investors are very
pleased to be sponsors of this research by Amin Rajan, who
in recent years has become a highly respected commentator
on the changing environment for Asset Management. It may
seem strange, in the current highly stressed environment, to
be a first time sponsor, but we think that it is more important
than ever to listen to the concerns of clients and other market
participants.
After the crisis of the 1930s a very durable and successful
regulatory environment for financial markets was created.
That framework was largely set aside from the mid 90s
onwards and we have subsequently experienced two of
the four worst bear markets of the last 100 years during
this decade. This turmoil looks likely to cause permanent
changes in attitudes.
There is an opportunity after the latest crisis to put in
place a more effective and fair framework for modern
global markets. Regulatory change is inevitable, with the
precise pattern for regulation now under active debate.
Markets have been highly correlated in the downturn. But
in more stable markets, diversification is still likely to have
advantages in mitigating risk.
It will take time for changing best practice to emerge. In
particular, assessing the likely changes in investor needs
will be crucial, as clients are likely to want simplicity and
transparency moving forward. We wanted to hear how
clients and others in markets think about the problems
caused by the recent crisis. This report is an excellent
contribution to the necessary debate.
Jim McCaughan
CEO
Principal Global Investors
Citi is pleased to sponsor the third in a series of thought
leadership reports from CREATE-Research, a prominent
observer of the asset management industry worldwide.
The subject of this report could not be more timely. As
we all know, the recent crisis has been the latest of many
developments that have impacted asset managers and their
clients worldwide. At this critical juncture asset managers
are taking stock and reviewing how the future of their
industry will unfold.
This is the first research report of its kind to analyse the
possible scenarios for the evolution of the global asset
management industry and its existing models. It shows that
the industry is at a point where a return to business-as-usual
is not an option.
Asset managers are now responding to the realities of
the new environment and are increasingly exploring
opportunities to adopt variable-cost models by outsourcing
functions. This is an important structural shift in the model
for the industry’s value chain, and the ultimate reward could
be a more efficient use of capital and maximization of alpha.
Citi, as a major provider of services to the investment
management industry, sponsored this research to distil both
the views and opinions of the industry post-crisis. Our goal
is to generate further discussion around the findings in the
report, which we hope will be of value to the industry and our
clients.
Neeraj Sahai
Global Head
Citi Securities and Fund Services
I
Acknowledgements
This is the latest report in a research programme designed to highlight the key
trends in global asset management. The programme has delivered a number of
acclaimed reports, white papers and articles to be found at www.create-research.
co.uk . Brief details are given on the inside back cover of this report.
I am deeply grateful to four groups of organisations and people who have made
this report possible.
The first group comprises 225 asset managers and pension funds who participated
in our electronic survey. Sixty of them were also involved in our post survey
structured interviews, thereby adding the necessary breadth, depth, rigour and
nuances to our findings. They are part of a growing body of thought leaders
who have profoundly influenced the content of our research programme by
contributing to an impartial research platform which is now widely used by all
players in the investment value chain.
The second group comprises Citi’s Global Transaction Services, Principal Financial
Group and Principal Global Investors, who jointly sponsored the publication of this
report, without influencing its conclusions in any way. Their arms-length support
helped our team to focus on the core issues in an exemplary impartial manner. I
would also like to thank the Financial Times for being our media partner.
The third group comprises five industry leaders who provided constructive
comments that improved the earlier draft of this report:
• Alan Brown, Group Chief Investment Officer, Schroders Investment Management
• Jean-Baptiste de Franssu, CEO, INVESCO Continental Europe
• Robert Parker, Vice Chairman, Asset Management, Credit Suisse
• Benjamin Phillips, Partner, Casey Quirk & Associates
• Todd Ruppert, President & CEO, T. Rowe Price Global Investment Services
The fourth group comprises my immediate colleagues. I would like to record
special appreciation to Dr Elizabeth Goodhew, Naz Rajan and Leanne Perry.
After all the help I have received, if there are any errors and omissions in this
report, I am solely responsible.
Prof. Amin Rajan
Project Leader
CREATE-Research
II
Contents page
Foreword...................................................................................................................... I
Acknowledgements.............................................................................................. II
Introduction.............................................................................................................. 1
Executive summary............................................................................................. 3
Headline messages and key themes
Market dynamics................................................................................................... 15
How will client behaviours change post crisis?
New business models......................................................................................... 29
How are asset managers responding?
Introduction
“Things that
count, often can’t
be counted.
Things that can
be counted, often
don’t count”
Albert Einstein
Two of the four worst bear markets of
the last 100 years have occured over a
span of seven years in this decade.
Indiscriminately, like a tsunami, the
latest has wiped out some US$15
trillion in asset values, hitting every
asset class, every market, every
geography, and every client segment:
15 years of capital gains were wiped
out in 15 months.
With the worst of the crisis seemingly
over, it is time for a stock-take and
scenario work.
This study explores how the market
dynamics of the asset management
industry will change and how its
business models will reshape. This
broad question is answered by pursuing
five specific issues:
• H
ow will client behaviours change
and what asset classes or generic
products are likely to be in demand?
• In the nascent recovery, will clients
revert to the old ways, driven by
greed and fear, which have long
distorted their behaviours?
ow has the latest crisis affected
• H
individual asset managers and
what steps are they taking to
create resilient business models that
work in bull and bear markets alike?
1
s a result, how will the industry
• A
business models change and
what will be the key features of
the winning model in the new
competitive landscape?
• W
hat are the likely scenarios of the
industry’s future and what will the
emerging architecture look like?
This report focuses on four client
segments: defined benefit (DB) plans,
defined contribution (DC) plans,
retail investors, and high net worth
investors. Our assessment is based
on two sources of information: an
electronic survey followed up by
structured interviews.
Some 225 asset managers and
pension plans from 30 countries
participated in the survey (see figure
on the opposite page). Together, they
had US$18.2 trillion in assets at the
time of the survey in April 2009, down
from the peak of US$24.4 trillion in
July 2007. The post-survey interviews
involved 60 asset managers, pension
funds, wealth managers, distributors
and industry regulators.
The survey provided the global reach; the
interviews; the subject depth. Together,
they provide fresh insights into recent
events and their future impacts.
Survey participants by geography and size of AuM
Source: Citi / Principal / CREATE Survey 2009
2
Executive summary
“Asset managers
need a new
narrative on
what they stand
for and what
they can deliver.”
Client behaviours
• L
ike other crises, this one will pass.
But its memory will long endure.
Clients have a new definition of what
pain feels like. Once the worst of
the current turmoil is over, the old
normal will not be the new normal.
• T
here will be a flight to quality,
simplicity and safety: quality
defined by consistent risk adjusted
returns; simplicity by transparency
and liquidity of the strategies
being used; and safety by capital
protection. Alongside, there will
be also periodic opportunism to
capitalise on the current mispricing
of distressed assets.
• C
lients know that safe liquid
assets mean low returns. Many
are unwilling to buy into the risk
premium story for the foreseeable
future. The scale of recent losses is
the immediate cause of the loss of
investor confidence. But it had been
eroding long before.
3
• F
irst, the buy-and-hold strategy
was not working, as equities were
outperformed by bonds over a long
period; second, nor was the coresatellite approach, as actual returns
diverged markedly from expected
returns for most asset classes; third,
nor was diversification, as excessive
leverage ramped up the correlation
between historically lowly correlated/
uncorrelated asset classes.
• F
or DB clients, these factors were
not the only ones that hastened the
pace of plan closures in every region.
They also had to contend with new
accounting and regulatory changes.
• T
hese had inflated the deficits at
a time when ageing populations in
the West left inadequate time to
plug them. Almost every asset class
they were advised to follow has
failed them. Sponsors’ patience has
been stretched to breaking point.
Covenant risk is at an all time high.
• G
oing forward, therefore,
mainstream asset classes will
outweigh alternatives in client
choices in the nascent recovery.
There will also be periodic
opportunism to capitalise on the
dislocation in the primary debt
markets as well as the secondary
buy-out markets.
• E
ach client segment will have
distinctive pre-occupations,
reflecting varying degrees of belief
in the risk premium story.
• D
B clients will be drawn towards
indexed and global equities, and
investment grade bonds; with a
slant towards opportunism.
• In the English speaking world, DC
clients will favour equities in some
areas and refined target date funds
in others. In Continental Europe,
insurance contracts will continue to
dominate DC choices. In Japan,
the interest in DC plans will wither
as zero interest deposit accounts
are perceived to remain a better
alternative.
etail clients will be drawn into
• R
products that offer capital protection
and tax efficiency, with periodic
opportunistic forays into absolute
returns or cash products. As
post-War baby boomers head for
retirement in all the OECD countries,
loss aversion will remain rife.
• F
inally, high net worth clients will
venture back into active long only
space as well as alternatives, with a
strong opportunistic slant.
• T
hus, for clients, the new normal will
be about “buy what you understand;
understand what you buy”. It is
influenced by discontinuities in the
investment landscape driven by six
factors (see figure on the following
page). In turn, these drivers are
expected to reshape the future of
the industry.
• O
n the one side are those demand
side factors which can cause a
tipping point, accelerate change
and commoditise the industry. On
the opposite side are those supply
side factors which can reverse client
sentiment, moderate the pace of
change and revitalise the industry.
• T
he final outcome will depend upon
the relative strengths of these
opposing forces. It is hard to imagine
that nothing is going to change after
everything that has happened.
• A
sset managers need a new
narrative on what they stand for
and what they can deliver.
Business models
• M
odest steps have been taken
towards attacking the sacred
cows which have long sustained
cost rigidities in global asset
management. A variable cost model
is emerging in which costs are linked
directly to revenue via variable pay,
4
slimmer product range and strategic
outsourcing. Diseconomies of scale
are under attack.
n the cultural side, these steps are
• O
being reinforced by enhancements in
the senior executive gene pool, client
service and incentive systems —
with a hard-nosed approach to
economies of scale and scope.
n the structural side, they are being
• O
enhanced by outsourcing front, middle
and back office activities to create a
distinct craft focus at the investment
end; customisation at the distribution
end; and standardisation at the
administration end. Independent and
multi-boutiques are becoming centres
of investment expertise.
• T
hus far, the scale of changes is
modest, with more in the pipeline:
the collapse of Lehman Brothers
was the catalyst. With a clear
strategic intent, what is now in the
works can potentially blow away the
old entitlements and entrenched
practices that have long conspired
against client interests and operating
leverage. These changes may outlast
the nascent recovery: the majority
of asset managers expect regulatory
pressures and fee compression to
intensify over the next three years.
Beyond that, they also expect more
systemic crises, like the current one.
hus, the causes and consequences
• T
of the current discontinuities suggest
three overlapping scenarios in
the medium term. At one end is a
commoditised industry in which
clients’ investment choices are largely
driven by capital protection, as has
already happened in Japan: 34% of
the survey respondents subscribe to
this scenario. At the other end is a
vibrant industry in which managers
put client interests first more than
ever: 17% subscribe to this scenario. In
between is a segmented industry with
a fragmented food chain and a distinct
focus on different client segments:
49% subscribe to this scenario.
• W
hatever the likely outcome, there
will be no return to business as usual.
Equally, the future will not follow a
pre-determined path. As in a game of
chess, final outcomes will depend upon
the quality of moves made by asset
managers at each iteration.
What are the causes and consequences of discontinuities?
Source: Citi / Principal / CREATE Survey 2009
5
Theme 1: The worst of the current crisis may be over in 2010 but further
upheavals are not ruled out in the new decade
Securitisation has proved perfect in its
failure. The sell-off in 2008 was almost
without precedent for its speed.
It has triggered a chain reaction
which will endure long after the
markets recover.
At times like this, the danger of
confusing the cyclical with the
structural is substantial.
Unsurprisingly, therefore, 45% of
our survey respondents do not
expect the worst to be over until
the first half of 2010. Nearly 25%
expect it to be even later (see left
hand figure below).
Clients nursing huge losses are
expected to take the money off
the table and head for the exit door
at the opportune moment.
Many were caught in headlights. They
had to sit tight on their assets. At least
some of them would want to get out at
the right time.
So, when global economic recovery is
here, the markets are likely to follow a
W-shaped path. Risk has been re-priced.
Its equilibrium level is far from clear.
At the same time, respondents do not
rule out more systemic crises in the
new decade for two reasons (see right
hand figure below).
Necessary though it is, the scale of recent
economic stimulus in G20 countries is
expected to stoke up inflation.
The global economic imbalances
between the East and the West are likely
to persist for the foreseeable future.
Given these unknowns, asset
managers’ response to this bear
market has been more strategic than
the last one in 2000-3.
Figure 1.1
When do you think the worst of the current
crisis will end?
How many more systemic crises do you
expect over the next decade?
Source: Citi / Principal / CREATE Survey 2009
Interview quotes:
“We will learn a lot in the short
term, a bit in the medium term and
nothing in the long term.”
“There is a large lumpy risk legacy.
So the initial market bounce will
not last long.”
“There’s no such thing as a
‘free stimulus’: high inflation and
interest rates are soon inevitable.”
6
Theme 2: Simplicity will replace complexity in clients’ investment choices
dynamics and onerous regulatory
and accounting rules have been
forcing plan closures or restructuring
throughout this decade.
Clients are scared and disillusioned. Risk
failed to generate returns in the 2000s.
Their confidence was shattered in 2008,
when several well known US money
market funds ‘broke the buck’, with net
asset values falling below one dollar.
Loss aversion will be rife for the
foreseeable future. Priorities will
change. Return of money will be more
important than return on money in
the retail space. Expected risks will be
more important than expected returns
in the institutional space.
Retail clients and DB clients are
likely to display stronger behavioural
changes than other segments (left
hand figure below). Together, they
account for the bulk of assets in main
markets except Australia.
The simplicity rebound will be hard.
It risks commoditising the long only
space. Besides, many asset managers
are not tooled up for product features
like low return, low risk, low volatility
and high liquidity. There are also fears
about the viability of the revenue
streams now tied to complex products.
The first group has been the victim of
poor asset allocation choices, whose
impact has been all too apparent.
Many of them are also baby boomers
who are migrating from risk- taking to
loss aversion in their DC plans.
For DB clients, persistent losses,
covenant risk, demographic
perceive a rosy outlook over the next
three years: 19% describe it as ‘poor’
and a further 39% as ‘limited’. Only
6% expect it to be ‘excellent’ (right
hand figure below). On the whole,
larger players are less sanguine than
the smaller ones; as are those with
bigger investment losses.
A notable minority in the English
speaking world expects clients to
revert to their old behavioural biases
when markets recover.
Not surprisingly, therefore, the
majority of respondents do not
Once the current crisis is
over, how would you describe
the industry’s growth
prospects in the following
three years?
Figure 1.2
To what extent will the current crisis alter clients’
investment behaviours in the medium term?
% of respondents
10
0
10
20
30
Not at all
40
50
60
Some extent
70
80
90
100
Large extent
Source: Citi / Principal / CREATE Survey 2009
Interview quotes:
“Trust doesn’t exist anymore. Most
investors can no longer spell it.”
7
“It is impossible to know if clients
would run for the door when
markets recover.”
“Change is often as durable as the
crisis that caused it.”
Theme 3: Core and explore will be the dominant theme in all client segments
In the old days, it was hard to get
capital but easy to make money.
