The purpose of this article is to introduce a critical overview of asset management industry and the challenges it faces. Its organisation and ethos is still governed by ideas emerging from research made in the 1950s. It totally ignores the massive global changes the world experienced since the last twenty years. This paper also suggests different alternatives as possible solutions to investigate. It focuses especially on the pervasive epistemological stance governing the decision-making processes in the global asset management industry.
This article is a conceptual paper reflecting the point of view of a practitioner. It is not an empirical study in an academic point of view. The primary objective it is to open discussion about topics which seems to be ignored by my fellow professionals. In the light of the last financial crisis and the poor solutions brought by leaders across the world, I believe the asset management industry has to reinvent itself, reviewing practices, way to make business and taking in consideration the reality instead of referring to ‘perfect theories’ to manage money.
The asset management industry is in full mutation and there is very little visibility as never before. While the US seems better and the Eurozone appears to have stabilized, at last, there are fundamental unresolved issues that could see those two regions slip into deep crisis at any moment. The last developments in the budget debate in the US or the instability of the Letta government in Italy have just recently highlighted this fact.
Despite the increasing focus on growth from emerging markets, many observers remain sceptical in relation with serious governance challenges facing many of these regions. The two giants India and China are experiencing serious economic troubles.
In addition, a regulatory tsunami continues to drive industry transformation and markets restructuring around the world. The financial services industry scrambles striving to rebuild public trust that was shattered in the aftermath of the financial crisis and the wave of high-profile bankruptcies and scandals that followed. Further, complicating matters are the fact that today, even as the industry works to regain some semblance of normalcy, it is facing new threats with the potential to alter the landscape of the investment management industry. Four factors are susceptible to having a serious impact in the coming month and years: 1 the geopolitical instability, 2 Regulatory changes, 3 changes to the distribution models and 4 new technologies.
An industry in full mutation
- The geopolitical instability
Globalisation moves power boundaries and changes the world balance. Energy issues, territory demands, social riots, natural resources and climate change have not finished impacting this world and, money by nature does not like changes.
- Emerging economies
The short-term problem for the industry is probably in the heart of the current growth world engine: China. The second world’s economy continues to be in a state of political transition with the recent changes to the country’s politburo. Historically, such periods of political transition have tended to dampen policy change in China, an effect that may well be exacerbated during an economic slowdown like the one the country is currently experiencing. In few years, the Chinese economy came down from over 12% annual growth to likely 7.5% in 2013. While small and medium enterprises continue to represent a key driver of employment throughout China, many of these businesses are having increasing difficulties accessing needed bank funding in order to finance this growth.
Another growing trend that will likely have significant implications for China down the road is the fact that a significant percentage of its wealthy inhabitants are actively looking to leave the country to live elsewhere. According to KPMG, a survey of 980 Chinese residents with more than USD1.6 million in assets found that 46% were seriously considering emigrating. An additional 14% have already emigrated or are currently in the process of doing so. Only 40% of the country’s wealthy class is not actively considering leaving China. This potential exodus of wealth from the world’s largest country represents a significant challenge for the government and would have significant ramifications for the country’s economy.
- The ‘ex-future developed economies’
In the meantime, what I call the ‘ex-future developed economies’ (Japan, Europe, and the USA) are experimenting unusual difficulties. Certainly after billions of stimuli and three easy quantitative programs bringing the FED balance sheets over $3.65 trillion, the US economy is recovering. But this recovery does not really convince and is subject to confirmation.
After the longest recession since its creation, the Euro area came technically out of recession in the second quarter of 2013. By the way, thanks to Germany, which put the Euro area in positive territory by itself. However, the growth is not good enough to reduce a historical unemployment rate and, a lot of dark clouds are still in the sky. Greece represents only 2.5% of European GDP, with private investors already having taken a 75% haircut on Greek debt, the country has essentially already defaulted on its debt obligations. It will need according to the IMF €4.4 billion more mid-2014 to fix its budget, so who is going to pay the bill? The real questions with respect to Greece today are ‘When and how the country will leave the euro area?’ Nothing so far has been done for the Greek population. The main objective was to give time to the Euro area facing a potential contagion effect and the resulting impact on Spain, Italy, and other struggling, debt-laden countries in the Eurozone.
Spain represents another source of economic and political concern. The country, which is the fourth-largest economy in the Eurozone, has suffered a massive real estate collapse and has currently an unemployment rate of approximately 25%. Political instability in Italy is also an issue masking the poor French economic situation. With 40% Italian debt and 49% French debt owned by other countries, Euro area is becoming very dependent on external perception.
