Organizational Challenges for Investment Firms

Overview: Organizational Challenges for Investment Firms Kathryn Dixon Jost, CFA Vice President, Educational Products If the headlines of recent years can be believed, the investment industry has been buffeted by heavy winds of change: globalization, consolidation, and other phenomena. Of course, competitive models and philosophies have quickly evolved to help firms adapt to the new circumstances. Depending on the school of thought, firms would need to become either larger or smaller, global or local, more homogeneous or more heterogeneous, and so on. Indeed, so much attention (or at least rhetoric) has been directed to dealing with these challenges that some observers have begun to question whether firms have forgotten their actual rationale—serving clients and shareholders. In the past decade, particularly since the publication of the seminal 1995 Goldman Sachs report “The Coming Evolution of the Investment Management Industry,” the industry has seen significant pressure (whether real or merely perceived) for firms to develop into global super firms. In this view, the leviathans would rule the world, smaller firms would need to seek niche roles in order to survive, and midsize firms would have to decide whether they want to become large and global or small and specialized. Several years into this fad, however, the superfirm model still has some kinks to work out, smaller firms continue to thrive, and midsize firms have yet to become an endangered species. Although acquisitions have occurred in considerable numbers, the investment ecosystem still supports an abundant diversity of firms. Recently, factors other than scale have come to the fore as potential industry drivers, such as demographics and technology. One common theme in several of the presentations in this proceedings is the importance of ownership structure, particularly the question of employee ownership. The level of employee ownership remains low at many firms, and several authors cite employee ownership as a key in aligning the interests of clients and firms. In fact, one speaker’s firm bases its strategy on helping other firms address challenges of ownership structure and continuity. The increasing emphasis on attracting, motivating, and retaining talented personnel is supposed to be a means to an essential end—client satisfaction. A few years ago, investors were supposed to be well on their way to becoming self-sufficient online traders. Rather than turning away from firms,

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however, today’s investors seem to be demanding better and broader services, as well as strong performance. Some industry figures believe firms should forget about theoretical paradigms of organization or competition and focus directly on their core investment responsibilities. For example, Jeffrey Molitor of The Vanguard Group asserts, “The ownership structure does not matter so long as the firm executes its strategy well and remains loyal to its clients.” Molitor’s perspective is a clue to a notable distinction. The presentations in this proceedings might be divided (roughly) into two groups: those who tend to see the industry as being shaped by macro forces to which investment firms must adapt, and those who tend to see firms as captains of their own destinies. The difference between these two schools is analogous to the nature-versus-nurture debate in biology. No one can insist on the absolute correctness of either view; it is simply a matter of degree. The fact is that firms must be both reactive and active. They must adapt to the overall investment/business environment, but they also must actively define and execute their own strategies. Searching for the right balance is what this proceedings is all about.

Structure and Strategy According to John Casey, the new generation of investment managers will have to grapple with a different definition of success: the complete firm. Despite the sound of the term, the complete firm need not be an all-encompassing, homogeneous megafirm but will be structured to excel in four areas: manufacturing, distribution, client service, and operations. Historically, investment firms have been run by investment professionals, not business professionals. Casey asserts that the key to future success will be striking a balance in firm management between these two groups. The reason for Casey’s assertion is the complexity of the increasingly competitive environment, which will be dominated by four principles: the client–partner–competitor paradigm, manufacturing quality, the importance of client segments, and the need for greater efficiency (or perhaps more accurately, reduced inefficiency).

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Organizational Challenges for Investment Firms The concept of the complete firm is intended to help firms adapt to these new demands. In this framework, business management is more than merely a necessary support function; it is a core capability in itself. “In other words,” as Casey says, “it is a good thing to be able to run a strong business. . . .” The success of a complete firm will depend on its mastery of one of four business models: distribution specialist, single-platform manufacturer, franchise conglomerate, or financial holding company. A detailed survey of almost 100 institutional, retail, high-net-worth, and other money managers shows that widely accepted notions about the investment management industry are myths. Paul David Schaeffer describes how his firm’s survey data reveal some possibly surprising truths about current and future industry trends. For example, the current downturn does not spell doom for growth prospects; the technology push is not over; investors are not spurning managers in favor of do-it-yourself investing; and biggest is not best. Managers are beginning to take a much more analytical approach to the business, and such factors as productivity and cost structures are likely to play a critical role in the future. Important directions for future competitiveness include seizing opportunities in open architecture, focusing on customer satisfaction, stretching investment expertise, exploiting organizational knowledge, finding new avenues of profitability, leveraging technology, and aligning compensation and business strategies. The success of a firm, in William Nutt’s view, depends largely on three things: motivating good individual performance; providing good investment performance, client service, and product development; and attaining sustainable growth. Affiliated Managers Group’s strategy is to invest in growing midsize firms in order to help them address these three challenges. The key to this approach is establishing an ownership structure that aligns the interests of clients, management, and owners. Importantly, the approach of a partial purchase that leaves direct equity with founders/owners and spreads direct equity to the next generation of management also solves the problem of succession and continuity, which furthers the interests of all involved. Otherwise, the only alternative is internally rotating equity among management or selling the firm outright, neither of which is likely to strengthen the loyalty of clients or staff. Another benefit is that it allows the firm to retain operational autonomy and continue to cultivate the unique culture that undoubtedly played a critical role in its initial prosperity.

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Aligning Firms and Clients A disconnect between the interests of firms and clients is the focus of Charles Burkhart’s presentation. He argues that the gap between the interests of those managing firms and those of clients seems to be widening in firms’ quest for global reach and power. Although large conglomerate firms have many advantages, growth often comes at a high price in terms of client satisfaction, investment performance, profitability, and productivity. Boutiques, however, still have a lot to offer because they put economics first and have far fewer constituents to consider. In his opinion, the quest to rule the asset management world and achieve global conglomerate status is misguided. In fact, the economics of large firms, such as Deutsche Asset Management, jeopardize such vital measures of success as employee retention, investment performance, growth rates and margins, and productivity. Small and midsize firms, on the other hand, have prospered in part because they have avoided the errors of the larger firms. They do not have to meld different cultures, pay structures, and distribution objectives or coordinate a transfer of leadership, all of which are activities that can distract a firm from its fiduciary obligations. Instead, the smaller firm’s culture, compensation structure, and client focus foster success in the area that matters most: protecting client assets. The smaller firm, particularly the boutique, can remain a viable business model as long as it can retain its focus on the business of securing demand for its capabilities and managing the cyclical aspects of product and performance. The most critical guarantee of success for an investment management firm, according to Jeffrey Molitor, is to maintain a focus on the clients’ best interests. About one-third of Vanguard’s assets are managed by 21 outside advisors. These firms vary greatly in style and strategy because Vanguard seeks to present its clients with diverse and distinctive investment opportunities. More important, Vanguard has established a stringent evaluation process for vetting new managers and monitoring existing ones. Subadvisors are evaluated according to four P’s—process, people, philosophy, and performance. A fifth P, packaging, is completely ignored. Although Molitor states that any business model can work, Vanguard’s subadvisors tend to fit one of three business models: boutique shop, boutique within a holding company, and boutique team within a big firm. Regardless of style or business model, these firms share at least one dominant trait: putting the client first. Molitor flatly declares that putting other issues before client interests is exactly what not to do in order to establish or maintain a subadvisory relationship with Vanguard.

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Overview Harold Bradley looks at firm–client interests from the perspective of trading. He argues that the use of electronic communication networks (ECNs) can greatly reduce trading costs and better serve clients, as long as firms step up to meet the challenge of adapting to new electronic trading technologies. Technology has produced myriad changes that will either facilitate or stymie a firm’s success in the marketplace, depending on its willingness to alter its trading methods. In making trading decisions, many factors other than the search for best execution come into play. Bradley reveals the economic interests that are at stake for entrenched financial intermediaries but argues that the investors who daily face the arcane, archaic, and anticompetitive rules of member-owned exchanges stand to benefit enormously from the greater equality and efficiency that ECNs can provide. He counsels that the U.S. SEC and industry standard setters (such as AIMR) will keep the pressure on firms to increase trade transparency, record keeping, and accountability. To avoid problems, firms will need to be more proactive in investing in new technologies, and in the process, they should thoroughly scrutinize their commissions, brokerage rates, and order execution process; establish a consistent method to measure best execution; and above all, let their traders be traders.

The Future Is Now The key factors of future industry change, as identified by Ronald Layard-Liesching, are technology, data, and experts. Technology will pose a serious

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threat to active risk budgets, will be central to efforts to cope with the exponential increase in data, and will weaken the “symbolic barrier” that has made investment management such a lucrative industry. Because firms will tend to move away from homogeneous areas of investment (less profitable) and toward heterogeneous areas (more profitable), firms will need to make more effective use of experts (otherwise known as human capital), but doing so will mean helping them surmount their own cognitive biases. Many of these trends will be brought into play by the global privatization of fixed-income markets, which will have major investment implications. Robert Froehlich is a man on a mission. He aims to convince the readers of his presentation that demographics are a major—perhaps the major—driving force of the new millennium. Furthermore, he seeks to disarm what he sees as a “built-in bias” against demographics. Demographic trends have numerous implications for investment management, he contends. The senior boom, birth bust, and Baby Boom generation will continue to shape economic activity in the United States. The financial services industry also stands to benefit from such demographic effects. For example, consider the potential impact of the Baby Boomers. Froehlich points out that during the 10-year period starting in 1996, in the United States, a person is turning 50 every minute of every day. Of course, such people are likely to focus intensely on investing for retirement, and Froehlich believes this aging generation will be a great boon to the investment industry.