Lately, it has been easy to raise
capital and hard to make money.
Now it is hard to get capital and hard
to make money.
For the foreseeable future, clients
will adopt a pragmatic approach
with the dominant emphasis on risk,
liquidity, volatility and transparency;
backed by periodic forays into the
dislocated debt markets where the
savagery of the downturn is creating
value opportunities.
Even equity and bond markets are
seen as suffering from undue
technical ‘noise’, where price no
longer represents intrinsic value.
Most clients recognise that without a
high degree of conviction, buy-andhold strategies amount to wishful
thinking. Being pragmatic, they will
focus on liquid asset classes, backed
by opportunism in debt markets,
emerging markets as well as equity
markets, as shown in the figure below.
For example, in the case of DB clients,
40% to 60% of respondents expect
them to chase returns and liquidity; and
20% to 60% expect them to engage
in opportunism. In the case of retail
clients, 43% to 63% of respondents
expect them to chase capital protection
and income upside; and 22% to 39%
expect them to be opportunistic.
Figure 1.3
Which asset classes and generic products are most likely to
be favoured for short-term opportunism and/or medium-term
asset allocation?
In any event, each client segment is
expected to have a special theme, with
strong traction around it: LDI in DB
space; advice in the DC space; capital
protection in the retail space; and
absolute returns in the HNWI space.
Neither hedge funds nor private
equity will feature highly in investor
consideration in the near term. Like
computers, they will morph — for
the better. Those with skills to make
money without recourse to heavy
leverage will survive and thrive,
especially in the US where pension
plans and HNWI still remain interested.
Good hedge funds are expected to do
especially well, if investors’ new found
love of opportunism spills over into
volatility trading, which now accounts
for 60% of all trading.
However, opportunism is only a more
acute version of the zero sum game.
When active management has not
generally delivered in the past, why
would opportunism work in the future?
Time will tell.
Source: Citi / Principal / CREATE Survey 2009
Interview quotes:
“The era of irrational exuberance
is over.”
“One definition of madness is to do
the same thing over and over again,
expecting a different outcome.”
“History is littered with the bodies
of CIOs who timed the markets.”
8
Theme 4: Regulatory creep is inevitable
As a result of the Madoff scandal,
regulators want to see consistency
in both outcomes and processes.
Five changes are likely in the US:
fiduciary rules for broker dealers;
more transparency around fees and
compensation; new guidelines on
‘breaking the buck’ in cash products;
guarantees in target date funds; and
low cost index funds in 401k plans.
Likewise, in Europe, new rules have
been announced for hedge funds.
Others are likely in three areas
(see figure 1.4). The first is product
integrity: under it, product labels are
meant to provide correct information
on features such as risk, returns, and
liquidity. The second is independent
oversight: under it, robust checks
will be required for critical activities
like asset valuations, performance
attribution and risk management. The
third is alignment of interest: under it,
transparency will be essential, as will
a bonus system based on risk-adjusted
returns, as proposed for banks in
Europe and the US. Regulators are
also likely to demand Chinese walls
between bank-owned asset managers
and parent-owned distribution
channels. They want to fragment the
industry to avoid the costly ‘too big to
fail’ rescues in the future.
career risks have prevented plan
sponsors, trustee boards, pension
consultants and asset managers from
tackling them.
On their part, asset managers view
regulation as an entry ticket. But the
granularity required by regulators
in different jurisdictions is already
very demanding. Some fear that we
are in danger of achieving the worst
of both worlds: too many rules that
deliver too little.
In all regions, governments are keen
to encourage private pensions, for
which a client-friendly asset industry
is an essential prerequisite, as
exemplified by the proposed UCITS
IV. They see fault lines in every link in
the investment food chain. Hitherto,
Figure 1.4
What would over-regulation mean?
Source: Citi / Principal / CREATE Survey 2009
Interview quotes:
“Gold plated images of alpha
managers have been unravelled.
The burden of proof has shot up.”
9
“About 40% of what we all save
and invest for our pensions, goes
out in charges to intermediaries.”
“The ‘invisible hand’ of the market
has to be balanced by the ‘visible
fist’ of the regulators.”
Theme 5: Psychological barriers towards a variable cost model are crumbling
The bear market has been a perfect
storm, especially for many large asset
managers with bloated cost bases and
executive sclerosis. Their compensation
systems resembled a hall of mirrors:
what you see is not as it is.
The industry never had a variable cost
bug. Now it is catching on, owing to a
lethal combination of market falls and
high redemptions (left hand panel in
figure below). On an asset weighted
basis, gross revenue fell like a stone,
averaging around 35% in 2008, with the
prospect of a further 15% drop in 2009.
Job losses have ranged from 5% to 38%.
Asset managers with AuM in excess of
US$100 billion have borne the brunt.
Only 13% of the respondents have the
shock absorbers to cushion exceptional
falls (right hand figure below).
The rest have embarked on a
long journey towards developing
them by introducing variable pay,
slimmer product range and strategic
outsourcing. Their initial steps have also
targeted improvements in executive
bench strength, service quality and
meritocratic incentives.
Finally, actual and virtual boutiques
are being created. The aim is to achieve
economies of scale as well as economies
of scope.
With a clear strategic intent and
determined management bandwidth,
these changes may blow away the old
entitlements and entrenched processes
that have long conspired against
client interests as well as operating
leverage. They aim to promote a small
Figure 1.5
What has happend to the gross revenue of your business in
2008 as the result of the credit crunch?
company mentality in a large company
environment.
More than ever, large asset managers
are now recognising that they cannot
be Jacks of all trades and masters of
none. They are forced to make a choice
between manufacturing and assembly.
The latter is emerging as a major
competency in its own right, as sub
advisory mandates have taken off. A new
supply chain is emerging, in which fees
have both a low fixed component and a
variable component.
In the past, pruning products was akin
to painting the Golden Gate Bridge:
products proliferated as clients chased
every new rainbow. Now sub-scale
products have come under the hammer.
To what extent do your costs
vary directly with the level of
activity in different parts of your business?
Source: Citi / Principal / CREATE Survey 2009
Interview quotes:
“Compensation costs have risen
at CAGR 15% in this decade,
irrespective of the state of inflows.”
“If we get rid of our Mickey Mouse
compensation system, we can have
a variable cost model tomorrow.
It’s as easy as that.”
“Everyone sobered up a bit after
the tech bubble but didn’t make
substantial changes to their business
models. Now the party is over.”
10
Theme 6: Alliances will fragment and reshape the asset industry
Spurred by new regulation, the
emerging variable cost model will target
core capabilities and net margins.
Investment, distribution and
administration will continue to decouple.
Vertical integration within a firm will
be increasingly replaced by horizontal
integration between firms.
Large houses will develop multi-asset
class capabilities by creating in-house
product based boutiques, giving
investment professionals the necessary
autonomy, space and accountability
to generate new ideas and execute
them. Like their small independent
peers elsewhere, such boutiques will
be used as one of the main avenues
for attracting, retaining, nurturing and
deploying talent.
Alliances with external managers will
also become more common, either
via sub advisory mandates or multimanager platforms, both of which are
expected to proliferate in all regions.
Institutional distribution of funds, so
well established in Australia and the US,
will spread elsewhere in Asia Pacific
and Europe.
Under it, a new breed of fund buyers
will deploy institutional quality tools to
select and package funds at wholesale
prices and sell them to retail clients.
Funds will be ‘bought’, not ‘sold’ in
the first instance; and then delivered
as customised solutions. Under this
Darwinian process, pressure to deliver
good consistent returns will intensify.
Last but not least, outsourcing of
back office activities will continue
apace, embracing high value added
services such as derivatives processing,
independent valuation, attribution
analysis, risk processes
and general oversight.
These developments will continue to
amplify the craft focus in investment,
mass customisation in distribution and
process concentration in operations.
Figure 1.6
What will the emerging industry architecture look like?
Source: Citi / Principal / CREATE Survey 2009
Interview quotes:
“Consolidation will continue to be
a game of musical chairs in pursuit
of nirvana. Industry will continue to
fragment”
11
“Mega mergers of the past 15 years
have unravelled in an elaborate
merry-go-round, as the industry
has evolved and morphed with no
steady state in sight.”
“Growth creates size, size creates
complexity, and complexity creates
hidden costs. Success only begets
success when you have savvy
business leaders driving the growth.”
Theme 7: The best way to predict the future is to invent it
Paradigm shifts are rare outside the
field of science. The world of investment
is cyclical and self correcting.
Yet, in breadth, scale and scope, the
current bear market has no parallel
in living memory. It has hit much
deeper into pockets of investors and
managers alike. It will reshape the
asset industry over the next decade.
At a defining moment like this, small
steps can deliver giant leaps over
time. Hence, the evolution of the
industry will depend upon the relative
strengths of those demand-side
factors causing a tipping point and
those supply-side factors offering
better alignment of interest between
managers and their clients (refer to
diagram on page 5).
On the demand-side, if enough buyand-hold investors stay away and
loss aversion takes root in investor
psyche, the industry may commoditise
significantly over time, as has been
happening in Japan. The pace may
accelerate, in the event of a regulatory
overdrive (see figure below).
On the other hand, if enough asset
managers revamp their businesses to
put clients ever more at the heart of
everything they do, the supply side
forces may nurture a vibrant industry at
the vanguard of the pension revolution,
as it sweeps across the globe.
In between the two extremes, there
is a third scenario which envisages
a segmented industry, combining
features of the first two scenarios.
Nearly one in every two respondents
subscribe to the segmented scenario,
one in three to commoditisation
scenario and one in six to the vibrant
industry scenario.
The scenarios overlap: their
distinctiveness is a matter of emphasis,
not detail.
On the one hand, they envisage
acceleration of many past trends aimed
at driving out systemic inefficiencies.
On the other hand, they suggest that
the future is not pre-determined. What
asset managers do at this critical
juncture will influence the outcomes in
years to come.
Figure 1.7
What are the most likely scenarios of the industry?
Source: Citi / Principal / CREATE Survey 2009
Interview quotes:
“Regulators will dumb down this
industry unless we can demonstrate
that we can get our act together.”
“You can keep doing what you
have been doing all the time and
march nobly off a cliff or you can
adapt and change.”
“Fund managers must not
mistake activity for action, pace
for progress.”
12
Theme 8: The business model associated with the segmentation
scenario is gaining traction
The continuing re-alignment in the
value chain is promoting new alliances.
Focus is their goal, Toyota their role
model. Distinct client segments are
targeted and their needs are met by
centres of specialist capabilities in the
investment cycle.
This model is taking root in large asset
houses which are either pure play
managers or owned by bancassurance
groups. It has three distinct building
blocks (see figure 1.8).
The first one segments clients and
sub-divides them by their identified
needs. The second covers a range
of capabilities like assembly, asset
allocation, manager selection, risk
management, and multi manager
platform. They channel funds to
internal boutiques or external asset
managers, depending upon the clients’
needs and managers’ track record.
The third block comprises these
manufacturing centres and third
party administrators who provide the
essential pipelines between internal
managers at one end, and assemblers
and their clients at the other.
Large managers are decoupling
manufacturing and distribution.
They are also creating internal
boutiques alongside external alliances
to deliver fettered and unfettered
products. Developing the requisite
DNA for the internal boutiques
remains a big challenge.
is done in small units as befits its
craft nature; assembly is centralised;
distribution blends with assembly in
some cases or outsourced in others;
and administration is outsourced.
The model leverages brand as well as
expertise. It recognises that, in future,
alpha will come from mispriced assets
as much as less transparent frontier
markets exposed to extremes of
volatility. Both require a deep reservoir
of expertise that mainly thrives in
small units.
The model is also being adopted by
pension consultants and pension
funds under the heading of fiduciary
management. Competition will intensify.
The model envisages an industry
over time where manufacturing
Figure 1.8
How does the segmented business model capture alpha via
strategic asset allocation as well as investment strategies?
Source: Citi / Principal / CREATE Survey 2009
Interview quotes:
“The Toyota-isation of the fund
industry is bringing together best
of breed producers, distributors and
service providers.”
13
“In the US, assets held in sub-advised
funds ballooned to $641bn in 2007
from $261bn in 2002.”
“Multi-asset class products
require a combination of fettered
and unfettered products.”
Theme 9: Extraordinary times offer opportunities to create businesses
of enduring value
Some of today’s industry icons
emerged from the ashes of the 192932 debacle. Crisis can be a concealed
opportunity. Introspection is rife. But
many incumbents are struggling.
Our respondents have identified four sets
of features of a winning business model
in today’s and tomorrow’s environment: a
model that can deliver a vibrant industry.
The first set covers investment
capabilities that centre on people
talent, fundamental research,
disciplined replicable processes and
deep insights into asset allocation,
cross correlation, and trade offs
between risk, returns, liquidity
and volatility.
The second set covers alignment of
interest between managers and their
clients. It means a value-for-money
fee structure, meritocratic incentives,
transparent compensation systems,
transparent execution costs and regular
inter-industry cost comparisons.
The third set covers service proposition.
It means understanding client needs,
selling products that are fit for purpose,
giving accurate timely information,
doing periodic investment reviews,
doing regular pulse surveys, and
creating internal panels to protect and
further client interests.
Figure 1.9
What are the critical success factors for a vibrant industry?
The fourth set covers capabilities
that provide best execution, CRM
capabilities, executive capabilities to
run alliances, dedicated innovation
processes and quality assurance
checks on all new products. There
is a crying need for identifying new
investment opportunities.
These business basics are at the
centre of the vibrant industry
scenario. They put clients at the
heart of everything. The genius of the
winning model is in the execution of
the basics more than design.
It enjoins top leaders to formulate
a client-centric business strategy,
subject it to reality checks,
communicate it to all staff, get the
necessary buy-in, allocate resources
and accountabilities, monitor
outcomes, do course corrections and
manage external alliances.
Savvy execution is the new silver bullet.
Those who have it will survive and thrive.
Those who don’t will wither and perish.
Source: Citi / Principal / CREATE Survey 2009
Interview quotes:
“We have duty of care to do the
right things for our clients.”
“To pay no attention to costs is
probably the biggest dumb mistake
investors can make.”
“The service mantra has made
a full-scale return after a long
stretch of relative dormancy.”
14
Market dynamics
How will client behaviours change post crisis?
“When facts
change, I change
my views. What
do you do?”
John Maynard Keynes
Overview
Issues
Of the four worst bear markets of the
last 100 years, two have blighted this
decade within a span of seven years.
Against that background, this chapter
aims to pursue the following questions:
• W
hy and how will client behaviours
change?
• H
ow will that affect asset
allocation?
hat asset classes will be favoured
• W
by different client segments once
the worst of the crisis is over?
• W
hat are the trade-offs that clients
will need to address?
• W
hen the recovery comes, what are
the chances that clients will revert to
old ways?
Key findings
• S
implicity, safety and quality
will drive clients’ investment
goals for the foreseeable future.
The immediate cause is the
indiscriminate speed and scale of the
credit crisis. The basic causes are the
fault lines that have been developing
under the surface throughout this
decade: namely, absence of equity
risk premium, divergence between
expected and actual returns on most
asset classes, and rising correlation
between the historically uncorrelated
asset classes.
Interview quotes:
“Humans learn far more from
failure than success. This time,
failures are big.”
