David Spina: A world turning upside down
The asset management business faces a period of fundamental rethinking and restructuring, says David Spina. The continued willingness of individuals to invest for the long term depends on the ability of institutional investors and investment managers to change what they do and the way they do it
The past decade has seen significant changes in the asset management industry. During the equities driven bull market of the 1990s, there was a dash for growth, as many asset managers merged or acquired their way to enormous size.
This became a global phenomenon, as Europe began to gear up and embrace an equity-led investment culture. Privatization and deregulation of key industries created a ready supply of available new investments. As financial markets grew deeper and stronger they gave rise to new opportunities to diversify portfolios and mitigate risk.
Despite these dramatic changes, important business foundations remained relatively unaltered. For example, we now know that there was little questioning of fundamental investment principles.
True, there was strong growth in indexed investments, including new enhanced products. But not enough people questioned the underlying cult of equity. Three years of stock market declines and portfolios that lost 60% of their value left investors with a hard lesson.
During this time, we’ve since come to learn, there was also a steadily growing willingness to compromise ethical standards that had been so carefully built and nurtured in previous decades. Basic trust was eroded and has yet to be restored.
An important period of change in the investment business lies ahead of us. The fact is that a typical day in the life of institutional investors is far from a routine experience.
The forces they are dealing with are enormous. At the same time that pension reform is creating larger and larger pools of retirement assets, they are struggling with weak markets, cost pressures, lightening-speed technological innovation and a whole host of regulatory changes, shifting tax policies and heightened disclosure requirements.
Intellectual renewal is proving to be the main driver of change. The broad conceptual framework for asset management is shifting in the face of daunting pension fund deficits and poor performance by many managers.
An important step was the decision by big rating agencies to begin to treat pension fund liabilities as debt on a company’s balance sheet. That encouraged people to think of pension funds as part of a bigger picture that includes corporate (or institutional) strategy, risk appetite and leverage.
The need for absolute returns
More and more firms and their clients are realizing that they need to rethink what they do and how they are doing it. We are seeing signs of major intellectual renewal as old ideas come under new scrutiny, fuelled by a cry for increased corporate governance and financial transparency.
Business models are also changing. Although we will see more consolidation, the rationale for it will be different, as firms become more concerned with geographic and product diversity rather than simply adding size for the sake of it.
We will also witness a fundamental shift of talent and resources from the sell side to the buy side of our industry, a process that has already begun in areas such as investment research.
This new thinking has enormous implications. Asset managers are venturing into so-called alternative investments, a trend helped by the recent proliferation of hedge funds.
This trend is shaking up the world of asset management, as firms must adapt to new demands and rethink their investment styles. This could set the stage for an industry that is characterized by a relatively small number of players with both the reach and technology to provide products such as tracker funds and hedge funds.
At the same time, asset managers are asking themselves whether their traditional approach to investing needs to be modernized in light of the recent low-return environment.
More and more firms are asking why they should not adopt a “long-short” approach to investing, rather than sticking to the “long only” approach that has typified fund strategies in recent years.
Finance theory and practical experience by a few pioneers support the logic behind the long-short methodology. That implementation will profoundly alter their ability to shape and manage risk profiles.
Consider, for example, the idea of benchmarking. Conventional benchmarking starts from the perspective of assets, whether defined by an index, a specific portfolio or a chosen group of portfolios.
Typically, a manager might begin an asset allocation process by choosing a strategic benchmark. But the ultimate aim of managing the pension plan is to ensure that it can meet its liabilities. The proper benchmark should be the return required by the nature of these liabilities, including their time horizon.
This simple insight opens the way to a new approach to pension plan management. Instead of trying to establish a strategic benchmark, there needs to be a strategic policy that states in advance what the fund will do with respect to its wealth and appetite for market risk.
In essence, the message to plan sponsors is that they have to define and manage their own risk preferences. We might call this the world of liability benchmarking.
How can this new approach be implemented? One way or another, pension plans must articulate their risk preferences at different levels of surplus – or wealth – and at different levels of expected reward.
To do this, they will need to get a lot of help from their consultant, and most likely their fund manager, since the language of utility functions is not for the average plan sponsor.
However, it is perfectly possible to calculate a utility function that reflects the client’s expressed preferences. A simple method would be to apply shortfall risk – that is, the probability that the fund will not be able to meet its obligations.