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A New Definition of Success in Investment Management John F. Casey Chairman BarraRogersCasey, Barra Strategic Consulting Group 1 Darien, Connecticut

The new generation of investment managers will have to grapple with a different definition of success: the complete firm. In order to operate effectively, complete firms will have to understand four principles: the client–partner–competitor paradigm, the reign of manufacturing quality, the importance of client segments, and the value of efficiency. Success will depend on the degree to which a firm excels at one of four business models: distribution specialist, single-platform manufacturer, franchise conglomerate, or financial holding company.

n 1999, my colleagues and I joined with Merrill Lynch & Company to perform a review of the rapidly changing investment industry.2 Our analysis shows that the industry is making the transition from a strictly product and sales dominated business to a more complex business in a more demanding marketplace. As industry standards have risen, we argue that certain general principles and guidelines for enhancing efficiency and streamlining process have emerged that apply to all firms in the industry, irrespective of their size, shape, or form. First, I will discuss the evolution of the investment industry from the first generation of managers in the 1960s and 1970s to the currently emerging third generation and the factors shaping the industry today. I will then turn my attention to the four principles that characterize the emerging third generation. Finally, I will present our idea of the “complete firm” as the way for firms to succeed in this new, more competitive environment along with four possible business models for the complete firm.

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The Third Generation The investment industry is on the cusp of a new generation of managers: the third generation. The 1

Mr. Casey is now chairman of Casey, Quirk & Acito. This presentation is based on Barra Strategic Consulting Group’s contribution to the joint publication “Success in Investment Management: Building and Managing the Complete Firm” (Merrill Lynch & Company/Barra Strategic Consulting Group, 2000). 2

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industry has changed significantly in the last 40 years in terms of professionalism, product breadth, assets under management, and business management capabilities as the industry moved from the first generation of managers (the recognition of investment management as a profession) to the second generation (an expanding, strengthening industry) to the third generation, which is characterized by a balanced excellence in manufacturing, sales, client service, and operations. Today’s environment is the most competitive environment yet, and success requires the most dramatic shift in business management thinking since the 1960s and 1970s. Development of the Industry. The first generation of investment management firms occurred in the period from 1970 to 1990, in which investment management became a profession. The client base at that time was relatively unsophisticated about the process of investing, so the competitive advantage fell to those in the investment management industry who were the most articulate. In other words, the first generation was based on perceived professionalism and persona. Investment managers at that time were also enabled by enormous pension cash flows (spurred by the enactment of ERISA in 1974) and the failure of the traditional players to maintain strong market performance. So much money was flooding into the market that the ability to run the business in a capable manner was simply unimportant; the

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A New Definition of Success in Investment Management money simply kept flowing in. In 1974, ERISA caused the 16 largest banks and insurance companies in the United States to face a vastly altered playing field that opened up tremendous opportunity and low barriers to entry for other less-dominant investment firms (i.e., boutiques); the impact of this event has continued until today. The second generation of investment management firms appeared in the mid-1980s, when professional standards entered the landscape of an expanding industry and firms were no longer just an advisory business for the wealthy. The second generation continues to exist today. It has seen the expansion of product breadth within the firm and the accumulation of personnel, and it has been enabled by strong market appreciation and rapid growth in retail assets. Importantly, the first-generation business management structure remains largely intact and barriers to entry are at their lowest point. As a result, we think that many of the most successful second-generation firms (success being defined as having a significant number of assets under management) have a high risk of underachievement in the emerging third generation because they are fat, comfortable, cumbersome, and bureaucratic. When a firm has been very successful and has added many employees to its ranks, the result can be a big mess. The third generation of investment management firms, which is just now beginning to surface, will be the generation of the “complete firm.” Less money will be flowing into the industry, which means that firms will probably have to change the way they run their businesses. The complete firm is one with balanced excellence in manufacturing, distribution, client service, and operations. Most firms today are dominated by investment professionals rather than business professionals, and if firms continue to follow this model, the results may be dire for their long-term prosperity. In the future, achieving a balance between investment professionals and professionals with other skills will be a critical factor in moving firms forward. Firms that have not secured sizeable assets in the second generation will have both a second chance and an enormous advantage in the third generation. Those smaller firms may now have a chance to surpass the successful firms of the past. Factors Driving Change. The emerging third generation of firms is being driven by exogenous factors. The three main exogenous factors are technology, capital markets, and global opportunities. I will not elaborate on these factors here because they are well known, but the point is that the blending of these forces will speed up the transition between the second and third generations and influence the capabilities necessary for future firm success. Figure 1 ©2002, AIMR®

(prepared in September 2001) illustrates one of the major changes expected to occur during the tenure of the third generation—reversion to the historical mean return from recently experienced outsized market returns. Investment management organizations must be prepared to compete in a more “normal” return environment.

Implications for Industry At Casey, Quirk & Acito, we believe investment management firms must fully appreciate and understand four principles that will characterize the third generation’s competitive environment: the client– partner–competitor (CPC) paradigm connects us all; manufacturing quality reigns; client segments matter; and efficiency energizes true talent.3 Client–Partner–Competitor Paradigm. Many of the firms in the industry used to be succinctly delineated by function, whether custodians, brokers, money managers, or clients, and those clean divisions are now a thing of the past. The proliferation of the subadvisory business and an open architecture are two examples of the relaxing of the functional separation within the industry. To successfully run a business without rules, other than those imposed by a regulatory authority, requires that firms focus on what they do best and place bets on the direction they think their business should head. Enabled by technology, investment management firms must be able to manage all of their re la t io n sh ip s — w it h cl ie n ts , p a r t ne r s , a n d competitors—simultaneously. In order to do this, the CPC paradigm requires managers to increase their focus on core competencies and mandates that firms incorporate four elements into their business operations. First, investment manufacturing and distribution should be managed independently. Cross-subsidization has led to inefficiencies, and all components of the business must be exposed to the discipline of the market because CPC provides viable alternatives that offer the ability to lessen current inefficiencies. Second, open architecture will proliferate. All proprietary channels must consider supporting other products to support greater scale. Third, brands must communicate core competencies (brand clarity). Distribution identities should be based on objective advice and efficient delivery; manufacturing identities should be based on product quality. Fourth, firms must challenge themselves to justify what functions should not be provided through alternative means, such as technology and outsourcing. 3 For

more detail on these principles, see “Success in Investment Management: Building and Managing the Complete Firm” (Merrill Lynch & Company/Barra Strategic Consulting Group, 2000):15–22.

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Organizational Challenges for Investment Firms Figure 1. Reversion to the Mean, as of September 2001 Cumulative Return (%) 10 10.2% Implied Return

7.4% Implied Return Long-Term Return Expectation 1/26 9/01 Long-Term Return Expectation 1/70 9/01 1

0.1 1/90

1/92

1/94

1/96

1/98

1/00

1/02

S&P 500 Historical Return

1/04

1/06

1/08

Historical Average Since 1926

Historical Average Since 1979 Source: Based on data from Barra Strategic Consulting Group.

Manufacturing Quality. Manufacturing quality reigns because the markets that firms are serving are becoming more sophisticated. We believe clients will soon be conversant with information ratios, Sharpe ratios, and so on in discussions with managers and in terms of stating their investment objectives. Investors already have agents, otherwise known as consultants, and consulting services are filtering down to almost all market segments. The CPC environment will permit little tolerance for all but the highest quality manufacturing; standards are being edged up in each market segment. A recent paper, “Style Is Dead; Long Live Style,” debates the relevance of current narrowly defined styles and argues that “style” should be redefined in terms of specific risk factors.4Also, in the third generation, benchmarks will become more sophisticated and customized, the highest standards for the investment process will be required to assure product quality, and alternative investments will become mainstream. Fixed income may be less prominent. Finally, prices will be rationalized: Price quality will become more transparent, and there will be a greater use of performance fee arrangements. I do not mean to say that these developments are already pervasive 4 Chris Acito, “Style Is Dead; Long Live Style” (Barra Strategic Consulting Group, 2001).

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in the market, but the shift is occurring and investment firms should be aware of it. Client Segments Matter. The third principle that will characterize the new competitive environment for investment firms is that client segments matter. The investment industry, which has matured with an emphasis on product and sales, thinks marketing equals sales, but it does not. Marketing involves identifying where a firm can go with what it does well, how it will get there, and what its strategy is. Investment management firms must be able to customize offerings to clients in each market segment and recognize that clients seek quality in both investment vehicles and customer service. For about 25 years, mutual funds used to be a bridge to the marketplaces they served: Technology was so inadequate that a mutual fund was the only way a firm could deliver an investment program to an individual investor. In the third generation, however, technology will remove the barriers that served to support the mutual fund business and mutual funds may be a less dominant vehicle for the delivery of investment management services. Mutual funds will instead become more of a vehicle for implementation in the smaller (assets per client) market segments. The mutual fund industry, like other investment vehicles, will change in response to ©2002, AIMR ®