15
“This was not the way the fairytale
of financial innovation was meant
to end.”
“Asia’s listed REITs market suffered
60% discount in pursuit of
liquidity.”
“Humans learn far more from
failure than success. This time,
failures are big.”
• ‘Core and explore’ will be a
common theme across all client
segments. This twin track approach
will entail a strong emphasis
on risk, liquidity, volatility and
simplicity, favouring commoditised
solutions. At the same time, it will
entail opportunistic forays at the
periphery into mispriced assets,
especially in the debt markets.
• M
ainstream asset classes will
be in the ascendancy. DB clients
will be drawn into indexed and
global equities, with a strong
opportunistic slant. DC clients will
favour equities in some parts of
the world and target date funds
in others. The latter will embody
a deferred annuity component to
protect capital. Retail clients will be
drawn into products offering capital
protection and tax efficiency, with
periodic bouts of opportunism. High
net worth clients will remain in the
active long only funds with periodic
forays into alternatives.
• In the face of unpredictable risk
premia, asset allocation will
become ever more dynamic.
Whilst recognising that few asset
managers have the skills to go
opportunistic, clients no longer
subscribe to the buy-and-hold story:
they have lost money in every asset
class they were advised to go into.
• C
lients also recognise that their
high liquidity, low volatility, high
transparency choices will deliver
low returns. But they no longer trust
their asset managers or advisors.
• B
ig losses and changing
demographics risk driving out a
whole generation of clients, as has
happened in Japan. However, if the
next recovery is V-shaped, greed
may once again overwhelm fear.
Chances are slim. Four standard
deviation events have burnt a
big hole. Its pain may well endure
beyond the recovery.
16
Simplicity, safety and quality will dominate clients’
investment goals for the foreseeable future
been developing under the surface in the
aftermath of the 2000-03 bear market.
The collapse served to turn the spotlight
on them.
Worldwide, some US$15 trillion in stock
market value vanished between July
2007 and December 2008, causing
widespread loss of trust in asset
managers. Like other crises, this one
will pass. But its pain will long endure.
Investment goals over the next three
years will be conspicuous by the flight
to quality, simplicity and safety: quality
defined by consistent risk adjusted
returns; simplicity by transparency and
liquidity around the returns; and safety
by capital protection.
First, the familiar buy-and-hold strategy
for buying stocks and holding them for
ever in the belief that they will deliver
out-performance in the long term
was coming under intense scrutiny as
equities were outperformed by bonds
over five, ten, fifteen and twenty year
periods, according to the Ibbotson
data. Equity risk premium was as
unpredictable as it was volatile. In the
bifurcated world of bar-belling, too, the
gap between expected returns and actual
returns was huge across the spectrum.
The speed and scale of the recent
market collapse has been the immediate
cause of the loss of investor confidence.
However, a number of fault lines had
Simplicity, safety and quality will dominate clients’
investment goals for the foreseeable future
What goals will your clients pursue most over the next 3 years?
Second, significant diversification into
alternatives occurred in 2004-07 at
a time when the peak returns were
history and the correlation between
uncorrelated assets was rising due to
excessive leverage. So, diversification,
too, was under sharp scrutiny. Finally,
regulatory and accounting changes
aimed at preventing the repeat of the
excesses of the last decade had the
unintended consequence of inflating the
deficits in DB plans, thereby undermining
their long term future.
Not surprisingly, therefore, as the
pension fund deficits persisted, the
traditional question ‘what is the
expected return on my money?’
became far less important than ‘what
is the risk that I can lose my money?’
Likewise in the retail space ‘return of
my money’ became more important
than ‘return on my money’.
What goals will your clients pursue most over the next 3 years?
0
10
20
% of respondents
30
40
50
60
70
80
Less complex / less risky products
Capital protection
Uncorrelated absolute returns
Consistent risk adjusted returns
A value-for-money fee structure
Better liquidity
Lower volatility
Relative returns
More complex / more risky products
Retail clients
DC clients
DB clients
Source: Citi / Principal / CREATE Survey 2009
Source: Citi / Principal / CREATE Survey 2009
With value-for-money at its core, the
simplicity theme will remain pervasive
for the foreseeable future, attracting
differing emphasis from different
client segments. DB clients will pursue
consistent risk adjusted (or absolute)
returns to plug their burgeoning deficits.
DC clients will go for less risky products
offering capital protection and risk
adjusted returns. Finally, retail clients
will seek capital protection, better
liquidity and lower volatility.
Behavioural changes will be there for
sure, but not necessarily for the better.
Safe liquid assets do not deliver much
in the long term. Most clients know
that. But currently, they are unwilling
Worldwide, some US$15 trillion in stock market value vanished between July 2007 and December 2008,
causing widespread loss of trust in asset managers. Like other crises, this one will pass. But its pain will
long endure. Investment goals over the next three years will be conspicuous by the flight to quality,
simplicity and safety: quality defined by consistent risk adjusted returns; simplicity by transparency and
liquidity around the returns; and safety by capital protection.
Interview quotes:
The speed and scale of the recent market collapse has been the immediate cause of the loss of investor
confidence.
However,
a number
of fault lines had been developing
the buy-and-hold
surface in the aftermath
of
“The global
credit
derivative
“Mostunder
retail
investors
the 2000-3 bear market. The collapse served to turn the spotlight on them.
markets were conducted in a way
never came back to the market
First, the familiar buy-and-hold strategy for buying stocks and holding them for ever in the belief that they
that
made
the Wild West
after
the
2000-02
will
deliver
out-performance
in thelook
long tame.”
term was coming
under
intense
scrutiny crash.”
as equities were
outperformed by bonds over five, ten, fifteen and twenty year periods, according to the Ibbotson data.
Equity risk premium was as unpredictable as it was volatile. In the bifurcated world of bar-belling, too, the
gap between expected returns and actual returns was huge across the spectrum. Second, significant
diversification
into alternatives occurred in 2004-7 at a time when the peak returns were history and the
17
correlation between uncorrelated assets was rising due to excessive leverage. So, diversification, too, was
under sharp scrutiny. Finally, regulatory and accounting changes aimed at preventing the repeat of the
“Commoditisation will be the norm
until greed returns.”
71%
44%
50%
expect their retail clients to opt for
capital protection
expect their DC clients to opt for a
value-for-money fee structure
expect their DB clients to target
risk adjusted returns
to buy into the risk premium story
which promised dreams but delivered
nightmares for a whole generation of
investors. Trust is a major casualty.
A view from the top
“Greed follows fear, as day follows the night. When Nikkei
225 was powering ahead in the 1980s, Japanese equity
warrants were all the rage worldwide. After its crash in
1989, Japanese investors began to withdraw from the
market. Elsewhere, there was a recovery, led by equities
and bonds till 1997, when tech stocks emerged on the
scene to create a raging bull market. Even in countries
where bonds had always been more popular — e.g. France,
Denmark, Germany, Italy Japan, and Sweden — the equity
culture began to take root. When the tech bubble burst
in 2000, losses shot up to US$7 trillion, the worst in
living memory.
But soon, a new theme emerged: uncorrelated
absolute returns. Assets poured into alternatives,
which grew to a US$5 trillion industry in record time,
mostly powered by HNWI and institutional clients. Long
only managers started using hedge fund type tools to
deliver absolute returns. Structured products also took
off in the retail space.
Then came the credit crunch, hitting every asset class,
every client segment, every market, and every geography.
The two bear markets in this decade have also turned out
to be amongst the four worst ones on record.
First, the changing demographics will ensure that some
78 million baby boomers will retire in the USA over the
next 10 years, and just as many in Europe, with little time
left to recoup the losses incurred in this decade.
Second, as the deficits persisted after the 2000-03 bear
market, the ensuing accounting and regulatory changes
have inadvertently either accelerated the closures of DB
plans or their restructuring such that employees share
the risk as well as the contributions. Either way, large
injections have been inevitable, weakening the sponsor
covenant. DC plans are continuing to grow. But outside
Australia, US and the UK, they don’t have significant
assets as yet. Even in these three countries, DC plans
have long suffered from poor asset allocation decisions,
or overly cautious choices.
Yet, as markets recover, inertia may bring back the
punters. But I wouldn’t bet on the idea that clients will
remain gullible and trust us again — some will, most won’t.
If anything, when things get better, we expect many of
them to cash out and never return.”
~ A Swiss asset manager
Hence, looking ahead, risk aversion will be the
dominant theme for all investors. It will be reinforced
by two other factors.
Interview quotes:
“Products now will have to have
liquidity filters, otherwise they are
no good.”
“Investors are caught in headlights.
So we’re not seeing a mass exodus.
Many of them want to get out but
at the right time.”
“BRIC funds will become even
more opportunistic.”
18
Clients in different segments will adopt a variety of
approaches to achieve their goals
Numerous avenues are likely to be
used by clients in order to achieve their
investment goals; some are common
across the client segments; others are
unique, reflecting the differences in
their core pre-occupations.
The common ones, cited by more than
25% of the survey respondents, are
inter-related. They involve putting
far greater emphasis on the use of
transparent processes and products,
on the one hand; and independent
performance measurement and
attribution analysis, on the other.
Taking them in turn, the days of
opacity are over. The current crisis
has shown that many investment
products of recent years had hidden
features such as leverage and asset
class exposures that were out of
sync with the expectations of those
who bought them. As an adjunct,
many products also promised more
liquidity than was inherent in the
underlying asset classes. They lacked
acceptable redemption processes
that aimed to minimise the quoted
prices from the realised prices. In its
absence, investors have been shocked
into discovering the true cost of
liquidity when there was a stampede
for redemptions. Liquidity will be
perceived as an asset class in its own
right from here on, according to our
post-survey interviews.
Transparency also has other
dimensions: execution costs, fees
Clients in different segments will adopt a variety of approaches
to achieve their goals
What avenues will your clients use to achieve their key goals
over the
3 your
years?
What next
avenues will
clients use to achieve their key goals over the next 3 years?
0
10
20
% of respondents
30
40
50
60
70
80
More transparent investment processes and products
Trusted brands at the fund provider end
More dynamic asset allocation
Reliance on intermediaries for advice
Liabilities matching
Higher contribution rates
Low volatility investments to help plan sponsors
Opportunistic buying of distressed assets
Independent performance attribution analysis
and business governance. Clients will
require an independent oversight
of performance measurement and
attribution analysis, when they
venture into risky asset classes as part
of dynamic asset allocation, as we
shall see below.
Moving on to the avenues that will be
specific to client segments, four points
from the survey are noteworthy.
First, despite the severity of the
current crisis, the appetite for
opportunism has not vanished,
especially on the part of retail and DB
clients. If anything, it has emerged
as a major part of dynamic asset
allocation, under the heading of ‘core
and explore’. It has involved holding
the bulk of assets in low volatility
options, with a small percentage
earmarked for active trading in
high volatility options that aim to
make money out of real-time market
movements as well as opportunistic
buying of distressed assets. As clients
have lost 15 years’ gains in the last 15
months, the notion of buy-and-hold
investment has come under close
scrutiny by DB clients and retail clients
alike. Whether opportunism will pay
off remains to be seen: being a bigger
zero-sum game, it requires special
skills which most assset managers do
not as yet have.
Renegotiate the terms of retirement benefits
Seeking tax efficiency
Selling liabilities to buy-out specialists
Source: Citi / Principal / CREATE Survey 2009
Retail clients
DC clients
DB clients
Source:
Citi / Principal
/ CREATE
Numerous
avenues are
likely toSurvey
be used2009
by clients in order to achieve their investment goals; some are
common across the client segments; others are unique, reflecting the differences in their core preoccupations.
Second, DB clients are also likely to
pursue LDI strategies to immunise
against unrewarded risks (especially
in the UK and the US), raise the
contribution rates to jack up the
The common ones, cited by more than 25% of the survey respondents are inter-related. They involve
putting far greater emphasis on the use of transparent processes and products, on the one hand; and
independent performance measurement and attribution analysis, on the other.
Interview quotes:
Taking them in turn, the days of opacity are over. The current crisis has shown that many investment
products of recent years had hidden features such as leverage and asset class exposures that were out of
sync withpension
the expectations
of those
an adjunct,
many products
promised
morenest
“Big Dutch
plans
arewho bought them. As“Most
retirees
willalso
empty
their
liquidity than was inherent in the underlying asset classes. They lacked acceptable redemption processes
suspending
the prices
benefits
eggprices.
longIn before
they
die.”
that aimedindexation
to minimise theof
quoted
from the realised
its absence,
investors
have been
shocked into discovering the true cost of liquidity when there was a stampede for redemptions. Liquidity
and jacking
up
the
contribution
will be perceived as an asset class in its own right from here on, according to our post-survey interviews.
rates.”Transparency also has other dimensions: execution costs, fees and business governance. Clients will
19
require an independent oversight of performance measurement and attribution analysis, when they
venture into risky asset classes as part of dynamic asset allocation, as we shall see below.
Moving on to the avenues that will be specific to client segments, four points from the survey are
noteworthy.
“The world of investment is
cyclical and self correcting. On this
occasion, that correction will be
long and drawn out.”
58%
52%
67%
expect their retail clients to
switch to trusted brands
expect their DC clients to opt
for more transparency
expect their DB clients
to go into LDI
funding levels, renegotiate the plan
benefits, and consider buy-out options
to exit from the DB space.
Fourth, retail clients are likely to
increase their reliance on trusted
brands at the fund provider end as well
as on intermediaries for better advice.
Third, DC clients are likely to engage
in more dynamic asset allocation and
raise their contribution rates, although
the incidence of either of these
options is unlikely to be widespread.
A view from the top
“Normality will not necessarily resume, once markets
revive. The oil price shock in 1973-74 produced a sideways
market until 1983. Our clients in Australia, China, UK
and US are ready to move in without causing a V-shaped
recovery. Each client segment now has a new definition of
what pain feels like.
So, retail clients are likely to be the most loss averse.
Many of them have cashed out at the wrong time, raising
regulators’ eyebrows. Like their institutional counterparts,
many of them had diversified into alternatives when their
peak returns were history. Those HNWI individuals who
drove the inflows into hedge funds genuinely believed
that they were investing in a very safe asset class.
Henceforth, safety and tax efficiency will drive their
goals; backed by opportunism from time to time.
Likewise, average losses of 30% in DC plans in
Australia and the US are forcing clients to have serious
conversations with their asset managers about asset
allocations, contribution sizes and charges. 90% of
clients never changed their initial allocation until the
current crisis. In turn, DC plan sponsors are revamping
their roster of managers. Target date funds that became
so popular after the 2000-03 bear market have come
under a spotlight by clients and regulators alike.
Clients who sponsor DB plans are also exploring new
approaches, after coming to terms with four painful facts
of life over this decade. First, risk-return features of all
asset classes are volatile and unpredictable. Second,
the time period over which risk premia may materialise
is highly variable. Third, no matter what asset class you
choose, timing is everything. Fourth, covenant risk is at its
all time high, due to the combination of mark-to-market
rules and persistent losses.
Hence, they are resorting to investment as well as
non-investment solutions. On the investment side, the
emphasis is on LDI, opportunism in the distressed assets,
and long term allocation to less risky asset classes. On the
non-investment side, contribution rates are being raised;
benefits renegotiated, and buy-out options explored.