Japan, that former economic powerhouse, continues to be an economic laggard, with the outlook for the country’s GDP remaining grim by all measures. The new monetary policy put in place by Prime Minister Shinzo Abe consisting basically of printing money to reach a 2% inflation target is clearly not working. Despite a massive devaluation of the Yen, pushing up the exports, the trade deficit is deepening. In July 2013, exports jumped by the most since 2010. However, rising energy costs boosted the trade deficit. Exports increased 12.2%, but Imports climbed 19.6%, leaving a trade deficit of 1.02 trillion yen ($10.5 billion), the third biggest on record in data back to 1979.
- Regulatory changes
In the background of the financial crisis, regulators who did not do their work on the right time, push things for the industry at the worst possible time. This is going to drive the industry to an unprecedented restructuration counting fewer players: few will not survive, other will be bought and new entries will be difficult.
Indeed, US, UK, and the European Union remain the primary epicentres of this regulatory change, but we also witness similar reforms being introduced in jurisdictions that include Hong Kong, China and Australia among others. In addition, there are a number of ambitious new local regulatory initiatives, such as the Foreign Account Tax Compliance Act (FATCA) in the US and the Alternative Investment Fund Managers Directive (AIFMD) in the European Union that promises to have wide-reaching cross-border implications. With the after-effects of the financial crisis still fresh in their collective minds, many of the world’s governments are clamouring to institute layer upon layer of stringent financial regulation. Unfortunately, these new regulations are tougher but no more comprehensive than any of their predecessors, with complex new requirements and many more products falling into scope. As part of this regulatory backlash, there is a swift and simultaneous shift toward greater governance, increased transparency and enhanced due diligence as these things become industry best practices, driven in part by regulatory change and in part by demand by institutional investors. In particular, we continue to witness an increased focus on governance and operational due diligence in the hedge funds realm, which has historically been one of the financial industry’s most enigmatic segments. But solutions have already been found to escape such regulations, like for instance investing in CTA or managed account instead of creating a fund. Indeed, the first consequence of these new regulations is an explosion of administrative work for compliance and lawyers. The second involves considerable limitation of new players in the industry.
- Changes to distribution models
Competitive and market driven pressures force firms to change their distribution models resulting in a significant shake-up of the industry. New technology, new behaviours and a loss of confidence in the industry play also a key role in these mutations.
With the continuing tidal wave of regulatory changes, severe margin compression, and increased market volatility, asset managers will be under intense pressure to reorganize their businesses in order to adapt to the ‘new normal’. According to a KPMG survey interrogating 25 CEO in the industry, between 20% and 30% of the people and companies in the asset industry, today will virtually disappear over the course of the next decade.
- New technologies
New potential market players could threaten current market players. Even as the global investment management industry struggles to adapt to a rapidly changing landscape, it finds itself facing a new set of serious threats from outside its traditional sphere of competition. Thanks to cutting-edge technological progress and the ‘sector creep’ of industry giants like Google and Facebook, these industry disruptors rapidly develop novel business models that have the potential to fundamentally change the status quo in the investment management industry.
These changes take place at a time when many of the world’s traditional financial services providers suffer from significantly diminished levels of trust from the consuming public. It is within this context of seismic change that newcomers to the financial services industry are identifying opportunities to enter the market with disruptive business models that may have a much broader appeal to key consumer segments. Why a company like Apple would not make the move to the Asset management industry? The company has more than 400 million iTunes accounts all attached to valid credit card holders. That is a sizable and loyal client base from which to build a potential banking entity. Google is another potential threat. The company has already caused significant challenges for the telecom, GPS, news media and advertising industries to name a few. Not only would financial services offering lead to increased usage of the Google family of products (e.g. Chrome, Gmail, etc.) but it would help diversify the company’s revenue streams. What about Facebook? With more than a billion registered users who already use the site as their ‘virtual ID’, Facebook has access to more personal data and information on users’ behaviour than any other company on the planet. And in 2011, 15% of the company’s revenue was generated by processing payments (primarily by users making purchases within social games).
An industry full of opportunities
According to the Boston Consulting Group, the asset management industry rose to a record high in 2012 to $62.4 trillion.
As Albert Einstein observed, “in the middle of difficulty lies opportunity.” All these threats are also potential opportunities to change, adapt, and create a new business model for current asset management companies or new potential players as private bankers which do not have asset management arms. New organisations, new risk management processes, and new distribution models have to be designed and implemented according to the value of each company.
