A recent pension plan survey asked respondents to assess the value added by asset managers and pension consultants via their eight core activities since the 2008 crisis.
Taken as line items, asset managers were rated as ‘good’ or ‘excellent’ in five of them by at least 50% of respondents
(see figure). They include investment returns, strategic asset allocation, stock selection and portfolio construction, risk management and access to new investment insights.The corresponding figure for consultants is three. They include listening and understanding their clients’ unique needs, strategic asset allocation, and risk management. Two points are worthy of note here.
First, these scores need to make a distinction between qualifiers and differentiators. Qualifiers are the basics that an organisation needs to get right in order to survive. Differentiators, on the other hand, are what give it a competitive edge. The positive scores in the survey largely relate to qualifiers, and good investment returns are attributed to the unusual largesse of central banks. Few asset managers and pension consultants have yet to differentiate themselves with strategies that have delivered stellar returns.
Second, for both asset managers and pension consultants, the scores for fiduciary management and tactical asset allocation are notably low. Taking them in turn, fiduciary management has gained traction but it remains a nascent phenomenon outside the Netherlands because of seeming conflicts of interest. Tactical asset allocation has gained ascendancy with risk-on/risk-off cycles that characterise markets today. But it requires enhanced investment capabilities that can turn volatility into opportunity. These are scarce currently.
In the wake of the crisis, pension plans have taken on board a number of innovations, such as risk factor diversification, private debt, and smart beta. But that does not detract from an over-riding message from our survey: while new asset classes and asset allocation tools are needed, there is also plenty of scope to improve the old approaches while the bulk of existing money is tied up in traditional asset classes.
GOING BEYOND FINANCIAL THEORY
Risk management was widely singled out as a key area that needed big improvements. The prevailing risk models came unhinged in the last 20 years when asset managers and pension consultants could not foresee the two vicious equity bear markets; nor did they detect the time bomb concealed in cheap money; nor did they anticipate asset class correlations going through the roof; nor did they imagine the unintended consequences of the mark-to-market rules that turned the US sub-prime crisis into a global disaster.
How do you rate the contribution of the following activities of your asset managers in helping you to meet your plan’s investment goals since the 2008 crisis?
Evidently, they missed the subtle nuances of the newly evolving investment scene that was far removed from conventional wisdom.
In an era where politics more than economics drives the markets, the art of investing needs to go beyond financial theory and develop deeper expertise in anticipating price distortions thrown up by wild periodic risk-on/risk-off cycles in which value traps and value opportunities are hard to distinguish. Investment ideas and their embedded risks need to be stress-tested under extreme macro-economic and geopolitical scenarios via personal judgement based on insights and foresight's gained by deploying a multiplicity of lenses. Descriptions are not enough to understand the behaviours of markets.
THE WAY FORWARD
The main reason is that investment returns have been turned into a monetary phenomenon. They are influenced far more by the regular stimulus of monetary authorities than by corporate earnings from the real economy. The perception that the US Federal Reserve would always intervene if markets tumbled has now been deeply ingrained in investor psyche. As a result, the price of financial assets is thus both the result of monetary action and a factor influencing it. The implied circularity is great when markets are doing well, but disastrous when they reverse. Thus, while central bank action continues to override fundamental value drivers, fat-tail events may well become the norm once central banks take away the proverbial punchbowl.
In the meantime, peer risk, agency risk and market risk have given rise to excessive herding. Groupthink and rear-view investing no longer work in today’s environment. Standing out from the crowd is often a precursor to being right. The past is a poor guide to the future while markets remain distorted.
Hence, the investment process needs additional lenses that look at markets from perspectives as diverse as politics, psychology and philosophy. Anticipating central banks’ next move may be hard. But it is vital to stress-test portfolios under different policy regimes. Additionally, asset managers and pension consultants must have an open, honest dialogue with their clients on what can and can’t be delivered while markets are behaving so irrationally. As part of expectations management, they must avoid making exaggerated claims about future returns.
Yet another area singled out for improvement in our survey was risk-return trade-off. In the past, it mostly featured market risks tied with traditional business cycles. Now new risks have emerged and are largely reflected via liquidity and volatility. Returns are neither predictable nor stable. Pension plans want their asset managers and pension consultants to understand these risks, their causes and their consequences. Of particular concern is the sequence of returns risk that hit pension investors hard after the crisis, when they learnt that their portfolio value is determined not by average returns, but the realised sequence of those returns.
The third area identified as requiring improvement is liquidity. Paradoxically, liquidity is everywhere – just look at the balance sheets of central banks. Yet dysfunctional imbalances are emerging, where banks no longer perform their traditional market making role due to new regulation. It now takes seven times as long for investors to liquidate their bond portfolios as it did in 2007.
Although asset managers and pension consultants cannot control liquidity, they need to factor in the new reality when predicting future returns. The quoted value of assets can differ markedly from the actual transacted value. The final area requiring improvement is client engagement; without it, hopes will continue to run ahead of expectations. Investing is now increasingly seen as a loser’s game: one in which the winner is not the one with the best strategy, but the one who makes fewest mistakes.
In today’s surreal environment, pension investors are especially exposed to ‘wrong time’ risk as well as ‘regret risk’. The aim of greater engagement is to help minimise them. The scope for more joined-up thinking remains big.
Amin Rajan is CEO of CREATE-Research
To request a copy of the survey results email amin.rajan@create-research.co.uk