Thus, on the whole, investment approaches of clients in
all three segments are likely to err on the side of caution.
However, regulators recognise investor foibles all too well.
They are likely to introduce measures which will aim to
protect clients as much from themselves as from overzealous fund sellers. Unless asset managers and distributors
adopt a fiduciary approach to their clients, there is a serious
risk that regulators will dumb down this industry.”
~ A US asset manager
Interview quotes:
“Virtually every strategy institutional
investors were advised to follow was
a complete disaster.”
“Products that use derivatives are
off limits now, unless performance
features are clear in extreme
scenarios.”
“Risk free returns mean you have
to work till you are 90.”
20
Clients operating DB plans will favour mainstream asset
classes whilst also engaging in short-term opportunism
The core and explore theme is duly
reflected in the investment options of
DB clients, where more transparent and
liquid asset classes feature prominently
in the medium term asset allocation,
alongside short-term opportunism.
The latter has gained traction as a
lot of forced sellers and re-financiers
have emerged in the distressed assets
space, when the index on solvency
margin fell off the cliff in 2008. A
number of sub-themes emerged from
our post survey interviews that shed
light on the survey results.
First, equities will make a comeback. The
excess premium placed on transparency
and liquidity is one factor. The other is
the belief that they are under-valued,
especially in the deep liquid markets of
America and Europe. Besides, DB clients’
fling with alternatives has not paid off in
this decade.
Second, the bond markets will change.
The seismic shift from investment
banking to traditional banking will
drive down demand for structured
products and LBO financed debt;
and drive up the debt issuance of
governments or government-backed
institutions, at the expense of private
sector issuance. This will reduce asset
managers’ ability to generate excess
returns from active management of
corporate bonds.
Clients
DB
plans crisis
will favour
mainstream
Once
the operating
worst of the
current
is over,
which assetasset
classes
classes
whilst
also
also
engaging
engaging
in
short-term
short-term
opportunism
classes
andwhilst
generic
products
are in
most
likely to opportunities
be favoured
for short-term opportunism and/or medium-term changes in
Once the worst of the current crisis is over, which asset classes and generic products are most likely to be favoured for
short-term
and/or medium-term changes in asset allocation?
asset allocation
by opportunism
DB clients?
Indexed equities (including ETFs)
Global equities
Liability driven investments
Investment grade bonds
Real estate
Emerging market equities
Global tactical asset allocation products
Indexed bonds (including ETFs)
Private equity
Commodity funds
Index-plus / enhanced equities
Hedge funds
Portable alpha
Structured products with capital protection
Currency funds
High yield bonds
Convertible bond strategies
Distressed debt / loans
Source: Citi / Principal / CREATE Survey 2009
Source: Citi / Principal / CREATE Survey 2009
Third, LDIs will gather momentum.
The recent adoption of mark-tomarket rules by the US pension plans
is one factor. The other is the growing
acceptance on the part of DB plan
sponsors that neither the mainstream
nor the alternative asset classes
can help them meet their long term
contractual liabilities. They have to
sterilise as many unrewarded risks
as possible. In order to cope with
the counter-party risk post Lehman,
the next generation of LDI mandates
will have two new features: more
cash-based long duration mandates;
and more inflation-linked assets like
commodities, that have the potential
to hedge the inflation risk while
providing a ‘return kicker’. Derivatives
are not dead, as long as they are
regulated and exchange traded. Any
derivatives-based products will be
subjected to worst case scenario tests.
Fourth, private equity and hedge
funds will morph under the weight
of deleveraging now in progress.
The recent decision by large buy-out
houses to return uncalled capital —
‘dry powder’, worth US$1 trillion — is
symptomatic of the trend that is
shrinking the industry on the one
hand and taking it back to its roots
on the other. Most of the institutional
investment in the near term will focus
on distressed sales in the secondary
market. Similarly, only those hedge fund
managers with the skills to play the
volatility card without excess leverage
will survive and thrive. The rest, nearly
50% of the industry, will disappear.
The core and explore theme is duly reflected in the investment options of DB clients, where more
transparent and liquid asset classes feature prominently in the medium term asset allocation, alongside
short-term opportunism. The latter has gained traction as a lot of forced sellers and re-financiers have
emerged in the distressed assets space, when the index on solvency margin fell off the cliff in 2008. A
number of sub-themes emerged from our post survey interviews that shed light on the survey results.
Interview
quotes:
First, equities will make a comeback. The excess premium placed on transparency and liquidity is one
factor. The other is the belief that they are under-valued, especially in the deep liquid markets of America
and Europe. Besides, DB
clients’
alternatives has
not paid off infunds
this decade.
“Out-performance
will
befling
an with
even
“Pension
will turn to more
Second,
bond markets
will change. The seismic shift low-cost
from investment
banking to traditional banking
bigger
zerothesum
game.”
beta.”
will drive down demand for structured products and LBO financed debt; and drive up the debt issuance of
governments or government-backed institutions, at the expense of private sector issuance. This will reduce
asset managers’ ability to generate excess returns from active management of corporate bonds.
21
Third, LDIs will gather momentum. The recent adoption of mark-to-market rules by the US pension plans
is one factor. The other is the growing acceptance on the part of DB plan sponsors that neither the
mainstream nor the alternative asset classes can help them meet their long term contractual liabilities.
They have to sterilise as many unrewarded risks as possible. In order to cope with the counter-party risk
post Lehman, the next generation of LDI mandates will have two new features: more cash-based long
“When the dust settles, people
will start investing in hedge funds
again, but under a new order.”
60%
60%
53%
expect their DB clients to go into
indexed and global equities
expect their DB clients to engage
in short term opportunism
expect their DB clients to go into
investment grade bonds
A view from the top
“Our institutional clients are de-risking on a breathtaking
scale. Today, fear overrides fundamentals in all client
segments. We don’t expect a reversal for the foreseeable
future. Worldwide, back to basics is a common theme,
since the current crisis is more systemic than cyclical.
First, our DB clients everywhere are moving into indexed
funds in record numbers. As part of new mandates, we
are also taking on their distressed assets on a ‘hold
and sell’ basis before transitioning them into our funds.
On clients’ part, the rush into index funds reflects two
considerations: long only funds cannot deliver their
promise; and indexed funds provide a cost effective
means of going opportunistic in case markets recovered
dramatically. This has been especially the case in Japan
where ETFs are being used alongside currency overlays
and hedge funds in opportunistic plays, marking a major
departure from the past. Our LDI pipeline is very busy.
New accounting rules in the US are a factor. In addition,
sponsor pressures in Ireland, Switzerland and the UK are
driving pension funds down this route.
Second, DC clients are also going cautious: they are
showing active interest in our target date funds which
now combine an element of deferred annuity to provide
income protection in retirement. This is yet another sign
of flight to safety.
Third, our sovereign wealth fund clients in the Middle
East, Russia and Asia are limiting their equity exposures
after being overweight in financials. Alongside
passives, they are becoming more interested in high
conviction equity funds as well as themed private equity
investments, favouring sectors such as water, energy
and agriculture. However, their new allocations may
remain insignificant for a long time, as crises in their own
economies have forced them to invest at home.
Doubtless, these may be no more than cyclical responses.
But you can’t ignore the underlying reality. First, plan
sponsors and trustees have realised that the world
of investment in this decade has proved ever more
challenging for them to deliver their pension promise.
89% of plans worldwide are below the statutory
watermark — twice the number since 2007. Some are now
below 50% and have little chance of survival without
massive cash injections. Second, the new absolute returns
promise has proved a mirage in alternatives as well as the
long only world for a big majority of plans. Third, sponsors
and their trustees are doing very detailed due diligence
when awarding mandates. Operational and counter-party
risks are taken just as seriously as investment risks.
Fourth, the current crisis is not seen as one off; they
expect more in the next decade. They no longer count on
efficient markets and long term risk premia. The appalling
reality of recent losses has forced soul searching and
unwise opportunism.
I find it hard to believe that things will be fine and dandy
when markets recover.”
~ A UK asset manager
Interview quotes:
“Via restructuring, many DB plans
will morph into DC plans, as in the
Netherlands”.
“Our LDI pipeline is now four times
bigger than last year’s.”
“Everywhere, DB plans are on a
death path. In 10 years, they will
be the preserve of public sector,
as in Australia.”
22
Clients covered by DC plans will also favour mainstream
asset classes alongside target date or target risk funds
Worldwide, DC plans have been at the
vanguard of the pension revolution
since the early 1990s. In countries
like Australia, Canada, Ireland, Japan,
the Netherlands, Switzerland, the
UK and the US, their growth became
pronounced with the continuing closure
of the conventional DB plans over time.
Alongside this restructuring, DC plans
also received an organic fillip as countries
like Denmark, Germany Finland, France,
Poland and Sweden started new DC
plans to relieve the pressures on the
state retirement systems due to ageing
populations. Unlike the first generation of
plans which relied on traditional equities
and bond investments, the second
generation have relied on insurance
contracts in order to provide a significant
measure of capital protection.
However, the current financial tsunami
has hit all plans. Fear now seems to rule,
with plan members often exhibiting a
Wall Street version of the fight-or-flight
mechanism: they were selling first and
asking questions later, to the extent that
major changes are likely.
61% of respondents expect the emphasis
on equities and bonds to continue
worldwide, but with an enhanced advice
infrastructure. Plan members in English
speaking countries — who make their own
investment choices — are now engaging
in serious dialogue with their managers
about their investment options,
Clients covered by DC plans will also favour mainstream
Once the worst of the current crisis is over, which asset
asset
classes alongside target date or target risk funds
classes and generic products are most likely to be favoured
for short-term opportunism and/or medium-term changes in
Once the worst of the current crisis is over, which asset classes and generic products are most likely to be favoured for
asset allocation
by opportunism
DC clients?
short-term
and/or medium-term changes in asset allocation?
40
30
20
10
% of respondents
0
10
20
30
40
50
60
70
Equity funds
Target date retirement funds
Bond funds
Target risk funds (dynamic, conservative or mixed)
Customised investment plans
Cash-like products
Stable value / Guaranteed insurance contracts
Target date retirement funds with deferred annuities
Deferred annuities
Opportunism
Asset allocation
Source: Citi / Principal / CREATE Survey 2009
Worldwide,
DC plans/ CREATE
have beenSurvey
at the2009
vanguard of the pension revolution since the early 1990s. In
Source:
Citi / Principal
countries like Australia, Canada, Ireland, Japan, Netherlands, Switzerland, the UK and the US, their
growth became pronounced with the continuing closure of the conventional DB plans over time.
contribution rates and retirement
dates. The current crisis has forced the
recognition that pension pots in most
cases will be inadequate in funding
ever longer periods of retirement
due to rising life expectancy in all the
Western countries.
Those who were in the target date funds
will be demanding a measure of capital
protection. In the US, 72% of 401k assets
were in equities. Now the number is
60%. As a result, asset managers are
now designing a new breed of products
that look like hybrid target date funds.
While they differ in structure, all combine
annuities — that provide periodic income
payments — with an investment portfolio.
In the pre-retirement phase, deferred
annuities feature in asset allocation. In
the post retirement phase, these are
replaced by actual annuities.
In contrast, in Continental countries
which have hitherto relied on deferred
annuities, a serious re-examination is
in progress in response to the counterparty risks associated with long term
swaps and options, emerging from the
collapse of Lehman Brothers. One idea
being considered by their governments
is to encourage DC plan members to
invest in the safest asset classes and
extend the retirement age. As a quid
pro quo, the state will pick up the tailend liabilities beyond a certain age.
Elsewhere, too, DC plans are attracting
policy attention. In the US, for example,
Congress is being lobbied to create a
federal retirement board to simplify
and clarify the retirement-savings
Alongside this restructuring, DC plans also received an organic fillip as countries like Denmark, Germany
Finland, France,
Poland and Sweden started new DC plans to relieve the pressures on the state retirement
Interview
quotes:
systems due to ageing populations. Unlike the first generation of plans which relied on traditional equities
and bond investments, the second generation have relied on insurance contracts in order to provide a
“Thesignificant
market
meltdown
is the chief
“The glide path of the next
measure
of capital protection.
culprit.
Buttheeven
the economy
generation
of with
DCplan
products
target
However,
currentif
financial
tsunami has hit all plans. Fear
now seems to rule,
members often
a Wall Street version of the fight-or-flight mechanism: they were selling first and asking
wereexhibiting
rock
solid,
401(k)
plans
would
date
funds
will
also
pick
up
questions later, to the extent that major changes are likely.
still be
a problem.”
deferred annuity.”
61% of respondents expect the emphasis on equities and bonds to continue worldwide, but with an
23
enhanced advice infrastructure. Plan members in English speaking countries – who make their own
investment choices – are now engaging in serious dialogue with their managers about their investment
options, contribution rates and retirement dates. The current crisis has forced the recognition that pension
pots in most cases will be inadequate in funding ever longer periods of retirement due to rising life
expectancy in all the Western countries.
Those who were in the target date funds will be demanding a measure of capital protection. In the US,
“We will introduce index tracking
annuity funds by forward swapping
LIBOR for a guaranteed return 20
years later. The main obstacle is the
counter party risk.”
61%
61%
30%
expect their DC clients to stay
in equities with an enhanced
advice infrastructure
expect their DC clients
to use target date funds
expect their DC clients to engage
in opportunism
process to replace the spaghetti of
private retirement options — 401(k),
IRA, Roth IRA, Roth 401(k), 403(b) —
that currently confront and confound
investors. A review of charges and
basic investment protection standards
also feature on the agenda.
A view from the top
“ Four systemic problems have dogged the 401k private
pensions plans in the US: up to a third of eligible
employees have not enrolled; contribution rates have
been too low; a bewildering array of products have gone
over the heads of most end-investors; and plan holders
have frequently succumbed to the latest fads when
making investment choices. In a mean-reverting world,
this behaviour condemned them to disappointment. For
example, from 1986 to 2007, the S&P 500 returned around
12% annually, while retail investors averaged only 4.5%.
In comparison, the Australian system of compulsory
superannuation schemes looked like a paragon of virtue.
Compulsion and auto-enrolment have ensured universal
participation. Pitched at 9% of salary, the employer
contribution is higher than in DC plans in other OECD
countries. An increasing number of distributors has
moved away from the age-old commission-based model
and created state of the art advice platforms for the mass
affluent. Most of all, the local stock market, powered by a
prolonged commodities boom, escaped the 2000-03 bear
market that savaged assets in most of the Western world.
At the level of the individual investor, too, choice is
rampant. Subject to trustee approval, anyone can choose
any superannuation funds and asset manager they like
and opt for any asset allocation mix. The typical mix
is 75:25 equities: bonds. In 2006, equity markets grew
at 27%, and the median return on growth funds was a
handsome 14.8% after fees.
Outwardly, therefore, fundamentals looked great until the
credit crunch wiped 50% off domestic equities in 2008.
When the super funds report in June, the losses will be
unprecedented, ranging from 20% to 40%. The era of
double digit annual returns is over. An exemplary DC
model has been shaken.
More intensive manager selection, more extensive
oversight and ever more demanding risk guidelines are
becoming the norm. Fees are under scrutiny, as is the advice
infrastructure, under which 85% of plan members chose
default options. People are seriously questioning whether
they can rely on markets to deliver decent retirement
pensions. The dream of retirement at 60 is gone.