But what are the keys to succeeding in the industry?
- The end of the dogmas
- The modern investment theory
Most of the investment philosophies and processes on which the biggest asset management companies rely on are grounded in the modern investment theory. The Capital Asset Pricing Model (CAPM) developed in early 1960 by William Sharpe and the portfolio theory already performed by Harry Markowitz in the 1950s constitute both the basis of most of the investment philosophies. The CAPM provides a way of theoretically splitting the risk of a portfolio into two different risks: systematic (holding the market portfolio) and specific (one individual investment). To complete the idea, James Tobin in the 1950s developed the concept of the ‘super-efficient portfolio’. Markowitz has already come up with the idea of the ‘efficient frontier’ or the point at which individual portfolios exhibit a maximum return for a certain level of risk. Tobin added into this mix an asset that paid the risk-free rate of return.
Well, the need for explaining everything is part of the human nature. When it is not possible, we love to create beautiful boxes where everything fits perfectly and where we can find any justifications to the reality. We invented Gods, so we could invent also a way to understand financial market and much better to anticipate its.
I will not be among the first to criticise the modern theory and probably not the last. You will find in the literature numerous articles using different arguments to discredit the theory. However in the last twenty-three years, an important factor has changed the face of the world and indeed the financial market. The Berlin’s wall fell and with it, socialism and communism alternatives to capitalism. Eastern Europe, China, and India turned to new economic systems where about 2.3 billion people invited themselves to the table of capitalism. Could financial markets continue to be efficient? Were they efficient previously? How such upheavals could not affect the efficiency of the market and the modern theory? New markets with different maturity, massive deregulation, an explosion of assets under management and apparition of new products have been the consequences of this event. Did we change something about our way to value assets? Still in the main universities and in the professional societies as the CFA institute, we learn that the Graal of finance lies within the modern investment theory. Therefore, the first element of success likely rests about identifying a real modern way of understanding the financial world. I have my own answers which I will not develop here. But I believe we do not have one perfect way to analyse investments and risks. As the world is diverse, realities different, risk profiles and goals could be various and analysed in different ways.
- The multi-asset class model (MAC)
In the U.S., Yale model is a reference. We do not go deeper into it, but remember that the main idea is to split the portfolio into a number of broadly equal tranches and invest each tranch into a different asset class, with as little correlation as possible between the various classes. Indeed, to do so, you need the benchmark. The idea of the benchmark is sadly almost universal in the investment world. Benchmark yourself against a peer group instead of against what you need to achieve is clearly wrong and it can explain why most of the pension funds around the world are in critical position. Secondly, the choice of asset classes should be done according to their intrinsic attractiveness and according to the risk/target goals. What is the point for pension funds to invest in developed economy fixed income for the next ten years? Likely, a pension fund will need to achieve between 7% and 9% to cover its futures liabilities. Who things that UK, euro, Japanese or U.S. bonds would deliver such results? The answer is easy: no one. So what is the point to invest in such asset classes? The only possible way to justify such investment is the need of liquidity to cover liabilities. A different example is some strategies as Long short Equity or neutral strategies. What is the justification to put these strategies out the Equity asset class? Is it because it is in absolute return? So, are the absolute return strategies an asset class? It sounds wrong to me considering when I think my universe should be made according to my target and not according to an ideal model.
I believe each company should define its own philosophy, defining its own goals and from that, build an investment process and design its own risk management instead of replicating models performing only in a perfect world that does not exist. The key point is to be able to think the unthinkable and to explore new frontiers.
- The key asset: people
But to explore new frontiers, to free ourselves of the dominating theories which guarantying our safe thinking, we need people able to think out of the box. People, who are able to challenge conformism and to rely on common sense. Unfortunately, as mentioned before, conservatism is surrounding big universities and professional associations. It is not easy to go against the ‘dictator of dogma’. So, the big challenge for investment institutions is to recruit the people able to create value and not just to manage a known situation. There is a time in history where you need people to re-invent the society, the rules, to discover new paths. Identify these key people and retaining them within the structure will be the greatest challenge for investment companies in the next decade.
Indeed, revisiting the theory of investment, developing new ideas, new philosophy, new investment process and new risk management would contribute hugely to a success. But all aspects of the business have to be improved: thinking new retail distribution, adapting demand to clients who are changing habits, developing proper IT structure, structuring properly new investment ideas, reviewing information system, auditing properly an asset management structure are other aspects which have to be taking in considerations to succeed.