A New Definition of Success in Investment Management the changing world, and the change is being driven by technology. Technology allows firms many alternatives in terms of deliverables to a much wider group of clients than ever before. The slower growing “mature” markets require sophisticated marketing, sales, and client service. Successfully competing will mean taking away market share from other firms so that a premium will be placed on client retention. Retention will be achieved by developing and enhancing products to meet clients’ specialized needs. And global opportunities will increase for reaching new client segments. But most firms have no business even going out of their state much less their country because their business practices are so far behind the times. Greater opportunities and choices require discipline and knowledge to concentrate only on those market segments in which a firm has true advantages; target markets should not be identified in an ad hoc manner. Firms outside the United States are actually falling behind firms in the United States because they are trying to protect old, archaic business models and ways of investing money rather than keeping up with increasingly more sophisticated business practices. Efficiency Energizes True Talent. The final principle is not at all popular, but we believe that inefficiency is particularly prevalent in the larger investment management organizations today; these larger organizations may be 50 percent overstaffed in the investment areas. The best people in the various firms are only as good or as fast as the people around them, and with too many people, even the best become inefficient. Investment management seems like a great industry because everyone can make a lot of money, it is intellectually stimulating, and people are proud of what they do. In reality, however, the industry and the firms are too big. My point is not about cost cutting; it is about efficiency. Efficiency has not been a big part of the industry lexicon thus far. It might be discussed in terms of trade processing or operational issues but not in terms of the actual investment process. I cannot stress enough that inefficiencies and cost cutting are two different things. Efficiency energizes talent; inefficiency loses talent. Inefficiency causes the best people in an organization to leave that organization and start their own business, usually a hedge fund. In the emerging third generation, however, barriers to entry will continue to be low, technology will enable firms to do more with less human capital, organizations will streamline, and ownership and culture will continue to differentiate the successful firms. As a result, in the next two to four years, large organizations could recognize that they need fewer people to ©2002, AIMR®

maintain the quality of their investment services and products. These firms may then put their money into other parts of their organization (noninvestment areas) to develop those areas to make both them and the firm a more competitive and successful entity.

How to Succeed in This Environment Leading firms of the third generation will observe what is happening around them. These firms will observe how the marketplace is evolving and where the opportunities are and are not. Many firms that have been blindly following what other firms were doing are stepping back now and indicating they will continue to do so no longer. Many firms that expanded horizontally will shift their focus back onto the vertical tasks they do well and rid themselves of these types of diversions and cash drains. To help firms succeed in the third-generation environment, we have devised the concept of the complete firm. We have also devised four business models—because there is no homogeneous road to success—through which firms can strive to meet the goal of completeness. In a complete firm, business management is a core capability. In other words, it is a good thing to be able to run a strong business; employees and clients are happier, functional departments operate at peak efficiency, and the entire organization works as a unit to achieve success. Our advice to investment managers is that saying the running of the business is anathema to them is no longer a wise statement because clients no longer welcome such a view. Another point in the complete firm concept is that the investment management industry will be enabled through an alignment of ownership interests (i.e., equity) and professional alliances. With the barriers to entry of the industry so low and with the inclination and ability to poach good managers so high, there will be a revolving door at investment management firms if the ownership and management of firms are not aligned through the giving of equity interests to managers. Many of the leading financial services companies who own asset management firms are open to this idea, but the problem is that the asset management firms represent, on average, only about 6 percent of the net income of financial services companies. The most stable firms in the business are the ones owned by the investment professionals who operate the firms or the ones that have some kind of equity alignment for employees. It is that simple. The firms that do not have some sort of equity alignment will be likely to experience fairly unstable periods.

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Organizational Challenges for Investment Firms

The Complete Firm To effectively compete in the future, third-generation firms must possess a broad set of common, balanced capabilities, regardless of size or specialty. We have defined 16 necessary capabilities and grouped them into three categories:5 Business management. (1) vision and leadership, (2) strategy and journey management, (3) corporate development, (4) integrated business performance monitoring, (5) knowledge management, (6) corporate governance, (7) human capital management; Investment manufacturing. (8) clearly defined added value, (9) institutional investment process, (10) quantitative skills and tools, (11) embedded alpha management, (12) protected investment factory; Distribution. (13) channel management, (14) coordinated distribution, (15) strategic marketing, and (16) thought leadership.

The applicability of each of these capabilities will depend on the size of the firm, but they are still useful general guidelines. The investment management industry today resembles a great patchwork quilt of systems and technology. Ultimately, however, successful (complete) firms will move toward highly integrated information p rocessing an d a risk ma na gem en t infrastructure that supports multiple facets of the business. This integration will occur partly for external reasons—to meet the new transparency standards demanded by clients—and partly for internal business management reasons. Embedded alpha, the “frictional” costs of investment management (those explicit and implicit costs of operating a firm’s investment management process), detracts from an investment firm’s net performance and is the biggest enemy of active returns. The investment process itself deserves some attention and fine-tuning in the complete firm concept. The steps in the investment management process are data collection and cleansing, macro policy/philosophy, screening, research and analysis (quantitative and qualitative), stock selection, portfolio construction and management (including trading analysis), and performance attribution, quality control, and enhancement. In the past three years, the industry has fine-tuned the first five steps. The industry has not, however, placed enough emphasis on steps six and seven. Those firms that do complete steps six and seven have an interesting opportunity for distinguishing themselves as quality firms to 5 For

explanations of these capabilities, see “Success in Investment Management: Building and Managing the Complete Firm” (Merrill Lynch & Company/Barra Strategic Consulting Group, 2000):23–33.

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sophisticated clients. Clients are beginning to get a much better handle on steps six and seven because they are the tangible outcomes of the first five steps.

Business Models for Success The concept of the complete firm does not mean the complete firm is homogeneous. There is no single route to becoming and remaining a complete firm. Any of four business models—distribution specialist, single-platform manufacturer, franchise conglomerate, and financial holding company—can create a complete firm and give it the ability to be successful. Distribution Specialist. A new type of business model has emerged in the past seven or eight years called the distribution specialist—a distributor of third-party investment products through proprietary channels. We think that many of the larger firms in the industry will stop investment product manufacturing and simply become distributors. Distribution, in the eyes of some, may not be asset management, but in our view, it is. Firms that opt to follow the distribution specialist model will say that their “competency” is in gathering assets and providing client services and that the investment talent (that creates the products they are distributing) can be “rented” or “leased.” This shift will be a fairly major trend in the future. Single-Platform Manufacturer. The singleplatform manufacturer is a bit of a boutique, a specialist product manufacturer (typically) that leverages third-party distribution channels. The distribution specialists need good quality products for their clients and thus support firms that choose to operate as single-platform manufacturers. Thus, the interaction between the single-platform manufacturer and the distribution specialist appears to be a natural systematic relationship for the industry that holds great promise for those third-generation firms that follow these models. Franchise Conglomerate. The franchise conglomerate is a more mature organization than either the distribution specialist or the single-platform manufacturer. It typically has multiple investment platforms and one distribution organization that serves multiple channels. Some of the larger investment firms have evolved toward this model. Fin an c ia l H ol ding C om pa ny . The financial holding company is a business in which a firm strategically takes the following position: “We like asset management, and we are going to buy a series of investment managers, but we are not going to ©2002, AIMR ®

A New Definition of Success in Investment Management integrate any of the platforms.” A financial holding company is a collection of complete firms brought together for financial advantage.

Conclusion For firms to be successful in the third generation, they must do five things: First, recognize the current indus-

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try transition (third generation), including the four principles I discussed that will characterize it. Second, assess their own firms against the complete firm capabilities. Third, identify core competencies (manufacturing or distribution). Fourth, align the firm’s vision with one of the four business models I presented. Fifth, manage growth carefully and with conviction.

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Organizational Challenges for Investment Firms

Question and Answer Session John F. Casey Question: What is a good source for acquiring the skills that you have described for investment professionals or nonrelated business managers and why? Casey: That is a great question that has no easy answer. Many people think investment professionals have innate skills to run a business, but in most cases, that is not true. They not only lack the skills to run a business, but often, they do not enjoy doing it. So, determining who should manage the business is a situational decision. It has to be someone who has previously demonstrated skill in this capacity or who really wants to attempt it. The ability to run an investment firm successfully is simply not a natural skill set. It is basically a strategic exercise in contrast to running investment portfolios, which is basically a tactical one. Blending those two skills in a managerial job is difficult. Professionals with sales or marketing backgrounds typically don’t enjoy managing a business or don’t have the skills, which means the search frequently leads into the operations area and so on. A likely candidate is someone with some type of a financial background who can also focus on the noninvestment part of the firm so that it is not neglected. No matter how you cut it, finding the right person to run the business is a situational decision that can be made only on a firmby-firm basis. Question: When I last checked, there were about 1,000 firms with between $100 million and $20 billion in assets under management that were majority-owned by employees. They were large enough to be arguably sustainable

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but still small enough to be characterized as boutiques. Would most of those firms never become complete firms? Casey: I think a $100 million firm can become a complete firm; it just doesn’t have all the infrastructure of a complete firm. A complete firm is one that can identify the markets it should be competing in and have a strategy to be successful in them—manufacturing quality, ownership alignment, and so on. If a firm has those capabilities and can execute them, it can have a wonderfully successful business. Question: Are clients going to fire their current managers to move to the complete firms of the future? Casey: Clients won’t grade you on being a complete firm as we have defined it; rather, clients will grade you on your manufacturing quality and client services. But if you adopt some of the guidelines and principles of a complete firm, you will have a much better business. Although clients do not really care if you are operating as a complete firm per se, such as doing market segmentation work, you will benefit from moving in this direction simply by keeping your healthy business healthy. Question: What do you think about the fact that it appears that leading holding companies are not creating a brand? And what do you think about the fact that they are substantially overstaffed on the investment side and must soon face the business integration issue? Casey: Branding is tricky. We believe that branding is internally driven. Your brand is your culture that you present to the market-

place. So, 80 percent of brand value is created internally and the residual is created externally. Many holding companies simply bought investment platforms; they did not buy businesses. Because the firms that were purchased are, for the most part, beneficiaries of the 1970s and 1980s— first-generation firms. The brilliance on their part was simply being in the business. Few of the firms that were purchased changed one iota, but the clients changed. The clients said, “We are more sophisticated; we want fewer managers; and at the margin, you have not kept up and you are gone.” And these firms had no marketing strategy; they did not have salespeople striving to keep the vibrancy and the cash flowing in over the ensuing years. In effect, most of those firms retired near their 20th year, although nobody told them. Those managers did not really do anything with their businesses. They just fell sound asleep, almost as the second generation began. They declared victory way too early for running an ongoing business. Question: Could you elaborate on the term “protected investment factory”? Casey: Yes. That is one of my terms, and I should change it because I’ve been asked about it before. I did some work for one of the real characters in this business, Larry Lasser at Putnam. He is a ferocious businessman who also happened to be an investment professional. He had a problem in the late 1980s and asked for my help. He had employees in the field who were not really equipped with the proper investment knowledge. My response was to create what is