A huge benefit from this approach is that it recognizes something that is obviously true, but which the traditional methodology has overlooked: no two plans are exactly the same. By definition they have different structures, lifelines and aims.
This is clear when comparing, say, an endowment fund with a corporate pension plan. But it is also true when comparing two corporate plans or two insurance companies.
Observations such as these have led to powerful new thinking by institutional investors and asset managers. Anyone undertaking enhanced liability modelling and the application of a risk budget, for example, is bound to consider whether they should adopt an absolute return target rather than the traditional relative return approach.
The problem with relative returns, as we now know only too well, is that it is small comfort to be down 15% when everyone else is down 17%. A plan that used a relative return target during the bull market might have been pleasantly surprised by some abnormally high returns, but would have been understandably dismayed in the past couple of years.
Of course, monitoring and evaluating a manager who has been assigned this type of mandate is a complex task. No longer can you just take a look to see if the manager has matched or beaten an asset-based benchmark.
Risk budgeting
Instead, you first need to check to see whether the manager complied with the client’s risk preferences given their actual level of wealth and given the actual level of expected returns.
Once you are satisfied that the manager has employed an appropriate risk budget, you will need to determine whether he or she deployed that risk budget well.
There are already signs that this type of approach will become standard practice in the future. Allowing asset allocation to change along with wealth and expected returns seems very sensible and it could have saved the industry some considerable trouble in recent years.
Today’s asset/liability modelling framework is clearly based on unrealistic assumptions. The asset management industry will be challenged to deliver the new approach, but the best funds, consultants and fund managers will move in this direction, albeit slowly and carefully.
There is a product dimension to this transition as well. We have long felt that there is room for new families of investment and pension products that reflect the changed environment.
At a time when investors’ trust in financial intermediaries has been shaken, consumers will surely want to see signs that the industry is making an effort to change.
Two things make trust especially important with regard to pensions. The first is the long-term nature of the pension promise. We ask people to invest for 30 or 40 years and give them the implicit promise that their invested assets will be there for them, with ample gains, when they retire.
It comes as a rude shock when investors find that this is not always the case and they are forced to work longer or to live more modestly in retirement. Who can blame these investors for losing faith in the finance industry as a result?
In the pension business, people say that the most important thing is to have a long-term perspective. Trust is the same way. You can’t win trust with one interaction any more than you can win performance with one asset allocation call. Winning trust is an iterative process.
The necessary commitment might be to replace uncertainty with a promise such as this: “We can’t guarantee that your pension will be XX amount, but we can guarantee that it will be no less than YY amount”. On that basis, people would find it much easier to make plans.
Adopting this concept broadly in the asset management business would mean careful collaboration – perhaps with insurers – but it would be much welcomed by the investing public.
The same is true for institutions seeking better ways of doing business. A major change already under way is the development of new approaches to investment research.
The aim is to move beyond the subjective, corporate finance-driven approach that characterized the past few decades. There are credible alternatives to this subjective model.
Financial academics and market practitioners are today producing objective financial research based on quantifiable, fact-based inputs that can effectively complement traditional research.
This analysis is produced by concentrating on a resource that financial firms have traditionally overlooked or have lacked the computational power to exploit – the financial data that these firms generate as a core component of their services.
As a leading global custodian and securities processor, our firm knows this better than most. We have begun to produce objective analysis that examines global portfolio holdings, borrowings and flows to illuminate investor behaviour, including the relationship between portfolio flows and price movements, persistent tendencies in portfolio flows, the correlation of flows into and between markets and sectors, leveraging, herding and crowding, and so on. This is exciting work and it represents a good example of how the industry might develop in the future.
As we leave the past behind, we have the chance to regain trust and to put our industry back on a more stable foundation. The willingness of individuals to invest their savings for the long term depends on it.
David Spina
David Spina is chairman and chief executive officer of State Street Corporation, a Boston-based firm with $7.9 trillion in assets under custody and $788 billion in assets under management. He joined State Street in 1969 and has held a variety of positions within the company, including chief operating officer, chief financial officer and treasurer, executive vice president, and vice chairman. He was elected president in 1995, CEO in May 2000 and chairman in January 2001.
