Asset Management As We No Longer Know It
November 21, 2011
The volatility that has gripped the markets in the wake of the 2008 financial crisis has changed the investment management game forever.
That was the resounding consensus of speakers at Fund Forum USA's Global Funds Distribution Summit in Boston earlier this month.
The new world order boils down to:
1. A "risk-parity" approach to portfolio construction.
2. Dynamically managed, widely diversified mutual funds.
3. A focus on delivering outcomes, rather than benchmarking against peers.
No longer can asset management firms advocate buying and holding static style boxes. Instead, dynamically managed funds held in truly diversified portfolios with a comprehensive risk overlay should be the new approach to investment management.
"What worked in the past will not work going forward," said Ronald P. O'Hanley, president of asset management and corporate services at Fidelity Investments. "Winning is going to be harder. Sustained success in equities is really going to require good stock picking, truly global investing and adding value beyond alpha in solutions. We have to do more than offer investors products-but solutions that will help them achieve an outcome. Simply losing less than the other guy" won't regain investors' confidence-or their business, he said.
"If you rely solely on a 60/40 portfolio, you are making a big mistake," concurred Colin Moore, chief investment officer of Columbia Management. "It is a deeply flawed approach. Our research now shows that most forecasting models are wrong. We have to radically rethink how we approach investment and risk management, or we will not be serving retail investors or pension funds that are behind on their funding."
Jan Straatman, global chief investment officer of ING Investment Management, added: "If you remain focused on past performance and want to do business as usual," you are going to lose out.
"Developed nations are facing lower growth, there is a shifting composition in the world's wealth and all are facing a more volatile market dynamic."
Risk-parity is being widely embraced as a new approach to asset allocation and risk management, said Peng Chen, head of investment research at Morningstar.
"The downturn has challenged traditional means-variance optimization, or modern portfolio theory," Chen explained. "Fundamental asset allocation theory that measures risk and return, with returns, by and large, distributed in a bell-shaped curve, is the process that people have utilized for the past 50 years," Chen said.
Investment professionals are now realizing that "something is not working right," Chen continued. "If you continue to rely on the traditional model, you underestimate the frequency and severity of 'fat tails,' or bad outcomes."
Thus, many asset managers are replacing modern portfolio theory with "risk parity," Chen said.
"Rather than looking at risk-reward tradeoffs, risk parity methods try to maximize the diversification of risks, ideally equalizing them," he explained. "The central claim of risk parity is that diversifying risks makes for more efficient portfolios."
Straatman agreed with Chen that it makes more sense to "manage a portfolio's risk-return profile more dynamically. Take more risk when your conviction is high. Reduce exposure when risk increases. There is a need for a more integrated approach and tighter risk control. Return objectives are better served by such a dynamic asset allocation."
However, just as the keenest investment managers see opportunities amid market inefficiencies or dislocations, Straatman also sees openings amid this volatility.
"Uncertainty also has a positive angle in that it means the opportunity set in the market is increasing a lot," Straatman said. "There are a lot of dislocations and inefficiencies in the markets right now. With the right skill sets, you can exploit those inefficiencies. Have imagination."
Straatman offered advice on how to take advantage of dislocations. "Start by looking at different market participants' long-term risk premiums and investment horizons," he said.
One example of a risk premium is regulations, he said. "We are in an overregulated market, which means different market participants are interpreting those regulations differently. That will also offer dislocations-and, therefore, opportunities."
Two other examples of risk premiums: liquidity and complexity.
"I disagree with the belief we need simpler strategies. The capital markets are too complex. You have to have a deep level of sophistication and sell interesting and potentially more complex strategies," Straatman said. "We have to beef up education and transparency to clients-not simplify strategies."
Lastly, Straatman pointed to an innovation premium. "We are seeing new products in emerging markets equities, emerging markets debt, emerging markets funds funded in local currencies," he said. "If you can develop strategies in growing areas at the right point in time, you will have first-mover advantage."
What do these new approaches mean for asset allocation and risk management? Straatman asked.