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A New Definition of Success in Investment Management called the “investment specialist.” We also created a rule that the investment specialists would spend 70 percent of their time on investment management issues (i.e., doing well for the clients) and 30 percent of their time on helping the firm prosper, however that is defined. These investment specialists would be working with the sales group to meet this goal. That is how the concept of “protecting the investment factory” was born, by making sure that the investment specialist at Putnam gave the highest priority to that 70 percent. Question: Your materials seem to advocate a formulaic approach.

©2002, AIMR®

Couldn’t the manager of a franchise conglomerate buy that approach, instill formulas in all the investment processes, and push out the true insight of an investment process? Casey: The seven steps we propose are not meant to be mechanical but rather to help disaggregate what is being done in each of those steps. But frankly, those seven steps are much more appropriate for a strong fundamental shop that struggles to articulate its process and to package what it does. Instead of buying the packaging, we are looking under the hood; for example, we think we like the red

car, but we need to know how the engine works. The marketplace is moving more toward seeing how the engine works. Investment steps six and seven sound a little mechanical only because they encompass technology providing information. But the first five steps are fundamental. Question: Where did Merrill Lynch go wrong concerning Unilever? Casey: It did not use portfolio construction and did not manage to the client’s objectives.

www.aimr.org • 11

Competitive Challenges: Managing Profitability and Productivity Paul David Schaeffer Executive Vice President Capital Resource Advisors, LLC Mill Valley, California

A detailed survey of almost 100 institutional, retail, high-net-worth, and other money managers shows that widely accepted notions about the investment management industry are myths. Managers are beginning to take a much more analytical approach to the business, and such factors as productivity and cost structures are likely to play a critical role in the future.

his presentation is about managing productivity and profitability in the investment management industry. Capital Resource Advisors is a provider of knowledge and solutions to the investment management industry. For the past 11 years, we have been conducting an annual Competitive Challenges survey and report on the money management business. We sign confidentiality agreements with roughly 100 leading firms representing a broad cross-section of the market (institutional, retail, high-net-worth, and public/affiliate/private money managers) who in turn provide us with profit-and-loss (P&L) statements and tell us who their clients are, what their assets under management (AUM) are, how and what they pay their people, and how they market and distribute their products. We analyze the major business components: portfolio management, staff head count, sales, marketing and distribution expenses, business processes, compensation, and business strategy. In 2001, firms representing a total of more than $6 trillion in assets, a broad cross-section of the industry, participated in our survey.

T

Industry Trends: Myths versus Reality After looking at the industry this year, we concluded that there are a number of myths about industry strategy, competitiveness, profitability, productivity, and business economics. For example, many people expected the current downturn in the markets to spell doom for the prospects of the industry. Everyone also worried that active management would decline as

12 • www.aimr.org

the Internet increased the number of do-it-yourself day traders. There was also concern that money managers who missed out on the boom of the 1990s and mutual fund companies lacking a bundled 401(k) product would be left behind. We found none of these to be true. In fact, we have identified seven common myths about the current state and likely future of the investment management business that are not supported by today’s business realities: Myth #1. The current downturn spells doom for money managers’ growth prospects. After evaluating the industry and talking to our clients, we see not so much a meltdown in the market for money management services as a meltdown in the investment markets. In fact, significant opportunities still exist for money managers. The total of all U.S. major market pools (institutional gatekeeper, traditional institutional investor, and individual investor) exceeds $34 trillion in assets. The institutional market for investment management services continues to be very fragmented and driven by the quest for alpha. Open architecture has expanded shelf space and product offerings, especially because banks, insurance companies, and brokerage firms have had to open up their investment product architecture to externally manufactured, nonproprietary products. (In this regard, Jeffrey Molitor’s discussion on the increasing amount that Vanguard now pays to outside managers is interesting.1 1 See

Mr. Molitor’s presentation in this proceedings.

©2002, AIMR ®

Competitive Challenges Later in this presentation, I will discuss how many of the managers in our study are using other managers’ products.) Finally, we have the “new millionaire” phenomenon that offers fresh opportunities for managers. New millionaires are those who are saving for retirement and are now entering their prime earning and investing years. We expect the new-millionaire opportunity to play an important role in the future growth of many managers. The challenge for the industry is that most of the asset growth is taking place in the most expensive market segments. Between 1997 and 2000, most of the firms that participated in the study increased AUM in their retail and private client high-net-worth businesses. Demand for customization and complex distribution, sales, and marketing models make these segments expensive propositions for the managers enticed by the opportunities they provide. Myth #2. Investors now prefer to operate in do-ityourself mode and spurn traditional advice givers. Despite the much publicized growth of do-it-yourself investors during the Internet frenzy, investors have moved away from the do-it-yourself mode and now want organizations to provide them with bundled advisory services. The advice bundle includes a wide spectrum of services: asset allocation, investment management, performance measurement, tax planning, financial planning, reporting, banking, and brokerage. As more investors move toward a bundled approach and want help sorting through the dizzying array of providers, investment management companies will see most of their new assets come in through intermediaries. In comparing the survey responses for 1996 with those for 2000, we saw an increase in the use of intermediaries as a source of new business. From 1996 to 2000, the percentage of intermediaries serving as a source of new business for institutional, high-networth, and retail firms rose from 51.1 percent to 65.6 percent, from 67.4 percent to 82.5 percent, and from 76.7 percent to 95.0 percent, respectively. This change highlights why we work with companies to help them with client satisfaction and awareness issues and to find the best way to structure their client services. Basically, we encourage them to broaden their definition of “client.” The client is not only the end investor or fiduciary but also the distribution platform—the intermediary. We expect the role of intermediaries to continue growing for all customer segments. Myth #3. If you missed the boom of the 1990s, it is too late now. During the 1990s, individuals dramatically picked up the pace of investing for retirement, which resulted in the rapid growth of the definedcontribution market and a revolution in packaged products (funds and variable annuities). A massive

©2002, AIMR®

pool of existing assets—never mind new assets—will come into play in the next 10 years. Disintermediation is on the horizon, and those firms that are properly positioned will be able to capture their share of these assets. Although we believe mutual fund companies may be a victim of the coming disintermediation, we also believe a lot of hype currently surrounds their rumored demise. Our view is that mutual funds will not disappear, but disintermediation will seriously affect many organizations that were big winners in the 1990s, especially organizations that built bundled 401(k) plans, used mutual funds to capture the 401(k) assets, or were big players in the variable annuity area. The clock is ticking for Baby Boomers, as Robert Froehlich points out, 2 and Baby Boomers will soon begin to roll over their assets, out of definedcontribution plans, and take their variable annuity distributions. In certain customer segments, there will be a move from mutual funds to separate accounts. Generational wealth transfer will begin to take place in larger amounts, and because of open architecture, more opportunity will exist to manufacture a product for distributors as they concentrate on providing the advisory bundle of services. So, if firms missed out on the boom of the 1990s, it is not too late, as long as they have a good product, good alpha generation, and the right orientation to capture part of the massive pool of assets that exists. Myth #4. Companies need to stick with their established product lines and build on their strengths. Because of the product-packaging revolution, companies need to customize their investment process to meet the needs of the distribution platforms and intermediaries who control assets. Approximately 75 percent of the firms surveyed market a product in more than two market segments, and slightly more than 40 percent have significant assets in three or more market segments. Consider the variety of ways in which products are now packaged. When I started in the business, product offerings were separate accounts, mutual funds, or commingled funds. Now, in addition to those traditional products, firms offer exchangetraded funds (and coming soon, actively managed exchange-traded funds), retail separate accounts or separate accounts/managed money (most often known as the wrap-fee business), and limited partnerships. On the horizon is what has been called the folio product; managers, rather than simply providing management services, give ideas on an ongoing model portfolio to intermediaries, and the intermediaries use the folio technology to put those ideas to work in their 2 See

Mr. Froehlich’s presentation in this proceedings.