On their part, superannuation funds will stick to equities with
a strong tilt towards emerging markets. Lately, they have
become more opportunistic. Their biggest challenge has
been to prevent members from making wrong asset choices
in a climate of panic, as evident in the non-superannuation
retail arena. There, clients want certainty of outcomes. They
are also demanding low volatility products via asset choices
rather than expensive overlays.
This crisis is a wakeup call. Asset managers now realise
that there is a lot they can’t control, apart from client
proximity. While the returns were good, business
basics were ignored. The government is watching the
developments with hawkish eyes.”
~ An Australian asset manager
Interview quotes:
“Denmark, Germany and Sweden will
continue to use insurance contracts
in their DC plans to provide capital
protection. The trick is to emulate
their approach in private DC products
in Ireland, UK and USA.”
“Pension landscape is a disaster area:
DB plans face insolvency; DC plans
suffer from poor returns.”
“DC clients are more willing to have a
serious conversation. We’re effectively
creating individual DB plans for them
by buying an annuity with part of
pension pot; and re-investing the rest.”
24
Retail clients’ choices will be influenced by loss
aversion, tax efficiency and periodic opportunism
irrespective of track record or client
needs. Even where distributors are
independent financial advisors, front-end
commissions have driven the choice of
products and providers. In Continental
Europe and Asia, distributors typically
adopt aggressive sales targets even
around products that are not fit for
purpose. However, clients are wising up,
as shown on the facing page
After two bear markets, retail clients
fall into two categories: dismayed and
distraught. Like their DC counterparts,
poor asset allocation choices have
cost them dear.
Of all the client segments, they have
proved most vulnerable. As asset
managers churned out freshlyminted products in the name of
innovation, retail clients have fallen
prey to the greed, hype and lingo
that characterised the last two bull
markets. Worse still, with distribution
dominated by banks in most countries,
retail clients have had a raw deal from
another source as well.
55% of respondents expect their retail
clients to opt for products that offer
capital protection and tax efficiency,
and annuities. The more sophisticated
ones are likely to venture into absolute
returns products and index funds, with
periodic bouts of opportunism that will
rotate between alpha funds and cash
plus products. While the demand for
absolute returns products will remain
Most large distributors have offered little
advice and placed funds automatically
with in-house managers or those
offering highest front-end commissions,
Once the Retail
worst of
the current
is over,
which by
asset
clients’
choicescrisis
will be
influenced
loss
classes and
generic
products
areand
most
likely to
be favoured
aversion,
tax
efficiency
periodic
opportunism
for short-term opportunism and/or medium-term changes in
Once the worstby
of theretail
current crisis
is over, which asset classes and generic products are most likely to be
asset allocation
clients?
favoured for short-term opportunism and/or medium-term changes in asset allocation?
50
40
30
20
% of respondents
10
0
10
20
30
40
50
60
Capital protection products
Tax efficient retirement products (e.g. IRAs in the USA; ISAs in the UK)
Absolute / real return products
Indexed funds
Annuities
Cash plus
Opportunism
Asset allocation
Source: Citi / Principal / CREATE Survey 2009
Source: Citi
/ Principal
CREATEretail
Survey
2009
After
two bear/ markets,
clients
fall into two categories: dismayed and distraught. Like their DC
counterparts, poor asset allocation choices have cost them dear.
strong — especially in the UK and the
US — its supply will be under intense
scrutiny due to the shock waves from
the Madoff debacle.
This emphasis on capital protection is
understandable in the wake of recent
losses. Retail clients are taking on
board yet another mantra: ‘do not buy
what you don’t understand’. But it is
not without significant trade offs.
In the short term, protection can be
secured via exposure to money market
funds. In the medium term, the use
of derivatives is inevitable. In today’s
environment, the first will offer nothing
more than a standard bank deposit
account; while the second raises the
spectre of counter-party risks. Either
way, the commoditisation of the retail
space seems inevitable, as accumulation
rather than speculation will be the name
of the game for most retail investors.
Those asset managers who can deliver
it will thrive. Those who can’t will wither.
Accelerated Darwinism may well be most
enduring legacy of this bear market.
It will be reinforced by heightened
regulatory scrutiny in areas like
product labelling, performance
management, risk modelling and
charges. Many asset managers
recognise that regulation alone is
not the answer. America has lots of
regulation. Yet, it is there that many
financial scandals have risen. Fresh
regulation or a stricter interpretation
of the existing one risks adding costs
and shutting the stable door after the
horses have bolted. On the other hand,
Of all the client segments, they have proved most vulnerable. As asset managers churned out freshlyminted products in the name of innovation, retail clients have fallen prey to the greed, hype and lingo that
characterised the last two bull markets. Worse still, with distribution dominated by banks in most
countries, retail clients have had a raw deal from another source as well.
Interview quotes:
Most banks have offered little advice and placed funds automatically with in-house managers or those
offering clients
highest front-end
of track
record
or client
needs.ofEven
where
“Now worried
are commissions, irrespective“IFAs
are
under
a lot
pressure
for
distributors are independent financial advisors, front-end commissions have driven the choice of products
and
providers.
In
Continental
Europe
and
Asia,
distributors
typically
adopt
aggressive
sales
targets
even
scrutinising the list of fellow
ignoring asset class correlations.”
around products that are not fit for purpose. However, clients are wising up, as shown on the facing page
customers, looking for weak names
55% of respondents expect their retail clients to opt for products that offer capital protection and tax
efficiency,
and annuities.
The more
that might
bail out,
forcing
thesophisticated
fund ones are likely to venture into absolute returns products
and index funds, with periodic bouts of opportunism that will rotate between alpha funds and cash plus
products.
While
the demandreturns.”
for absolute returns products will remain strong – especially in the UK and
to sell assets
and
hurting
the US - its supply will be under intense scrutiny due to the shock waves from the Madoff debacle.
25
This emphasis on capital protection is understandable in the wake of recent losses. Retail clients are taking
on board yet another mantra: ‘do not buy what you don’t understand’. But it is not without significant
trade offs.
“Bar belling was a clever marketing
ploy that worked while investors
believed that outcomes would
always match expectations.”
55%
49%
40%
expect their retail clients to
go for capital protection
expect their retail clients
to go for real returns
expect their retail clients
to turn opportunistic
it is inevitable, unless asset managers
tackle the hidden abuses that exploit
clients’ low financial literacy worldwide.
A view from the top
“Retail clients in Japan provide penetrating insights into
how a lethal combination of market losses and an ageing
population can create a commoditised savings industry
and a generation of unforgiving clients.
First they encountered big losses when the Nikkei crashed
from its all time high of 32,000 in 1989. There was widespread
expectation that it would rebound soon: at the time, hardly
anyone had understood the gravity of the unfolding banking
crisis. So investors stayed in. However, as the bear market
developed during the 1990s, three things happened.
First, retail clients became more risk averse by channelling
their savings into post office accounts. These flows
accelerated, as the Japanese population continued to age at
the fastest rate of any OECD country. In 2005, for example,
26.4% were over 60; by 2010, that will rise to 30.3%. As time
horizons for recouping the losses have got shorter, capital
protection channels have amassed a record US$13 trillion
pile of cash earning nothing. Even the jargon around equity
markets is now perceived as having gambling undertones.
Second, on the other hand, the younger generation of
retail investors has developed a stronger risk appetite,
as evidenced by the scale of momentum investing in this
decade. In 2005, a lot of money flowed into Chinese, Indian,
Thai and Vietnamese equities, only to sustain huge losses
when the downturn came in 2007. The losses were also
big on the bond side due to the currency effect. In any
event, these youngsters don’t hold a lot of wealth to drive
the markets by themselves. Many of them are part of that
flexible component of the polarised Japanese labour market
which offers low wages and low job security. In Japan, there
are no major disparities in wealth, as in the West, that can
create a critical mass in the asset markets. In this decade,
the momentum behaviours have been weakening for the
same reasons that are causing the flight to safety.
Third, institutional clients typically have a conservative
portfolio in line with the guidance from the regulators. These
require them to hold over 50% in domestic bonds, under
30% in domestic equities, under 20% in real estate and
under 30% in foreign assets. This cautious approach follows
the ‘Daicho Henjo’ ruling which transferred the substitution
portion of employee pension funds to the Government
which, in turn, reinvested them into indexed funds. Large
slugs of equities were dumped at the bottom of the
2000-03 bear market. Furthermore, there have been
accounting changes which have inflated the liabilities of the
plans, as in the West. DC plans have not gained traction:
contribution rates are low and investment choices poor.
So, it is easy to see why our stock market has been largely
driven by foreign money over the past ten years. Two
‘lost decades’ have taken root in investor psyche, with
the Nikkei at around a quarter of its peak value. As a
desperate measure, through its Pension Investment Fund,
the government has tried to shore up the markets as a part
of “price keeping operations”, in breach of the fiduciary
interest of plan members. But to no avail.”
~ A Japanese asset manager
Interview quotes:
“Retail clients are often victims
of their own irrationality and
exuberance.”
“What does buy-and-hold mean
when 15 years’ worth of capital gains
were wiped out in 15 months?”
“Alternatives will remain a high
dispersion space. If your returns are
not top quartile, don’t be there at all.”
26
High net worth clients will invest in long only funds
with a strong slant towards alternatives
which is underwritten by another
insurance company. It was hard to
know who was involved and whether
they had a problem.
Compared to their retail peers, high net
worth individuals are likely to retain a
more pragmatic risk profile. In the near
term, the majority are likely to venture
into actives and passives in the long only
space. Their allocations to alternatives
will be initially lower than in the pre
crisis days and more opportunistic
than strategic. There are a number of
contributory factors, according to our
post survey interviews.
The second is the failure of hedge
funds. HNWI had powered their growth
in the belief that their downside
risks were hedged, only to find that
that wasn’t the case. In 2008, HNWI
accounted for 80% — around US$500
billion — of hedge funds redemptions,
even though they held less than
two thirds of the assets. The long
term affinity with hedge funds has
weakened, albeit temporarily. Hedge
funds are now perceived as a high
dispersion space for pursuing the
best uncorrelated returns, so long as
one chooses the right managers. In
a low volatility environment, hedge
The first is the failure of risk models.
When models failed as they did, many
HNWI clients were advised to go
opportunistic until the dust settled
and a new framework emerged. The
old models failed to factor in the new
world of finance in which a company
is linked to a monoline insurer, which
is attached to a credit default swap,
Once
thenet
worst
of clients
the current
crisis in
is long
over,only
which
asset
High
worth
will invest
funds
with a
classes and generic
products
are most
likely to be favoured
strong
slant towards
alternatives
for short-term opportunism and/or medium-term changes in
Once the worst
currentnet
crisis is
over, whichclients?
asset classes and generic products are most likely to be
asset allocation
byof the
high
worth
favoured for short-term opportunism and/or medium-term changes in asset allocation?
40
30
20
% of respondents
10
0
10
20
30
40
50
60
Actively managed equities and/or bonds
Absolute / real return funds
Indexed equities
Real estate
funds were forced to use leverage.
Now in a low leverage high volatility
environment, the best ones are
expected to do well. Besides, as global
equities have effectively shed all their
gains notched up between the Asian
economic crisis of 1997-99 and the
onset of the credit crisis, they are no
longer perceived as the only engine of
decent long term returns.
Third, the new inflows are likely to
emanate from a new generation of
entrepreneurs in Asia, the Middle
East, Africa and LATAM, with personal
assets in excess of US$50 million.
Most of them believe that now is the
once-in-a-generation opportunity to
make money. At the same time, they
are far more demanding than their
peers in America and Europe, many
of whom are sitting on inherited
wealth. They are especially alive to the
counter-party risks associated with
prime brokers, custodian banks and
structured products. They realise that
‘fat tails’ proved the downfall of fat
cats in the banking world. Accordingly,
they factor in extreme adverse events
in their investment choices. They also
scrutinise the list of clients their asset
managers have, looking for weak
names that may bail out at the wrong
time and hurt the returns.
Capital protection products
Private equity
Other alternatives (e.g. commodities; currency)
Hedge funds
Indexed bonds
Opportunism
Asset allocation
Source: Citi / Principal / CREATE Survey 2009
Source: Citi / Principal / CREATE Survey 2009
Compared to their retail peers, high net worth individuals are likely to retain a more pragmatic risk profile.
In the near term, the majority are likely to venture into actives and passives in the long only space. Their
allocations to alternatives will be initially lower than in the pre crisis days and more opportunistic than
strategic. There are a number of contributory factors, according to our post survey interviews.
The quotes:
first is the failure of risk models. When models failed as they did, many HNWI clients were advised
Interview
to go opportunistic until the dust settled and a new framework emerged. The old models failed to factor in
the new world of finance in which a company is linked to a monoline insurer, which is attached to a credit
default swap,
which is underwritten
by another insurance“HNWI
company. Itwill
was hard
to knowfascination
who was involved for
“The centre
of gravity
will shift
retain
and whether they had a problem.
towards the East — for clients as
risky assets but not on a buy-andThe second is the failure of hedge funds. HNWI had powered their growth in the belief that their downside
risks were hedged, only to find that that wasn’t the case.
In 2008,
HNWI accounted for 80% – around
well as alpha.”
hold
basis.”
27
US$500 billion – of hedge funds redemptions, even though they held less than two thirds of the assets.
The long term affinity with hedge funds has weakened, albeit temporarily. Hedge funds are now perceived
as a high dispersion space for pursuing the best uncorrelated returns, so long as one chooses the right
managers. In a low volatility environment, hedge funds were forced to use leverage. Now in a low
leverage high volatility environment, the best ones are expected to do well. Besides, as global equities
have effectively shed all their gains notched up between the Asian economic crisis of 1997-9 and the onset
of the credit crisis, they are no longer perceived as the only engine of decent long term returns.
Third, the new inflows are likely to emanate from a new generation of entrepreneurs in Asia, the Middle
“There’s extreme suspicion
about products that involve
banks as counter parties, directly
or indirectly.”
51%
38%
30%
expect their HNWI clients to
remain in active space
expect their HNWI clients to
engage in opportunism around
commodities and currency
expect their HNWI clients to
retain interest in hedge funds
and private equity
A view from the top
“Between the peak in October 2007 and the trough
in November 2008, the stock market losses totalled
US$21k for every individual in the developed world. In
the high net worth segment, the losses were even more
staggering. Yet the segment is set to grow.
Over the next five years, assets in the private wealth
industry will grow at CAGR 7.5%. Europe and North America
will remain the epicentre but the growth engines will be the
Middle East, Africa, APAC and LATAM, in that order. The bulk
of the new wealth will come from business entrepreneurs
running the emerging market multinationals, in marked
contrast to the inherited wealth held in Europe and America.
This has a number of implications.
To start with, wealth managers are expected to develop
the necessary client proximity by setting up offices in
far flung jurisdictions. Furthermore, these clients want
one-stop-shop solutions normally associated with family
offices. Finally, they want their wealth managers to help
them raise capital from time to time to leverage their
business as well as financial assets.
On the investment side, their demands are complex and
heterogeneous. Being entrepreneurs, they are more
demanding, less trusting, keen to manage their own affairs,
less loyal, and more interested in growing their wealth.