www.aimr.org • 13

Organizational Challenges for Investment Firms products. In this arrangement, the intermediary does the customization while the manager is responsible for generating knowledge. The driving force in the packaging revolution is the desire of investors and intermediaries to pick the package that makes the most sense for them, whether the criterion is account minimum, cost effectiveness, tax efficiency, or liquidity. (One of the reasons mutual funds will not disappear, especially in the 401(k) market, is liquidity.) Other important decision criteria in the product choice are diversification, customization, active security selection, and the degree of transparency in the performance and investment process. One of the challenges for mutual funds is that they are not transparent. One of the advantages of retail separate accounts or wrap-fee accounts is that they are transparent. A single product will not necessarily win out over the others. Each product has the potential for success when that product has attributes being sought by investors and intermediaries. Greater customization in the investment process causes expenses to rise and product economics to change. In the past, for example, the operational economics of mutual funds were embedded in the expense ratio of the fund. The product revolution causing the rise of retail separate accounts will lead to an unbundling of costs so that some of the costs previously borne by the shareholder will be borne by the manager instead. Myth #5. The technology push is yesterday’s news. In the 1990s, computing technology was personal computer based. The medium was mainly text, and users depended on wired connections limited by relatively slow modem speed. Today, streaming video and voice data are available over the Internet; technology is becoming more appliance based and interactive, and wireless connectivity and broadband access are more readily available. As a result, technology is no longer simply a cost of doing business—it is a way of doing business. Indeed, the process of innovating through technology has only begun. In their book Blown to Bits, Philip Evans and Thomas S. Wurster of Boston Consulting Group present the notion of using technology to enhance the richness and reach of a product or service bundle.3 EBay exemplifies this type of richness and reach. In the old economy, to sell something at a garage sale, people were limited to how many fliers they could post in their neighborhood, and success depended on how many people would physically come to the garage sale. The more people the seller 3 Philip

Evans and Thomas S. Wurster, Blown to Bits: How the New Economics of Information Transforms Strategy (Boston: Harvard Business School Press, 1999).

14 • www.aimr.org

could reach, the better. The seller could run a newspaper advertisement and reach more people, but that method would not be as descriptive as the flier that could be posted in the neighborhood and the supermarket. So, the richness of the experience was narrow. With eBay, however, the problem of richness and reach is turned on its head. A seller can reach a lot of people—anyone on the Internet—and the experience is rich with data, history, communication, and comparable products. Clearly, technology has the potential to greatly increase the richness and reach of investment management products. More firms are spending on technology to take advantage of this opportunity. Investment continues to grow in Internet technology, network security, portfolio accounting, client reporting, contact management databases, remote access, and virtual private networks. Likewise, the qualities of richness and reach through technology have advanced client service and communication delivery. Our 2001 survey showed that conference calls and video conferencing, e-mail, message boards and chat rooms, Webcasts, and updates to Web sites are some of the methods firms use to communicate with clients. Portfolio managers can now have an ongoing dialogue with clients and intermediaries without leaving their Bloomberg terminals. Technology will continue to be an important component of firms’ cost structures in the future as firms continue to identify ways to gain advantage through its implementation. Myth #6. In the coming years, it will be “survival of the biggest.” In the 2001 survey, we analyzed firms by asset and revenue size and concluded that, even though big may be better and a certain amount of scale is important to maximize profit, biggest is not best. As shown in Figure 1, in 2000, firms in the $20 to $75 billion range for AUM and the $75 to $250 million revenue range appear to have some economies of scale. Yet larger firms do not seem to enjoy the increasing economies of scale. We discovered that many of the value-added activities at an investment management company do not lend themselves to scale efficiency. To help our clients understand this, we classified the major functional components in an asset management firm into two categories: scope and scale. In the scope category, for functions such as investment management, portfolio management, client service, and sales and marketing, firms need specialized knowledge, understanding, and capability. Size does not confer a lot of efficiencies in this area. In fact, in some ways and in some cases, especially for investment performance, size may be a detriment. The scale category includes infrastructure, processing, and technology capabilities. Scale in backoffice, middle-office, administration, and enterprise

©2002, AIMR ®

Competitive Challenges Figure 1. Profit Margin by Firm Size, 2000 A. A. ByBy AUM AUM Profit Margin (%)(%) Profit Margin 50 50 44.0 44.0

45 45 40 40

37.1 37.1

37.1 37.1

35 35 31.0 31.0

30 30 25 25 20 20

sory arrangements can also provide such access. For example, Turner Investment Partners has benefited greatly from playing a subadvisory role to big investment organizations. Turner decided it did not want to create the scale needed to be a distributor in the mutual fund market, so it partnered with Merrill Lynch & Company and The Vanguard Group, letting them build the scale while Turner focused on what it does best, which is concentrate on the scope activities. As shown in Table 1, the overall number of firms that use subadvisors is growing, as is the number of firms that act as subadvisors.

15 15 10 10

11.1 11.1

Table 1. The Increase in Subadvisory Arrangements, 1996–2000

5 5 0 0

Year

B. By Revenue B. By Revenue

Percent of Firms Acting as Subadvisors

Percent of Firms Using Subadvisors

1996

56.7

32.6

1997

60.4

30.5

1998

54.5

34.8

1999

68.9

39.3

2000

72.3

40.0

Profit Margin (%)(%) Profit Margin 45 45

40.0 40.0

40 40 35 35 30 30

37.9 37.9

35.2 35.2

26.9 26.9

25 25 20 20 15 15

14.4 14.4

10 10 5 5 0 0

resource management functions may provide efficiencies, but only 40 percent of a typical firm’s operating expenses are devoted to these activities. Thus, we are skeptical about whether size truly offers an advantage. Size does not add value to the scope activities, and in many cases, it creates cultures and dynamics that may be counterproductive for the individuals with scope-related skills. As the industry evolves, the importance of scale may not always be a necessity or an advantage. Firms do not need to do everything or have everything to meet customer demands. One of the driving forces behind the notion of “big is better” was to garner sufficient capacity to succeed in certain distribution channels. But companies are finding that subadvi©2002, AIMR®

Whether through a subadvisory relationship or some other form of partnership, growing numbers of firms are no longer doing everything in-house. The notion of size as the primary driver of competitiveness is being invalidated as quickly as firms are able to discover new and innovative ways to access different customer segments. Myth #7. All firms can do is pull in their belts and hope for a market recovery. Profit margin growth averaged between 23 and 27 percent annually from 1996 through 1998 but has plummeted in recent years: –4.4 percent in 1999, 3.3 percent in 2000, and an expected –4.9 percent for 2001. Declining profitability has not been caused by lower fee realizations. Despite all the talk about fee pressures, fee realizations have held up consistently, as measured by total revenues divided by average assets of the firm. On the surface, industry productivity has been increasing, as shown in Table 2. From 1995 to 2000, assets per employee rose from about $99 million to $178 million and revenue per employee rose from $290 thousand to $609 thousand. It is the market, however, that is responsible for most of these apparent productivity gains. As shown in Table 3, revenue growth per employee declined from 1996 to 1998. The strong market in 1999 pushed up revenue growth per employee, but then it dropped off again in 2000. We expect the number to decline dramatically. In terms of the revenue growth, industry productivity has not been maintained. At the same time, even though the industry has had a good rolling three-year compound

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Organizational Challenges for Investment Firms Table 2. Industry Productivity Measured in Assets per Employee and Revenue per Employee, 1995–2000 Assets per Employee (US$ millions)

Revenue per Employee (US$ thousands)

1995

99.2

290.3

1996

108.1

352.8

1997

119.1

382.5

1998

115.0

409.9

1999

143.0

514.6

2000

178.3

609.4

Year

Table 3. Revenue Growth per Employee versus Revenue Growth, 1996–2000 Year

Revenue Growth

Revenue Growth per Employee 21.5%

1996

27.8%

1997

25.8

8.4

1998

26.5

7.2

1999

20.0

25.5

2000

22.6

18.4

asset growth rate, most of this growth has come not through the addition of new assets but through market appreciation, as shown in Figure 2.

Since 1999, expenses have been growing faster than revenue. This expense growth has mainly been driven by the fact that the industry has been on a talent binge and that personnel considerations continue to drive the cost structure of the industry. Despite tough market conditions, in 2001, the firms we surveyed expected to continue to add head count for their investment management, operations, and marketing functions, as shown in Table 4. Another significant driver of higher compensation costs is the effort to close the talent gap between the type of talent needed in the 1990s and that needed today. In the 1990s, emphasis was on the chief investment officers, portfolio managers, sales vice presidents, and directors of operations. Today, there is a growing need for the skills of technology strategists, brand managers, media relations managers, and client solution specialists. In terms of the overall expenses in the industry, people have driven—and will continue to drive—the cost structure of the business. Consequently, total compensation expenses continue to represent the largest component of operating expenses, as shown in Table 5. Although most of the focus is on the compensation of investment professionals (still the highest paid category of individuals and firms), the

Figure 2. Market Growth and Industry Asset Growth, 1994–2000 Market Growth (%)

Industry Asset Growth (%)

35

25

30 20 25 15

20 15

10

10 5 5 0

0 1994

1995

1996 Market Growth

1997

1998

1999

2000

Industry Asset Growth

Industry Asset Growth Excluding Market Growth Note: “Market growth” based on weighted three-year compound asset growth rate (CAGR) (70 percent S&P 500 Index, 30 percent Lehman Brothers Government/Corporate Bond Index); “industry asset growth” based on Competitive Challenges three-year CAGR; and “industry asset growth excluding market growth” based on the difference between the Competitive Challenges CAGR and the S&P/Lehman Brothers CAGR.