Around 65% of their assets are in active equities and bonds
and nearly 15% in alternatives, mainly hedge funds. The latter
have declined substantially in the current bear market on
account of large losses incurred in the fund of hedge funds.
Although interest will revive once the current turmoil is over,
counter-party risk has come under sharp scrutiny. Over the
next three years, three other developments are likely.
First, the bulk of investments will be active equities and
bonds with zero tolerance of managers who cannot
deliver the benchmark returns. Liquidity will become
more important as regular dynamic switching will be the
norm. Hedge funds or anything illiquid will be frowned
upon, unless they are part and parcel of high conviction
investing. There will be greater interest in domestic
market investment, preferring more familiar ground at
the time of heightened uncertainty in the global economy.
Second, a part of the portfolio will be earmarked for ESG
investments as an alternative to philanthropy. In the
Middle East, Indonesia and Malaysia, Shariah compliant
products will become more popular.
Finally, product push will be replaced by a more collaborative
approach to portfolio construction, involving clients and
their relationship managers.
These developments will continue to have huge implications
for the wealth managers located in the US and Europe.
They will need strong local presence in manufacturing and
distribution. They will need investment and non-investment
skills to provide a bundle of services. They will need a
large army of relationship managers well versed in local
cultures, languages and traditions. It adds up to financial
intermediation at the level of a super service provider.
No wonder most wealth managers are already struggling.
Long used to having captive clients that were attracted to
places like Luxembourg and Switzerland by the prevailing
banking secrecy laws, these managers are having to make
painful adjustments.
They have been decoupling from their in-house asset
managers lately. They have to either develop onshore
manufacturing capabilities or form alliances with good
local managers, who are few and far between. They also
need an offshore CRM infrastructure at a time when the
requisite skills are thin on the ground.”
~ A German private bank
Interview quotes:
“Wealth management remains
conflicted: most ‘advisers’ get rebates
from fund providers.”
“The Middle East will remain the
preserve of family offices.”
“We need a superb advice
infrastructure and deep pockets to
deal with law suits; there are no signs
of either emerging from the ashes of
the recent crash.”
28
New business models
How are asset managers responding?
“The goals and
values we now have
are appropriate to
a species blindly
struggling along
with other species
in the stream
of life. They are
appropriate to
passengers not to
navigators”
Mihalyi Csikszentmihalyi
29
Overview
Key findings
Issues
• W
orldwide, asset managers have
taken steps towards variable pay,
slimmer product base and strategic
outsourcing.
A lethal combination of market falls
and high redemptions have wiped out
profit margins in many asset houses in
this decade. With prospects of further
systemic crises in the next, asset
managers have duly responded by turning
the spotlight on the sacred cows that have
long conspired against the necessary
operating leverage in a down market.
This chapter addresses the following
issues:
• W
hat steps are being taken to create
the necessary shock absorbers that
work in bull and bear markets alike?
• H
ow are they creating knock-on
effects on the industry’s value chain?
• What are the key transitional issues?
• W
hy do they require a culture of
leadership?
• O
n the cultural side, these are
being reinforced by additional steps
towards improving the executive
gene pool, service quality, and
incentive systems. With a clear
strategic intent, these changes
have the potential to blow away
the old entitlements, mindsets and
practices that have worked against
client interests.
• O
n the structural side, the industry
food chain is being fragmented via
outsourcing of front, middle and
back office activities to generate
economies of scale and scope in
order to create a craft focus at the
investment end; mass customisation
at the distribution end; and
“Regulators will call our
bluff and give us what we
want. Can we really give
clients a better deal without
radical changes in the way
we do things?”
standardisation at the administration
end. Actual and virtual boutiques are
being created to widen and deepen
the investment expertise.
• Increased regulation will raise costs,
intensify competition, create fee
compression and hasten mergers
as well as de-mergers. Polarisation
between the large and small players
will intensify.
• F
our transitional problems have
come to the fore: loss of key skills,
loss of revenue streams, entrenched
attitudes and inadequate
management bandwidth.
• A
combination of demand side and
supply side pressures suggest three
likely scenarios for the asset industry
over the next five years: one envisages
more commoditisation, as asset
managers struggle to deliver value;
one envisages more segmentation, as
asset managers accelerate their attack
on the embedded inefficiencies; one
envisages more dynamism, as asset
managers put their clients first.
• T
he final outcome will depend
upon the relative strengths of
factors as diverse as client inertia,
behavioural biases, regulation,
leadership capabilities and
economic stimulus in G20.
Interview quotes:
“Regulators will call our bluff and give
us what we want. Can we really give
clients a better deal without radical
changes in the way we do things?”
“When the water goes down the
drain, you discover the dirt.”
“This crisis is a perfect storm for a
large house like ours: it has shaken
complacency.”
30
In creating a variable cost business model, asset
managers have targeted the sacred cows
our sample: ranging from 5% to 38%.
Medium and larger houses with AuM
in excess of US$100 billion have borne
the brunt. A lethal combination of
market falls and high redemptions have
together taken a disproportionate toll
on their gross revenues.
Two bear markets in this decade have
done what disruptive technologies have
done in other industries: weakened the
mindset barriers that have long shielded
expensive entitlements unrelated to
merit. With prospects of further crises
in the pipeline, as shown on page 6 in
Executive Summary, there is a dawning
realisation that a business model
that works only in a bull market is a
recipe for disaster, unless it has shock
absorbers to cushion the exceptional
drops in gross revenue like the recent
one. On an asset weighted basis, the
falls worldwide have averaged around
35% in 2008, with the prospect of a
further 15% in 2009. In response, job
losses have been inevitable across
Hence, actions have been taken over
a wide front. They aim to create a
variable cost model by reducing fixed
costs, converting as many fixed items
into variable ones, and ensuring that
variable items move in line with gross
revenue, as far as possible. Similar
initiatives mounted after the first bear
market of this decade fizzled out when
markets recovered. On this occasion,
however, the incidence of changes is
In creating a variable cost business model, asset
Which of
the following
actions
havethe
yousacred
taken, or
are you likely
managers
have
targeted
cows
to take, to create a variable cost business model that aims to
preserve
the actions
net have
margin
inor are
bull
andto bear
markets?
Which of the following
you taken,
you likely
take, to create
a variable cost business model that
aims to preserve the net margin in bull and bear markets?
0
10
20
30
% of respondents
40
50
60
70
80
Making bonus a major component of compensation
Linking bonus of other staff to business performance
Sharing overhead services with the parent company
Eliminating non value adding activities from the cost base
Outsourcing back office activities
Negotiating special deals on all sell-side services
Freezing the base pay in real or nominal terms
Outsourcing non-core manufacturing
Paying bonus via equity stake in the business or funds
Focusing on core capabilities by narrowing the product base
Having staff on short term contracts, where possible
Linking bonus of investment professionals to individual or team results
Eliminating guaranteed bonuses unrelated to business performance
Outsourcing distribution via open architecture and alliances
Outsourcing middle office activities
Expanding the client base to create economies of scale
Have taken
Likely to take
Source: Citi / Principal / CREATE Survey 2009
Source:
Citi /markets
Principal
CREATE
2009what disruptive technologies have done in other industries:
Two bear
in /this
decadeSurvey
have done
weakened the mindset barriers that have long shielded expensive entitlements unrelated to merit. With
prospects of further crises in the pipeline, as shown on page 4 in Executive Summary, there is a dawning
realisation that a business model that works only in a bull market is a recipe for disaster, unless it has
shock absorbers to cushion the exceptional drops in gross revenue like the recent one. On an asset
weighted basis, the falls worldwide have averaged around 35% in 2008, with the prospect of a further 15%
in 2009. Inquotes:
response, job losses have been inevitable across our sample: ranging from 5% to 38%. Medium
Interview
and larger houses with AuM in excess of US$100 billion have borne the brunt. A lethal combination of
market falls and high redemptions have together taken a disproportionate toll on their gross revenues.
“Virtually nobody is hiring. The whole
“People are incentivised to
Hence, actions have been taken over a wide front. They aim to create a variable cost model by reducing
industry
has converting
groundastomany
a halt.”
Butthat
they
still
get
fixed costs,
fixed items into variable succeed.
ones, and ensuring
variable
items
move in
line with gross revenue, as far as possible. Similar initiatives mounted after the first bear market of this
rewarded
when
they fail.”
decade fizzled out when markets recovered. On this occasion,
however,
the incidence
of changes is
widespread due to uncertainty about the timing, speed and strength of any nascent recovery, as much as
the likelihood of further systemic crises. Accordingly, three areas have seen significant actions so far.
31
The first is compensation. Over 50% of the respondents have frozen base pay, and linked bonus with
either investment performance or business performance, depending upon the staff category. Over time,
over 80% expect to use meritocratic bonus as the most variable component of compensation. These
numbers are twice as high as those in the last bear market, according to one of our previous studies.
90
widespread due to uncertainty about
the timing, speed and strength of
any nascent recovery, as much as the
likelihood of further systemic crises.
Accordingly, three areas have seen
significant actions so far.
The first is compensation. Over 50%
of the respondents have frozen base
pay, and linked bonus with either
investment performance or business
performance, depending upon the staff
category. Over time, over 80% expect
to use meritocratic bonus as the most
variable component of compensation.
These numbers are twice as high as
those in the last bear market, according
to one of our previous studies.
The second area is non core activities.
Over 60% have cut back on travel,
entertainment and marketing. More
significantly, 38% have outsourced
the back office so far: the number will
double in future. 17% have outsourced
manufacturing: the number will
quadruple. 20% have outsourced the
middle office: the number will double.
Outsourcing contracts now typically
have a low base fee plus a variable fee
linked to the volume of activity.
The third area is product base. This has
been pruned substantially in medium
and large houses — by as much as 300
in notable cases — eliminating the sub
scale products. This has been painful;
rather than switch into truncated
options, many customers have chosen
the exit option. Hitherto, in the absence
of flexibility on the cost side, large
houses had relied on an ‘all weather
“For the first time in history, we’ve
cut the headcount in the front office
and challenged the old entitlements.”
58%
41%
38%
have frozen the base pay and
linked bonuses to performance
have narrowed their
product range
have outsourced the
back office activities
portfolio’ to maintain the revenue
streams in good times and bad. As
with outsourcing, asset managers
now recognise that product pruning
has to have a strategic intent that
clarifies what the core capabilities of
the business are and how they can be
best deployed. This introspection has
forced a number of other structural
changes, as we shall see later.
Thus, baby steps have been taken
to make the existing models
more robust in the face of heavy
downdrafts. Low-hanging fruits as
well as the previously intractable
ones have come within reach. Their
success will depend on the speed of
the recovery as much as the resolve
of business leaders.
A view from the top
“Asset business was always seen as a fixed cost people
business that can’t be leveraged in a down market. Now,
this conventional wisdom is being turned on its head after
two bruising bear markets in this decade with expectations
of more to come in the next decade. Focus is our new
mantra and Toyota the role model.
The Japanese giant’s lean production methods have
transformed many industries. Its just-in-time approach
relies on extensive alliances with component suppliers,
leaving it to focus on two areas: R&D and assembly. It
assembles more models per assembly line, at faster line
speeds than any auto manufacturer. So, it has a very cost
effective mass customisation platform that delivers fewer
models than its competitors but they are unbeatable, with
lowest defection rates and highest productivity.
After the last bear market, we started moving towards
lean production; only to realise that it involved a choice:
do we have an all weather product portfolio by going into
assembly and having alliances with best of breed external
managers, or do we concentrate on ‘killer’ products by
becoming a specialist manufacturer. After all, the sources
of operating leverage in a bear market are very different.
For an assembler, leverage primarily emanates from a
wide product range, targeted at multiple client segments
in multiple geographies. For a specialist manufacturer,
it primarily emanates from having low fixed and high
variable costs. We chose the latter route.
We started pruning down our product and client portfolio
by gradually phasing out bells and whistles products as
well as the low margin clients. This was not easy as it
effectively involved closing off many revenue streams.
Besides, to produce winners every year, the laws of
randomness favour more dispersed bets via larger
product base. But the market recovery of 2003-07 helped
to accelerate the streamlining process.
Like other asset managers, we also recognised that
variable costs mean variable pay. Most asset managers
are reluctant to reduce the bonus when performance
is poor for fear of losing key staff. Top executives are
also unwilling to have difficult conversations with bonus
guzzlers. Guaranteed bonuses are still common; as are
bonus formulas, which are rarely observed in bad times.
No variable cost model is worth the piece of paper it is
written on unless it tackles the archaic compensation
system that does not serve clients’ interests. We have
moved towards a system that gives low base pay and
deferred payments based on equity stake in the business.
Staff here own 20% of the company. But, from time to
time, there is nostalgia for the old ways that still prevail in
our industry.”
~ A UK asset manager
Interview quotes:
“The UK and USA lead the way on
variable pay followed by Japan,
Hong Kong, Singapore. Continental
Europe is well behind.”
“Our gross revenue shrank by 40%
in 2009 and a further 25% in 2009
on a run rate basis. Our parent bank
has put up a ‘for sale’ sign.”
“The industry needs a moratorium
on new products: we’ve lost money
for clients in every way.”
32
Cultural changes aim to promote a small company
mindset in a large company environment
A new ‘moral’ environment is
emerging. Under it, asset managers
perceive themselves as the trustees of
clients’ assets by fostering a fiduciary
heritage on the one hand, and a hard
nosed approach to scale, scope and
speed, on the other. Together they aim
to create meritocratic cultures via new
initiatives on leadership capabilities;
service quality; fees; staff incentives;
and operating model.
Taking them in turn, over 45% of the
respondents have aimed to improve
the quality of their leadership gene
pool via in-house training and external
recruitment; with just as many planning
to do so in future. 55% hold all their
senior executives accountable for the
success of their businesses. These
numbers are three times what they were
in the first bear market of this decade.
This new focus on executive capabilities
and accountabilities partly reflects the
trends elsewhere in financial services
sparked by the banking crisis; and partly
the need to have savvy people chart a
flight path out of the current traumas.
On the client side, two areas have
attracted action. The first one aims
to improve the quality of day to day
service. 33% of the respondents
have implemented changes; with
just as many likely to do that in the
near future. Clients are increasingly
segmented by their needs, with clear
service propositions developed for each
segment. In some houses, special client
protection panels are being set up to
Cultural changes aim to promote a small company
a largehave
company
environment
What othermindset
cultural in
changes
you made,
or are you likely
to make, to create a robust business model that can survive
What market
other cultural changes
havein
you the
made, or
are you likely to make, to create a robust business model that can
major
events
future?
survive major market events in the future?
% of respondents
0
10 20
30 40 50 60 70 80 90 100
Improving the leadership capabilities of senior executives
Holding all executives accountable for business success
Enhancing the quality of client services
Creating in-house product-based boutiques
Reviewing the fee structure to create a better alignment of interest
Encouraging new ideas for ‘cutting edge’ innovation
Recruiting talent proactively to capitalise on the current labour shakeout
Creating quality assurance structures which deliver ‘fit for purpose’ products
Introducing meritocratic incentives
Offering staff more equity stake in the business
Creating asset gathering and asset allocation capabilities
Creating more ‘joined up’ thinking between different functional areas
Source: Citi / Principal / CREATE Survey 2009
Have taken
Likely to take
A new ‘moral’ environment is emerging. Under it, asset managers perceive themselves as the trustees of
Source:clients’
Citi / Principal
/ CREATE
Survey 2009
assets by fostering
a fiduciary
heritage on the one hand, and a hard nosed approach to scale, scope
and speed, on the other. Together they aim to create meritocratic cultures via new initiatives on leadership
capabilities; service quality; fees; staff incentives; and operating model.