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©2002, AIMR ®

Competitive Challenges Table 4. Growth of Head Count by Skill Set Skill Set

Percent of Firms

Investment management

40.6

Operations and administration

26.6

Information systems and technology

26.6

Marketing

23.4

Client service

21.9

Sales

10.9

E-commerce

6.3

Table 5. Compensation Expenses as a Share of Total Operating Expenses, 1997–2000 Year

Total Compensation Expenses

1997

66.0%

1998

66.8

1999

67.9

2000

69.8

skill sets that have been growing the fastest are some of the noninvestment professional skill sets. Even though firms are spending more, they are getting less productivity in terms of revenue per dollar of compensation cost. Despite the challenges of tougher economics, money management continues to have the best business attributes (asset growth, revenue growth, and profit margin) in the financial services industry. Opportunity still abounds, and smart, strategically attuned asset managers will go after it. The crucial challenge is to understand how the characteristics of the business evolved from the 1970s and 1980s to the present. The investment management business has moved from being a product-driven business that places a premium on investment skills, toward becoming a client-oriented business that requires a variety of skill sets appropriate for a customizedproduct, client-oriented environment.

How to Remain Competitive The money management business is different from other sectors of the financial services industry in that market opportunity requires a sustained presence. Investment management is an annuity business, not a transaction business. Because an investment management firm needs to keep its performance track record in place, as well as its sales and marketing channels, laying off employees is simply not the option it is for other industry sectors. Industry economics remain fragmented, largely in response to the wide-ranging product mix, customer segments, and ownership structures typical of the investment management business. Above all, the people employed in the sector remain the key to a competitive infrastructure. To a ©2002, AIMR®

large degree, firms in the industry must meet competitive challenges with the understanding that a majority of operational expenses are inviolate. To be and remain competitive, firms will have to adapt to the challenges in the areas of open architecture, customer satisfaction, investment expertise, organizational knowledge, new avenues of profitability, technology, and employee compensation and satisfaction. With the industry’s changing dynamics and economics, running a successful business is much tougher than it used to be. We have identified the following eight areas on which firms will need to focus. Seize the Opportunities in Open Architecture. Firms need to understand the triumph of open architecture. The industry no longer operates based on the choice of a separate account or a fund but rather the choice of separate accounts, funds, folios, exchangetrade funds, and perhaps even partnerships in all market segments. Forget the concept of limited shelf space; we are witnessing the supermarket phenomenon. Different, rapidly evolving channels—such as registered investment advisors, brokers, consultants, fund supermarkets, and Web-based financial portals—offer unprecedented choice of and access to investment management products. In this environment, pricing distinctions are fading as pricing is embedded in a bundle of products and services. As John Casey mentions, a good example is the bundled wrap-fee business.4 Clients want a bundled product. Disintermediation will lead clients away from some of the past winners (in terms of profits, AUM, and revenues) and toward portal firms offering advice and bundling, thereby changing the notion of distribution and shelf space. Firms need to build brand identity by segment, channel, and intermediary. To seize the opportunities in open architecture, firms need to identify which of the three major pools of assets they want to target: traditional institutional, institutional gatekeeper (in which the end investor is an individual but an institution serves as a gatekeeper), and individual investor. Once firms decide which major market pool to play in, they have to think about the customer segments they want to pursue. Then, they have to decide which distribution channels to use to reach those segments and how they will package their product to meet the needs of the distribution channels and customer segments. Big changes are occurring in packaging, and all market segments will be affected. Firms of all sizes and types are becoming successful with this segmented approach. Turner, for example, plays directly in the traditional institutional business, but it decided to go after the individual 4 See

Mr. Casey’s presentation in this proceedings.

www.aimr.org • 17

Organizational Challenges for Investment Firms investor business by becoming a subadvisor to Vanguard and Merrill Lynch, not by building out an investment and distribution platform in the fashion of American Century or Vanguard. Foc us on C ustome r Sa tis fac tion. Firms should make meeting customer demands their mantra. When we asked firms to identify their key areas of success, virtually all of them indicated client satisfaction, yet most firms take what we call the “don’t ask, don’t tell” approach to understanding clients. Fewer than half of institutional firms regularly assess client satisfaction, and high-net-worth and retail firms have even lower rates of assessment. In a more competitive environment, firms will need more frequent assessments of their clients to find out which services they want, how to add value for their clients, and how their clients perceive the firm. Stretch Your Investment Expertise. Firms need to stretch their investment expertise. John Casey raised an interesting point about overcapacity in the investment management function. We have been thinking about this issue, not so much in terms of overcapacity, but rather in terms of how the investment management function could be scaled in a world where firms need to offer investment products in multiple packages, customized to meet a variety of investor and intermediary demands. Firms need to package their products for multiple segments in order to maximize opportunity. In order to successfully stretch their investment expertise, firms will need to separate investment management from portfolio management. Investment management activities are those based on an asset class, where research, security selection, and model portfolio construction take place. Portfolio management is organized by a customer segment or distribution channel and entails taking the ideas or model portfolio from the investment team and customizing it for application to the end client or the distribution channel. This approach helps insulate the investment factory, but it also gives firms some scalability and the ability to stretch their investment expertise across more customer segments, customized to meet client demands. Remember, investment management accounts for about 35 percent of a firm‘s total cost center, so maximizing investment productivity in this core area is vital. Exploit Organizational Knowledge. Leveraging organizational knowledge is crucial for maximizing productivity and profitability in the current financial services environment. A tremendous amount of

18 • www.aimr.org

unused information is locked in money management firms. Many money management firms possess or acquire a tremendous amount of information about customers, markets, companies, and investing, but few do a good job of analyzing and using it as competitive leverage or for providing knowledge to clients. In recent years, a growing number of firms have been implementing customer relationship management systems. More firms are creating internal knowledge platforms, and one of the best ways to determine if and how firms are disseminating their knowledge is to evaluate the information they post on their intranet sites. More and more companies are sharing knowledge by forming discussion groups and putting product updates on their intranet so that everyone in the firm can know what is going on in the firm. Such efforts are intended to leverage the one unique thing about these firms—their organizational knowledge. Find New Avenues of Profitability. New avenues to profitability have to be located. Historically, the investment management industry has thought about where their profitability came from primarily in terms of security selection. But there are many other potential profit pools—trading, advice, custody, operations and administration, monitoring and reporting, trust administration, or securities lending. Perhaps no single firm should try to maximize all of these potential profit areas, but a wider range of profit opportunities exists now than ever before, and managers need to think about their operations appropriately. A cost center for one firm may be a potential profit pool for another firm, so firms can benefit by outsourcing certain businesses. Many operations and functions—fund administration, shareholder services, tax preparation and compliance, and transfer agency—were beginning to be outsourced in 2000, as shown in Table 6. Although some firms continue to build their own portfolio accounting systems and their own trading systems, more firms will outsource such activities, which are favorably disposed to technology and scale. Outsourcing these activities will allow firms to concentrate on the scope activities with which they can really add value. Leverage Technology Focus. The developments I have described have a definite implication for how firms use technology. Firms need to focus their efforts where the payoff is greatest. The problem is that many firms work backward, focusing primarily on processes and treating client satisfaction as a secondary outcome. Ultimately, a firm’s internal process and activities should be designed to benefit clients, not the other way around. ©2002, AIMR ®

Competitive Challenges Table 6. In-House versus Outsourced Functions (percent of firms) Operations and Functions

only because it pays well, but also because of the opportunity for personal growth and development. If a firm’s leadership has credibility and trust, the organization is likely to have a strong culture and sense of purpose. The investment management business is about a lot more than just making money.

In-House

Outsourced

Trading/order management systems

70.7%

32.4%

Portfolio accounting systems

61.0

48.6

Fund accounting and administration

43.9

45.9

Defined-contribution trust services

19.5

13.5

Defined-contribution record keeping

22.0

16.2

Shareholder services

26.8

37.8

Legal and compliance

70.7

29.7

Table 7. Importance of Various Factors for Employee Satisfaction

Partnership accounting

41.5

27.0

Factors

Tax preparation and compliance

46.3

40.5

Leadership credibility and trust

82.6

Custody

17.1

48.6

Organizational culture and purpose

74.5

Trust accounting and administration

17.1

32.4

Opportunity for growth and development

56.5

Client statement and reporting

70.7

29.7

Total compensation

56.5

Challenging and meaningful work

54.3

Client relationship management

92.7

8.1

Transfer agency

14.6

37.8

Call center

34.1

16.2

Percent of Firms

Know the Score

Align Your Compensation Strategy with Your Business Strategy. Employee compensation must be aligned with business strategy. Obviously, compensation is important in terms of the capability of employees, but more firms are trying to align compensation structures with strategy and productivity. Compensation is becoming much more variable at firms for which bonuses constitute a growing percentage of total compensation expense, and more firms are using objective measures in determining bonus pools. Profitability, revenue, and asset growth are becoming more important as they relate to compensation, and discretionary bonus pools are becoming less important as firms try to link compensation to their employees’ individual goals. Many firms are also giving their employees a greater ownership stake and are broadening the definition of ownership beyond strict investment positions, extending such compensation to marketing, sales, and operational positions. Many of the firms we work with, whether public, private, or an affiliate, are trying to figure out how to align compensation with business goals in a knowledge-based business. Without a strong ownership component, success in this endeavor is hard to achieve. As William Nutt describes, one of the reasons Affiliated Managers Group has been so successful is that they have built employee ownership into their business model.5 Firms should remember, however, that compensation is not the only factor in employee satisfaction, as shown in Table 7. The largest proportion of firms in our 2001 survey rated credibility of leadership as very important for employee satisfaction and commitment. People choose to work in this business not

Firm managers are taking an analytical approach to understanding their businesses. One obstacle for our survey is that, although some firms are willing to give us the information we seek, they cannot because they do not know some basic data, such as head count, AUM, or revenues. Relative to other industries, much of the investment management industry still operates with immature information technology systems. Our 2001 survey showed that among core measures of firm success, profitability leaped to the number one spot. Nearly 88 percent of firms surveyed said that profitability has a strong impact on firm success, as shown in Table 8. Previously, revenue growth and asset growth shared the number one spot, and productivity, which was minimal in prior surveys as a core measure of success, showed up in our 2001 survey at 34 percent. Interestingly, few firms said firm size is important, which bolsters our belief that size, at least from a business leadership perspective, is not a primary concern. People are beginning to take a more granular, detailed approach to measuring productivity. Fee realizations and the cost of managing assets are

5 See

Overall market share

Mr. Nutt’s presentation in this proceedings.