Taking them in turn, over 45% of the respondents have aimed to improve the quality of their leadership
gene pool via in-house training and external recruitment; with just as many planning to do so in future.
55% hold
all their senior executives accountable for the success of their businesses. These numbers are
Interview
quotes:
three times what they were in the first bear market of this decade. This new focus on executive capabilities
and accountabilities partly reflects the trends elsewhere in financial services sparked by the banking crisis;
“In Asia,
aggressive
“We
tell people
and distributors’
partly the need to have
savvy people chart a flight path
outdon’t
of the current
traumas. exactly what
sales targets
rely
massive
are
On the client
side,on
two areas
have attracted action. Thethey
first one
aimsbuying.
to improveInnovation
the quality of daydoes
to day
service. 33% of the respondents have implemented changes; with just as many likely to do that in the near
productfuture.
push.”
not always have to mean highly
Clients are increasingly segmented by their needs, with clear service propositions developed for
each segment. In some houses, special client protection
panels are being set
up to ensure that clients are
complicated
products.”
sold products that are fit for purpose. Improving client proximity has become an important tool for
33
retaining existing assets as much as attracting new assets. Regular ‘pulse’ surveys have also been initiated
to track how clients perceive the delivery of service on the ground. The second area covers the fee
structures. 25% of the respondents are reviewing their fee structures to create a better alignment; with the
number likely to double in the near future. This area has not received the priority it deserves because of
the acute pressures on the margin currently.
ensure that clients are sold products
that are fit for purpose. Improving client
proximity has become an important tool
for retaining existing assets as much as
attracting new assets. Regular ‘pulse’
surveys have also been initiated to
track how clients perceive the delivery
of service on the ground. The second
area covers the fee structures. 25% of
the respondents are reviewing their fee
structures to create a better alignment;
with the number likely to double in the
near future. This area has not received
the priority it deserves because of the
acute pressures on the margin currently.
On the staff side, meritocratic
incentives have been implemented
by 38% of the respondents; with half
as many planning to do so. 22% have
introduced an equity stake in order to
promote greater alignment of interest.
These and other actions have been
taken to retain and deploy talent in a
challenging environment.
Finally, on the structural side, 45% of
asset managers have created actual
or virtual boutiques, as businesses
within a business, built around product
classes. The aim has been three-fold: to
give autonomy and space to talented
individuals to create and execute high
conviction ideas, to have a sharper
business focus and to have a clear sense
of accountability.
All the above actions aim to promote
a small company mentality in a large
company environment. They aim to run
the business like a normal business —
from peak to trough to peak by weeding
“Senior executives like their titles,
but not the territories that come
with them.”
45%
45%
33%
25%
are improving their
executive capabilities
are creating in-house
boutiques
are improving their
client service
are reviewing their
fee structures
out old entitlements and fostering new
accountabilities. The incidence of these
changes, however, is low at this point.
Few mangers expected the crisis to
turn systemic. The collapse of Lehman
Brothers was the catalyst. Many of the
actions reported here came in its wake.
The initial response was tactical cost
cutting. However, the accompanying
measures reported above have the
potential to turn it into a strategic
blueprint that can have a far reaching
effect on the future of the industry, if
they outlast the next recovery.
A view from the top
“Asset management is a craft industry and may always
remain so. Its food chain is changing but predictions
about consolidation are too simplistic. In manufacturing,
consolidation is occurring in ownership, not activities: as
size has proved an enemy of alpha, the craft end is being
fragmented to create independent and multiple boutiques.
Independent boutiques are owned either by their
managers and staff or external shareholders. Each tends
to have two clear entities: the mother ship and individual
autonomous product groups with their own P&L; their own
compensation structures — typically with low base pay
and profit-sharing. They buy overhead services from the
mother ship when needed, while sharing profit with it. They
target internal alignment by profit sharing; and external
alignment by strong craft focus on client needs.
In contrast, we are a multi-boutique firm with a similar
model that targets economies of scope as well as scale.
The former comes from 9 separate businesses that
cover the whole waterfront of the main asset classes,
with operational independence. Like shops within a shop,
they increasingly share common platforms in research,
distribution and administration, which are run from the
centre to achieve scale. Those boutiques with a large
institutional client base do their own distribution. Initially,
the mother ship had twin focus: asset gathering and global
oversight. Latterly, it has ventured into specialist services
around asset allocation, risk management and multi-asset
class products. It is also developing a multi-manager
platform, involving alliances with best of breed external
managers. There have been numerous teething problems
in the transition to the multi-boutique model.
Tensions have been inevitable in revenue sharing, capacity
sharing and product development when products of one
unit are sold by its peers elsewhere. Opportunistic rules of
engagement have produced ambiguities to the extent that
collegiality has only been there in name. Each boutique’s
relations with the centre have not been easy either:
the entrepreneurial spirit of the one sits uncomfortably
alongside the oversight responsibility of the other. Different
regulatory regimes have created extra bureaucracy.
Few senior executives at the centre or in the regions are
experienced in running a global business. So, we have
increased our forward spend on training on pertinent
issues like how to balance the inevitable contradictions in
our matrix, how to rethink the mental boundaries of our
businesses, and how to work as equals with people from
other cultures.
Our single biggest challenge is to manage the inevitable
ambiguities in an operating model which is at once
centralised and decentralised. Global success requires a
high tolerance for ambiguity. It’s a mindset issue.”
~ A German asset manager
Interview quotes:
“Asset allocation is highly nuanced.
Niche managers get it far better
than the large ones.”
“We have replaced 14 members
of the 16-person executive board
who were bonus guzzlers and
not much else.”
“The new ‘moral environment’ is
about do or die.”
34
Back office outsourcing will continue apace
Back office outsourcing has been a
major growth phenomenon of this
decade, initially covering low value-added
activities like custody and settlement and
progressing to middle office activities like
valuation of assets, derivatives pricing
and attribution analysis. Growth is likely
to continue for two reasons.
First of all, post Madoff, regulators are
likely to demand greater independent
oversight of these and other activities
such as product labelling, risk models
and transparent charges. In the
alternatives space, outsourcing is
expected to extend to front office
activities like stress testing, simulation
models and product development.
Secondly, rapid growth since 2003
has inevitably created complexity in
asset management via a multiplicity
of product classes, client segments,
delivery channels, geographical
locations, and legal jurisdictions. A
number of unintended consequences
have ensued: business has lacked
focus; product propositions have
been diluted to the detriment of client
interests; and cost increases have
mostly outpaced revenue increases
proportionately, inflating staff egos
and entitlements in equal measures.
The cumulative effect has been
diseconomies of scale which have
undermined the scalability of asset
managers as they have ramped up their
growth. Even in areas like distribution
and administration, it has proved
difficult to extract scale economies as
businesses have gained complexity.
Thus, outsourcing is seen as a
tool that allows senior executives
to professionalise the business
by concentrating on their core
manufacturing capabilities. If
performance is the target, focus is the
silver bullet. In the new environment,
asset managers are expected to
outsource progressively more activities
in order that that they may concentrate
on four strategic areas that deliver
a vibrant business: deep investment
capabilities, strong service proposition,
realistic charges and sound business
basics. Without a clear strategic intent,
outsourcing is just a cost cutting tool.
The success of outsourcing and other
initiatives critically depend upon
how closely they are aligned to core
business goals.
They require a culture of leadership
that can enable top executives to shift
the employee mindset from personal
entitlement to business growth; from
short term personal gain to long
term client interests. The agenda for
survival is clear, as are the tools.
Back office outsourcing will continue apace
What will be the optimal division of back office
functions in the next 5 years?
What will be the optimal division of back-office functions in the next 5 years?
% of respondents
90 80 70 60 50 40 30 20 10 0 10 20 30 40 50 60 70 80 90
Custody and settlement
Independent valuation of investments
Shareholder services
Derivatives and processing
Proxy voting
Performance measurement and attribution analysis
Tax planning
Financial reporting
Regulatory compliance
Risk management services
Remain in-house
Has been outsourced
Will be outsourced
Source: Citi / Principal / CREATE Survey 2009
Source: Citi / Principal / CREATE Survey 2009
Back office outsourcing has been a major growth phenomenon of this decade, initially covering low valueadded activities like custody and settlement and progressing to middle office activities like valuation of
assets, derivatives pricing and attribution analysis. Growth is likely to continue for two reasons.
First of all, post Madoff, regulators are likely to demand greater independent oversight of these and other
activities such as product labelling, risk models and transparent charges. In the alternatives space,
Interviewoutsourcing
quotes:
is expected to extend to front office activities like stress testing, simulation models and
product development.
“RFPs go Secondly,
into operational
offices
no longer
rapid growth since 2003 has inevitably “Back
created complexity
in asset
managementhave
via a the
multiplicity of product classes, client segments, delivery channels, geographical locations, and legal
infrastructure
likeA never
image;
they
seen as
jurisdictions.
number of before.”
unintended consequences Cinderella
have ensued: business
has lacked
focus;are
product
propositions have been diluted to the detriment of client interests; and cost increases have mostly outpaced
the
life blood
of theThe
business.”
revenue increases proportionately, inflating staff egos and
entitlements
in equal measures.
cumulative
effect has been diseconomies of scale which have undermined the scalability of asset managers as they
have ramped up their growth. Even in areas like distribution and administration, it has proved difficult to
extract scale economies as businesses have gained complexity.
35
Thus, outsourcing is seen as a tool that allows senior executives to professionalise the business by
concentrating on their core manufacturing capabilities. If performance is the target, focus is the silver
bullet. In the new environment, asset managers are expected to outsource progressively more activities in
order that that they may concentrate on four strategic areas that deliver a vibrant business: deep investment
“No two funds are the same.
Getting scale in the back office
is not that easy.”
62%
52%
20%
have outsourced custody
and settlement
have outsourced
asset valuation
have outsourced performance
measurement and attribution
analysis
A view from the top
“Outsourcing of non core activities is essential for
developing a variable cost model. Starting in the last
2000-03 bear market, the first wave of outsourcing aimed
to kill two birds with one stone: tackling the cost spiral and
exporting the ‘problem children’. The current wave aims to
enable asset managers to move towards a business model
that produces more for less.
The current wave of outsourcing is now penetrating the
middle office to cover activities like vendor management,
performance measurement, attribution analytics, risk
models and data management. Post Madoff, regulators are
either planning to introduce new rules or reinterpreting the
existing ones in three specific areas, all of which are raising
the demand for external expertise.
In pursuit of high returns, asset managers are forced
to make a strategic choice between doing business and
running the business. In the current market, the choice
has become more acute with clients becoming more
demanding. Segmentation is the name of the game and
alliances are the most cost-effective tool. Hence, three sets
of organisational innovations are kicking in.
The first is product integrity. They would like to ensure
that the product labels provide correct information on
features such as risk, returns, liquidity and volatility.
The second is oversight. They want to see more robust
checks on asset valuations, performance attribution, risk
models and transfer agent activities. The third is fees and
compensation. Regulators want greater transparency
around charges and also want managers to be paid on
the basis of risk-adjusted returns. That these regulatory
pressures are building up is not in doubt. They will be one
of key drivers of growth for all the outsourced activities.
First, they are reinforcing the craft focus in investment
by creating internal boutiques or forming alliances with
external asset managers in pursuit of good returns. Such
alliances are underpinned by multi-manager platforms
with product assembly capabilities. The aim here is the
separation of alpha and beta in the production phase.
Second, they are reinforcing the mass customisation
focus in distribution by increasingly using third party
channels. They are shifting the emphasis from products
to solutions. Intermediaries are increasingly employing
institutional-quality tools to engineer best of breed
packaged solutions. Approximately, 70% of their sales
in the US now involve a professional overlay that aims to
ensure that funds are bought, not sold.
Third, they are chasing scale in the back office activities
via either outsourcing or building proprietary operational
platforms. Their choice has been governed by factors
such as size of assets, growth expectations, and product
complexity and compliance environment.
Thus, asset managers are under pressure to re-engineer
their business models to deliver value-for-money to
their clients. In the process, we expect to see continuing
fragmentation in the industry’s value chain.
Outsourcing is neither a panacea nor a bold fix. It is an
important tool in a larger initiative that forces asset
managers to be clear about their strategic intent and core
capabilities. It enables them to exploit economies of scale
in activities where external service providers can add most
value; and economies of scope in activities where they can
add most value themselves. On their part, service providers
are coming under enormous pressure to deliver scalable
systems and people capabilities to cope with the new
demands made by a rapidly morphing industry.”
~ A global custodian bank
Interview quotes:
“We’re seeing raw Darwinism that
regularly kills off the weakest in
the industry.”
“Selling a sound bite is so much
easier than selling the truth.”
“M&A has created undue
complexity in the back offices of
the firms concerned. The one-time
cost of fixing it is too high.”
36
With increased regulation, competition will intensify
as will fee pressures, ensuring that demergers are
as notable as mergers
The scale of losses inflicted by the
current crisis is such that there cannot
be a return to business as usual. 68%
of respondents expect more regulation
or law suits. Worldwide, regulators have
been busy lately. Proposals have already
been made with respect to hedge funds
and private equity after the G20 meeting
in April 2009. There are others in the
pipeline, too, which aim to improve
product labelling, cost transparency and
independent oversight of some of the
middle office activities in the long only
space. A remorseless regulatory creep
is inevitable, as are lawsuits, with the
distinct potential to commoditise the
industry. Some proposals – described in
the executive summary – risk outlawing
common sense: they seek to displace
human judgement. Whatever their
ultimate shape, regulatory changes in
the pipeline will reinforce the structural
forces ignited by the crisis in three areas.
The first one is M&A. 53% of the
respondents expects more activity.
Rising costs and competitive pressures
have already sparked a new wave of
mergers. It is especially likely to impact
the bank-owned asset managers
who are no longer perceived as core
businesses by their parents who are
strapped for cash in the wake of the
banking crisis. However, the new wave
will focus on acquiring book of assets
more than specialist expertise. It will
not be as dominant a force in the
likely rationalisation of capacity as
competitive pressure. This is because
45% also expect further demergers
and buyouts, as asset houses sell or
swap part of their businesses. Genuine
With increased regulation, competition will intensify as will fee
pressures, ensuring that demergers are as notable as mergers
As a result of the current crisis, which of the structural
changes inAsglobal
asset management will have the biggest
a result of the current crisis, which of the structural changes in global asset management will
have the biggest impact
on your
business
over the
next threeyears?
years?
impact on your business
over
the
next
three
Increased regulation / more law suits in the industry
Fee compression in the wake of big capital losses
Further consolidation via M&A
Capacity rationalisation due to increased global competition
Greater industry fragmentation via de-mergers and buy-outs
Accelerated decoupling of manufacturing and distribution
Large asset managers developing multi-manager platforms
Pension consultants venturing into fiduciary management
Source: Citi / Principal / CREATE Survey 2009
Source: Citi
Principal
/ CREATE
Survey
2009
The/ scale
of losses
inflicted by
the current
crisis is such that there cannot be a return to business as usual.