©2002, AIMR®

Table 8. Rated Importance/Impact of Core Measures Core Measures

Percent of Firms

Profitability

87.8

Revenue growth

79.2

Net new asset growth

76.0

Employee retention/compensation

57.1

Productivity

34.0

Firm size

17.0 8.5

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Organizational Challenges for Investment Firms important, but firms need to drill down and look at cost of revenue, revenue per marketing staff, assets per portfolio manager, revenue per portfolio manager, and cost of new assets. More firms are beginning to focus on these measures and have been working with clients to help them develop the right benchmarks and information-gathering tools to better understand the profitability and productivity of their businesses. Firms need to examine their cost structures. How should firms measure their internal business processes? How much does it cost to do a trade? How much does it cost to do reconciliation? How much does it cost to serve a particular institutional client?

20 • www.aimr.org

Obviously, to be competitive, firms need to understand their strengths and weaknesses. More specifically, they need to develop a set of objective performance measures. We recommend that our clients adopt a Competitive Challenges scorecard that analyzes the major areas of investment performance: investment product performance, business growth, customer segments, technology capability, productivity, profitability, employee satisfaction, and management. The important thing is to then share this information within the firm and make sure the firm has the right strategy to link the information to business and operating results. Achieving this goal will lead to future success.

©2002, AIMR ®

Competitive Challenges

Question and Answer Session Paul David Schaeffer Question: Do firms face a clientdriven consequence if they fail to get within shooting distance of best practices on the measures you describe? Schaeffer: The consequences we have seen so far are on the retail intermediary side, which is not where you would expect a reaction. When Merrill Lynch, Salomon Smith Barney, or Citigroup do due diligence on their retail separate account managers or the mutual fund companies they are using in their premier programs, they’re really concerned about the business side of the company because they don’t want the relationship to blow up on them. When Vanguard does due diligence on a manager, performance is not all that matters. Vanguard wants to make sure the organization can sustain its performance and retain the people responsible for achieving it. As relationships between distributors and money managers evolve, the distributors are going to become more concerned about the health and best practices of the money managers. Client vigilance, however, is just now developing to the point at which people are beginning to analyze investment organizations. Institutional consultants lag behind on this issue. Question: How does your profitability equation change if you assume a long-term future asset growth rate of 4 or 5 percent? Schaeffer: Because profitability has been propped up by asset growth rates and market appreciation, firms will need to stretch the investment process, do more outsourcing, or take a more segmented approach. Firms will not be able to count on market appreciation to bail them out economically. Margin growth has been ©2002, AIMR®

declining for the past three years and is expected to decline further. Because firms can no longer count on the market margins for growth, they will have to develop a fundamental understanding of the economics of their business and change the way they do business. For example, firms have to change the way they pay people by tying more compensation to longterm criteria, making compensation more variable, making sure compensation is linked to business profitability, and not paying sales and marketing people based on gross asset flows. In the mutual fund industry, firms could pay their wholesalers a lot of money this year because they’ve brought in a lot of gross assets, but the firms could end up with a decline in assets on the books, not only because of market depreciation but also because of asset outflows. In the future, sales and marketing people will be compensated based on net assets or asset profitability. The nature of how people are paid will change because in a 4 percent market, keeping or expanding margins will be difficult without fundamentally changing the business economics. Question: How much has the market affected the prospects for the industry? Schaeffer: The fundamentals continue to erode. Expenses are growing faster than revenue. Even in a down year, asset growth was driven mainly by market appreciation. In our view, a lot of market opportunity still exists. Customers have assets and need those assets managed. People still need to save and invest for their retirement. To succeed, firms must reevaluate their business economics. A challenge for mutual fund companies is that their business is driven by

the expense ratio in the fund. Although this ratio gets deconstructed to the firms’ disadvantage in retail separate accounts, this area is receiving a lot of the asset flows. By the way, regarding retail separate accounts, one other big misconception is that most of the money is coming from mutual funds. Most of the money going into retail separate accounts is coming from brokers who used to try to also be their clients’ portfolio managers. So, retail separate accounts do not represent a shift out of mutual funds. They represent brokers or intermediaries trying to move their clients away from picking stocks. Question: Given the additional demands that are anticipated for the industry and the lower expected industry growth, how do you maintain your optimism about investment management remaining the excellent business it has been for the past five years? Schaeffer: I’m not trying to say business will be as good it has been in the past five years, but relative to other parts of the financial services industry, business is still quite good. Revenue flows and sustainable fee income still have an annuity aspect. Firms will nevertheless have to work much harder to be successful. In the recent past, firms haven’t had to work so hard because the market has done a lot of the work for them. Now, faced with a more normal market environment, returning to historical growth in the 8–12 percent range, they will have to make some tough decisions about how and where to spend money and how to compensate employees. Question: How many firms with less than $5 billion are in your study? Schaeffer: Fourteen firms.

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Aligning the Interests of Clients, Management, and Owners William J. Nutt Chairman and CEO Affiliated Managers Group, Inc. Boston

The success of a firm depends largely on three things: motivating good individual performance; providing good investment performance, client service, and product development; and attaining sustainable growth. Affiliated Managers Group’s strategy is to invest in growing midsize firms in order to help them address these three challenges. The key to this approach is establishing an ownership structure that aligns the interests of clients, management, and owners.

his presentation focuses on aligning the interests of clients, management, and owners. The success of a firm depends on the answers to three sets of questions. First, what motivates good individual performance? What attracts, retains, motivates, and inspires good investment performance, commitment to a firm, and cooperation in its growth by each individual member of the management team? The answers to this set of questions are important to the success of a firm as a whole. Second, what motivates a firm to continue to provide good investment performance, client service, and product development? What is the motivation to continue growth of the entrepreneurial spirit and the culture that has made the firm successful in the past and is most likely to secure a successful future? Third, how do firms attain sustainable growth? Growth is defined not only in terms of individual products, assets under management, or fees for the whole firm but in terms of the types of opportunities that are given to the management team. In my experience over the past 20 years, firms achieve growth through either adding assets to existing products or creating new products with new assets. These growth opportunities attract the best people to a particular firm. It is not always about growth at any particular rate; instead, it is simply about providing visibility to growth opportunities and being able to participate directly in the economic rewards of that growth.

T

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At Affiliated Managers Group (AMG), we think about these questions in terms of our investments in growing midsize asset management firms, but other firms consider these questions more directly. Although all three of these issues are important to all firms, they are particularly crucial for midsize firms with between $500 million and $25 billion in assets under management. In such firms, the founders/ owners are still a core part of the management team. They have a vision for continued growth of their firm and want to continually develop and retain the best people on their management team. They think about these issues in terms of the future.

AMG Overview As the institutional equity partner for a number of firms, AMG brings a unique perspective to the three key issues that I identified. When AMG was founded in 1993, we did it with a certain view. We believed that in order for global midsize firms to grow out of personal services firms or boutiques and become sizable institutions that would last for generations and create the kind of wealth that global founders/owners expected out of a business they had been running for some years, these firms needed an alternative to either rotating equity among management on an internal basis or selling 100 percent of the firm. We developed a structure in which we would be an investor taking a majority position with these firms but allowing them to retain and spread their direct

©2002, AIMR ®

Aligning the Interests of Clients, Management, and Owners equity through generations of management. To date, we have been a majority owner of 17 midsize investment management firms with more than $80 billion in combined assets under management. These global affiliates have different investment styles or disciplines and different investment products and distribution channels. About one-third of our EBITDA is generated by affiliates in the high-net-worth distribution channel, one-third comes from the mutual fund distribution channel, and one-third comes from the institutional channel. The affiliates have several things in common. They all retain approximately 30–45 percent of direct equity participation in their own firms. Today, this equity is spread over a broader group than was the case not only prior to the transaction but also at the completion of the transaction. These firms followed this path because they were looking for a solution to succession planning issues. They wanted to find individuals to carry on the business of the firm at the same high level. They also wanted to align the interests of clients, management, and the owners in addressing the issue of continuity—that is, a transfer of ownership to the next generation of owners/managers without disrupting the reasons the firm has been successful to date. The best way to align these interests is through AMG’s partial purchase of some of the direct equity of the firm while leaving a material part of that direct equity with the owners/managers of the firm, spreading it among the next generation of management, and finding a vehicle by which there can be future liquidity based on the growth of the firm. This approach will motivate continued good performance and growth in the firm. As I mentioned, the 17 firms in which we have made investments vary greatly, with different investment styles and distribution channels. Nonetheless, they all retain direct equity in their firms as well as the responsibility for running their firms (along with the necessary independence and autonomy to do so). They market under their own name and product and operate as they did before, but they have AMG as an institutional equity partner for the transition of ownership to the next generation. Although the firms are different, they have a number of similarities. They share a commitment to future growth of the business. They want to increase net client cash flows and expand their product offerings. They enter different distribution channels because they believe that growth will enable them to continue to attract the best people. In addition, these firms either had or have a multigenerational management team composed of not only founders/owners who may be in their 50s or 60s but also a group in their ©2002, AIMR®

40s, 30s, and even 20s. They are committed to the development of those individuals, in terms of both professional skills and their ownership of the firm. They have a proven track record with a particular discipline and stick to that discipline through various market cycles. This record goes beyond investment performance to include performance in terms of client service and their ability to understand what their clients want and how to match those needs with products. They also have a distinct entrepreneurial culture that is enhanced, rather than impeded, by the ownership structure associated with our investment.