68% of respondents expect more regulation or law suits. Worldwide, regulators have been busy lately.
Proposals have already been made with respect to hedge funds and private equity after the G20 meeting in
April 2009. There are others in the pipeline, too, which aim to improve product labelling, cost
transparency and independent oversight of some of the middle office activities in the long only space. A
remorseless regulatory creep is inevitable, as are lawsuits, with the distinct potential to commoditise the
industry. Some proposals – described in the executive summary – risk outlawing common sense: they seek
to displace human judgement. Whatever their ultimate shape, regulatory changes in the pipeline will
reinforce the structural forces ignited by the crisis in three areas.
mergers will consolidate asset gathering
and administration far more than
manufacturing, which will remain
fragmented with the ascendancy of
independent or multiple boutiques.
Many name plates will change without
discernible impact on capacity. The
necessary management bandwidth is not
there yet.
Second is fee compression. Around
55% of respondents expect it to
happen. As the value of assets has
shrunk, institutional clients have
already been demanding downward
revision in fee scales in the long
only space. In alternatives, too, fee
compression is evident on a large
scale in a bid to retain assets. Outside
the retail arena, clients were already
becoming more discerning prior to
the crisis: they were unwilling to pay
alpha fees for beta performance.
It is unlikely that the previous fee
structures in the absolute returns
space will remain intact once a
sustainable recovery is here.
Third is operating models. 40% expect
the decoupling of manufacturing and
distribution to accelerate, partly because
of the sell offs by banks; and partly
because of the strategic decisions by
very large asset managers to focus
on manufacturing or assembly within
elaborate supply chains centred around
multi manager platforms thriving on sub
advisory mandates. Pension consultants
will continue to venture into fiduciary
management by providing one-stop-shop
Interview quotes:
first one is M&A. 53% of the respondents expects more activity. Rising costs and competitive
“60% of The
hedge
fund
managers
lack
pressures
have
already gains
sparked a new wave of mergers. It“Bank-owned
is especially likely to impact
the bank-owned
asset managers who are no longer perceived as core businesses by their parents who are strapped for cash
were typically
eaten
up
by
the
resources
to
revitalise
in the wake of the banking crisis. However, the new wave will focus on acquiring book of assets more their
than specialist expertise. It will not be as dominant a force in the likely rationalisation of capacity as
intermediaries
gotexpect further
businesses.
Many
are
upsellfor sale.”
competitivebefore
pressure. Thisinvestors
is because 45% also
demergers and buyouts,
as asset
houses
or swap part of their businesses. Genuine mergers will consolidate asset gathering and administration far
a look in.”more than manufacturing, which will remain fragmented with the ascendancy of independent or multiple
boutiques. Many name plates will change without discernible impact on capacity. The necessary
management bandwidth is not there yet.
37
Second is fee compression. Around 55% of respondents expect it to happen. As the value of assets has
shrunk, institutional clients have already been demanding downward revision in fee scales in the long only
space. In alternatives, too, fee compression is evident on a large scale in a bid to retain assets. Outside the
“The return to pension savers
comes from the tax relief. Most of
the investment gain is eaten up by
professional fees and charges.”
68%
55%
40%
expect more regulation
or law suits
expect fee compression
expect further decoupling of
manufacturing and distribution
solutions to pension funds that lack
the governance structures and skill
sets at the time when plan sponsors
are extremely reluctant to make oneoff cash contributions to raise the
funding levels close to their statutory
levels. Consultants will compete head
to head with large asset managers
who are also expected to have their
own version of fiduciary management
around assembly platforms.
A view from the top
“M&A will be grabbing media headlines over the
coming months. There is over capacity in global asset
management. Over the past two years, fee compression
has been common, especially in the institutional markets.
Large plan sponsors on both sides of the Atlantic have
been driving down the fees which have been hard to
swallow on top of market losses and redemptions. For
bank owned asset managers, the situation is even more
challenging, as their parents are looking for ways to shore
up their balance sheets. So, we see a lot of invisible ‘for
sale’ signs. Buyers want a book of assets that can give
scale and market position; they are not looking for skills.
We have been involved in 3 of the 10 biggest mergers of the
last 15 years. Two failed to achieve the stated goals and one
succeeded. The quality of integration was the key factor.
The ones that failed were no more than an elaborate game
of musical chairs which added nothing to the business
other than an extra layer of complexity. In an unwise
rhetorical flourish, CEOs of the merging companies have
often deployed all the well worn management clichés to
justify their decisions: synergy, scale, operating leverage,
global reach, alpha capability, one stop shop and many
more; generating palpable media frenzy.
Crunching businesses together has felt like mission
impossible. Integration inevitably produced more complex
operating models that were soon undermined by five
factors: internal politics, unrealistic expectations, the
legacy of previous failed attempts, the blame culture and
excessive hype. The top executives simply did not have
the bandwidth to cope with them. Most of them were exportfolio managers.
By the time we came to the third one, we had wised up a
lot. Top executives had produced a proper business case
for the acquisition which was closely scrutinised by all
the movers and shakers responsible for integration. Their
emotional buy-in up front was critical for setting metrics,
accountabilities and timelines.
Savvy leadership made the difference; as did the speed
of execution. Senior jobs were allocated within days of
the acquisition. Co-head roles were avoided, as they
were viewed by staff as cop-outs. Core decisions on the
integration of processes and systems, along with staff
redundancies, were announced at the outset. Targeted
synergies were set timelines for finite periods, with clear
accountabilities.
The expected flurry of acquisitions in the industry will,
before long, be followed by a flurry of de-mergers. In
a craft business like ours, M&A are hard to execute. No
wonder the most admired houses have become preeminent via the organic route. Egos will always get in the
way of economics. So, M&A will continue. Whether they
will rationalise capacity is another matter. It will take a new
generation of CEOs to achieve that.”
~ A US asset manager
Interview quotes:
“It will be hard to stay close
to shifting expectations of
acceptability as regulators
reinterpret the rules.”
“It’s cheaper to buy a book of
assets instead of skills.”
“Without slash and burn,
acquisitions are ego trips.”
38
There is no single scenario for the next five years
Despite exceptional uncertainty about
the future, our survey respondents
were definite about one thing: 70%
expected their industry to become
more polarised. While drilling deeper
into this theme in our post survey
interviews, it was evident that large
players would emerge to dominate
either assembly or manufacturing.
This domination will occur within one
of three scenarios.
At one extreme is the commoditisation
scenario. 34% of respondents expect
their industry to dumb down. More
regulation and law suits will tilt the
balance in favour of low return, low
volatility, high transparency, high
liquidity, low fee products, where
clients’ investment choices will be
largely driven in pursuit of capital
protection and predictable outcomes.
Under this scenario, there will be a
talent drain. Competition will intensify
and scale players will be the winners,
as commoditisation will deliver
standardisation of products as well as
processes consistent with economies
of scale.
At the other extreme is the vibrant
industry scenario: 17% of respondents
expect asset managers to rise
proactively to the challenges thrown
up by two bear markets in this decade
and putting clients at the heart of
their businesses via better alignment
of interest. This means selling
products that clients need rather than
what they have. It means delivering
innovations that create new ideas
that add value rather than copycats.
It means having a fee structure that
offers value-for-money. It means
providing a service that anticipates,
identifies and delivers client needs in a
way done in all other industries. Above
all, it means developing a fiduciary
heritage under which asset managers
become the trustees of clients’ assets.
There is no single scenario for the next five years
In the light of the anticipated structural changes, what would
the asset industry look like five years from now?
In the light of the anticipated structural changes, what would the asset industry look like five years from now?
A polarised industry between big scale players and independent boutiques
A segmented industry with multiple alliances in front, middle and back offices
A commoditised industry with pockets of high alpha managers
A dumbed down industry stifled by over-regulation and talent drain
A concentrated industry with a few outstanding managers and a fat tail of mediocrity
A hybrid industry with alliances between asset managers and insurance companies
A vibrant client centric industry
A shrinking industry as investors resort to cheaper savings
Source: Citi / Principal / CREATE Survey 2009
Source: Citi / Principal / CREATE Survey 2009
Despite exceptional uncertainty about the future, our survey respondents were definite about one thing:
70% expected their industry to become more polarised. While drilling deeper into this theme in our post
survey interviews, it was evident that large players would emerge to dominate either assembly or
manufacturing. This domination will occur within one of three scenarios.
This scenario envisages the client
base expanding around the world as
well as the emergence of new players
who can reshape the contours of the
industry. Regulation may help to raise
client confidence. The asset industry
already has players who are fiduciaries
in word, thought and deed. But not
enough of them.
In between the two extremes is the
segmented industry scenario: 49%
of respondents expect significant
acceleration of some of the existing
trends giving rise to a number of
complementary possibilities. First,
consolidation will focus on asset
gathering and administration,
alongside demergers and buyouts that will tend to fragment the
manufacturing end. Second, there
will be ever more alliances along the
industry food chain, involving front
office activities as much as middle and
back office activities, with assembly
emerging as a major business
capability. Third, client groups will
become more segmented as their
needs become more differentiated.
Finally, the fee structure will deliver
a better alignment of interest under
competitive and client pressures.
Client inertia and behavioural biases
will work against the commoditisation
scenario; and asset managers’ lack
of change management capabilities
against the vibrant industry scenario.
The scale of bear market losses
and new regulation will favour the
commoditisation scenario; and the
scale of economic stimulus in G20
countries will reinforce client inertia
and undermine the vibrant industry
At one extreme is the commoditisation scenario. 34% of respondents expect their industry to dumb down.
Interview
quotes:
More regulation and law suits will tilt the balance in favour of low return, low volatility, high
transparency, high liquidity, low fee products, where clients’ investment choices will be largely driven in
pursuit of capital protection and predictable outcomes. Under this scenario, there will be a talent drain.
“China and
Indiawillnow
have
“Most
will bewillout
of asset
Competition
intensify
and scale players will be the
winners, banks
as commoditisation
deliver
standardisation of products as well as processes consistent with economies of scale.
settlement processes and
management within 10 years.”
At the other extreme is the vibrant industry scenario: 17% of respondents expect asset managers to rise
regulation
equal
tochallenges
that thrown
in the
proactively
to the
up by two bear markets in this decade and putting clients at the heart
of their businesses via better alignment of interest. This means selling products that clients need rather
than world.
what they have.
It means
deliveringto
innovations that create new ideas that add value rather than
developed
This
is going
copycats. It means having a fee structure that offers value-for-money. It means providing a service that
identifies and
delivers client needs in a way done in all other industries. Above all, it means
level outanticipates,
the playing
field.”
39
developing a fiduciary heritage under which asset managers become the trustees of clients’ assets. This
scenario envisages the client base expanding around the world as well as the emergence of new players
who can reshape the contours of the industry. Regulation may help to raise client confidence. The asset
industry already has players who are fiduciaries in word, thought and deed. But not enough of them.
In between the two extremes is the segmented industry scenario: 49% of respondents expect significant
“You can’t predict the future; you
have to invent it.”
49%
34%
17%
subscribe to the
segmentation scenario
subscribe to the
commoditisation scenario
subscribe to the
vibrant industry scenario
scenario. The inter-action of all these
factors probably favours the third way:
the segmentation scenario. In any
event, change will be the law of life.
Those who stick to the past will miss
out on the future.
A view from the top
“Is the current crisis a watershed in global asset
management or just another convulsion that capitalism
goes through periodically?
On the one hand, it may well be an inflection point.
We’ve had two crises of historic dimensions in this
decade, in which asset allocation has gone dynamic, the
asset diversification rationale severely challenged, and
opportunistic trading replaced long term investing as the
main source of returns. The only constant is uncertainty.
On the other hand, we know that economic systems always
revert to the mean, especially in response to the scale of
losses incurred worldwide in the past 2 years. Markets ebb
and flow with the greed-fear cycle. Whilst the efficient
markets hypothesis has hardly any adherents left now,
markets have rallied and bulls are back in sight.
As a result it is difficult to be definitive about how the
asset management industry will evolve; especially since
evolution is not something that is pre-determined. Much
will depend upon how clients feel about the scale of
their losses; how regulators will respond; and what asset
managers will do to tackle various systemic inefficiencies
in our industry.
If a sufficient number of clients decide that they have
had enough and wait for the next opportunity to get out,
as happened with a whole generation of buy-and-hold
investors after the last bear market, then we mustn’t read
too much into the recent rally. It may well lead to loss
aversion on a scale which will commoditise the industry
over time. The process will receive an unwelcome fillip
from a regulatory creep which seems unstoppable. Today,
they are after hedge funds and private equity guys.
Tomorrow, it will be the long only guys for one simple
reason: governments in the industrialised world are trying
to encourage their citizens to embrace private retirement
plans, in response to mounting deficits in welfare budgets
wreaked by the ageing population. They have a duty of
care to ensure that their citizens are investing with firms
that deliver value. As an unintended consequence, this
noble aim may well commoditise the industry over time.
At the other extreme, the industry already has many
iconic players who deliver value, with many more who
can emulate them and reshape the future. Some of
today’s icons emerged after the crisis of 1929-33. Asset
management is a simple business made complicated by
those who thrive on greed, fear and lingo at the expense of
their clients. Whether a sufficient number of managers will
grasp the nettle and create client-centric businesses with a
close alignment of interest remains to be seen. This is not
an impossible goal.
In between these two possibilities, it is also likely that
the competitive pressures from the crisis will accelerate
the ongoing realignment in the value chain, with
manufacturing, distribution and administration emerging
as separate competences, promoting new centres of
excellence around the generation of alpha and beta
separately. This third way is the most likely outcome. The
new normal will not be the same as the old normal.”
~ A Dutch asset manager & pension fund
Interview quotes:
“The best fund managers
are either assemblers or
manufacturers. You can’t be
everything to everybody.”
“It is essential to tackle the executive
sclerosis. Many senior executives lack
the insights and instincts to migrate
to the new model.”
“Clients will be nudging asset
managers in the direction which
is not in managers’ interest in the
short term.”
40
Other publications from CREATE-Research
The following reports and numerous articles and papers on the emerging trends
in global investments are available free at www.create-research.co.uk
• DB & DC plans: Strengthening their delivery (2008)
• Global fund distribution: Bridging new frontiers (2008)
• Globalisation of Funds: Challenges and Opportunities (2007)
• Convergence and divergence between alternatives and long only funds (2007)
• Towards enhanced business governance (2006)
• Tomorrow’s products for tomorrow’s clients (2006)
• Comply and prosper: A risk-based approach to regulation (2006)
• Hedge funds: a catalyst reshaping global investment (2005)
• Raising the performance bar (2004)
• Revolutionary shifts, evolutionary responses (2003)
• Harnessing creativity to improve the bottom line (2001)
• Tomorrow’s organisation: new mindsets, new skills (2001)
• Fund management: new skills for a new age (2000)
• Good practices in knowledge creation and exchange (1999)
• Competing through skills (1999)
• Leading People (1996)
Contact details:
Prof. Amin Rajan
[email protected]
Telephone: +44 (0) 1892 52 67 57
Mobile/Cell: +44 (0) 7703 44 47 70
41
42
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