Aligning the Interests When aligning the interests of clients, employees, and owners, an important first step is to prioritize them. We consider clients first because if firms do not satisfy their needs, the next two groups are irrelevant. If the ownership structure and vision for the future are to be attractive to clients, they must also be attractive to employees and to the founder/owner group. Clients. Clients select a firm for a particular reason. They may like its investment performance, products, culture, or the individuals who work there. They are not afraid of ownership transition, except when it extinguishes or diminishes the reasons they selected the firm. If an ownership transition drives away the people to whom the clients felt they were entrusting their money, the transition will not be successful from the clients’ standpoint. They want to continue to maintain the relationship they have established with the firm. They also want to work with owners who have a management stake. In the November 26, 2001, issue of Pensions & Investments, Geoffrey M. Fletcher and Paul D. Schaeffer published a survey of investment management clients. Of the clients who responded, 86 percent indicated they would like to hire a firm with an independent employee ownership structure. Most clients—whether a high-net-worth individual, a trucking business, a college treasurer responsible for a foundation, or the CFO of a large industrial company or public employee plan—know their own business will be successful only if they provide for continuity of management (i.e., manage the firm for the future in a successful manner). Thus, they are not afraid of a transition per se. They want to continue the investment focus and the results that have been achieved in the past, and they want the firm’s people to have the same motivation they have always had. Employees. The next generation of management wants the same kind of ability to build the firm that the original management group had—plus the

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Organizational Challenges for Investment Firms same kind of economic rewards. They want to gain direct participation, not only in the financial sense but also in the management sense. They want to have a voice in how the firm will be run. They also want their participation to grow (i.e., as the firm grows, they want their reward to grow with the firm). If it does, direct equity can serve as a retention tool that keeps employees committed to the firm and its clients. Employees understand this connection and are willing to support a structure that furthers their responsibility and their equity ownership and allows the value of their equity to grow with the firm. Foun de rs /Owne rs . The firm must get the first two interests right before addressing the founders/owners. Founders/owners have the choice to do nothing, but doing nothing will not work forever. Founders/owners want to realize at least a portion of the value of their equity in their firm. They want to achieve a level of personal diversification, but they want to receive fair value for doing so (i.e., a market multiple for the percentage of equity they sell). In taking a degree of liquidity from the enterprise they created, they also want to continue to maintain real equity exposure so that they can participate in the future economic growth of the business—all while maintaining the ability to run the firm exactly as they have in the past. This structure essentially involves a partial purchase of a percentage of the equity with a succession plan in place (i.e., an ability for that equity to grow in value, be liquefied, and be passed to the next generation of management). At AMG, we purchase a majority interest of a firm’s equity but leave all of the governance with the firm. The equity that is retained, however, is not retained by the same group of individuals that held it before the transaction. This group expands at the time of the transaction and, in the following years, expands further, as equity comes back to AMG (in its role as the institutional partner) for the purpose of rotating it to the next generation of management. This process enhances the growth and profitability of the firm by preserving its culture and operating autonomy while providing for the rotation of equity to subsequent generations of management. We will work with an affiliate firm to develop new products and assist it in different markets, but generally, such initiatives are undertaken as part of a collective effort on behalf of all AMG’s affiliates rather than one-onone, with each firm continuing to operate independently. These firms already know how to grow and are successful in their own right. We simply put the icing on the cake. One of the most important parts of the affiliate development process is the rotation of equity (i.e., getting equity to the next generation and spreading

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its ownership). In an AMG investment, we purchase a majority equity stake. To provide operating autonomy, we establish a revenue-sharing agreement that gives the firm complete discretion over how to spend a portion of the revenues, generally 50 percent. We provide specific equity incentives for both senior and junior management by giving them “puts,” or the ability to liquefy their equity at a future time at a specific value. In other words, their equity stake is real equity in the sense that it can be liquefied in the future based on a formula that reflects the growth of the firm in the increase in value of the retained equity. As an example, Figure 1 depicts a hypothetical investment in which AMG buys approximately 60 percent of the equity of a new affiliate. The remaining 40 percent is owned by the existing management team and, often, new members of that management team. Each partnership agreement has two broad provisions. First, all of the daily operations of the firm are directed by the members of management—hiring, firing, compensation, how to spend the resources of the firm, and so forth. AMG retains only the essential interest that a minority shareholder would have in any corporation. Incidentally, because the affiliates are set up as LLCs or partnerships, there are no boards of directors. A 51 percent stake does not mean control in the corporate sense. A revenue-sharing agreement defines the economics of the arrangement. We divide each dollar of revenue, shown in Figure 1 as $20 million, into the operating allocation and the owners’ allocation. The operating allocation is the amount needed to pay all of the expenses of the firm, plus a component for the development of its future business and a cushion against any downturn. Salary, bonuses, and other operating expenses are shown as $8 million (see Figure 1). The $2 million earmarked as the excess operating allocation is retained by the management team at the end of the year, if it is not spent. As illustrated, the owners’ allocation is divided 60 percent to AMG and 40 percent to the affiliate management equity holders. With regard to this 40 percent, the managers own put options that begin in the fifth year after the transaction; they can put their equity back to AMG at a multiple of the then current owners’ allocation.

Succession Issues Succession planning is an issue of growing importance. In December 1993, about 800 firms had between $500 million and $15 billion in assets under management. Today, more than 1,300 firms have this level of assets under management, and many of the ©2002, AIMR ®

Aligning the Interests of Clients, Management, and Owners Figure 1. Illustration of AMG Structure Salary, Bonuses, and Other Operating Expenses $8 Operating Allocation $2

Revenues = $20 Affiliate

RevenueSharing Agreement

50%

$10

50%

$10 40%

Affiliate Management ’ rs ne on Equity Holders Owocati l $4 Al

Owners’ Allocation 60% O $6 All wner oca s’ tion

AMG

Note: Operating allocation equals 50 percent, and owners’ allocation equals 50 percent. Ownership: AMG equals 60 percent, and affiliate management equals 40 percent. Revenues are in millions of dollars.

founding principals are approaching an age at which succession has become a real issue. Many midsize firms have a limited set of succession options. First, they could use an internal sale to transfer equity to the next generation according to an artificially derived formula, such as one, two, or three times book value or revenues. The problem with this approach is that it has negative tax consequences for both the founder/owner and the individual purchaser. The newest members of management, who are buying into the firm with their own cash and are essentially buying an illiquid security, do not know when they will be able to get liquidity. With an internal transfer, the only way everybody gets liquidity is if the whole firm is sold. The second alternative is a 100 percent sale. Although this approach is appropriate for some, growing firms that want to retain their independence and value the culture they have created do not find this sort of solution appealing. Finally, a partial sale to an institutional partner is perhaps the best way to align the interests in a growing firm, but this alternative entails the institutional partner not merely taking some percentage

©2002, AIMR®

interest but also having the expertise to rotate the interest through successive generations of management. Of our 17 affiliate firms, 13 have had a further spreading of equity since the date of our initial investment. In only two cases have the original principals passed almost all of their equity to the next generation of management. In most cases, they still retain a material amount, but the ownership structure is quite different several years later for many of these firms.

Summary We have found that a partial purchase that leaves direct equity with founders/owners and spreads direct equity to the next generation of management is the best way to align the interests of clients, management, and owners. This approach solves the problem of succession and continuity for both individuals and the firm as a whole. It also preserves independence, or operating autonomy, and hence the culture that built the firm. Such culture is the key to real future growth, particularly for midsize firms in which human capital plays a vital role.

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Organizational Challenges for Investment Firms

Question and Answer Session William J. Nutt Question: What kind of multiples are you currently seeing, and would you comment on the percentage of assets under management times revenues in Figure 1? Nutt: In Figure 1, the free cash flow, or the portion of the owners’ allocation, is $6 million. We pay a multiple of that $6 million. For all 17 of our transactions, multiples have ranged from 4 to 10. The most recent transactions, particularly those since we went public in November 1997, have generally been between 8 and 10 times. Multiples for the best firms have not changed much recently. What is most important for our affiliates is the structure, flexibility, support, and the ability to continue to run the firm exactly as it has been run. Price is important. We pay fair prices. When making a presentation to a prospect who has asked us about this structure and how it works, we invite them to call our 17 partners at our affiliates because they are the best reference for judging how fair the price was and how well the transaction was executed; how clients and employees responded; and how successful the firm has been since the transaction. Question: I was impressed you were able to buy a firm of the quality and profitability of Tweedy, Browne Company. If you are not familiar with a 70 percent bottom line, how was that accomplished? Nutt: Tweedy, Browne was originally founded as a broker/dealer in 1927. The firm started managing money for high-net-worth clients in the late 1970s and started its mutual fund business, which accounts for about 60 percent of its assets, in the late 1980s and early 1990s. The firm manages separate

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accounts, private partnerships, and mutual funds for high-networth clients as well as some smaller institutions. At the time of the transaction, Chris Browne was 53, his brother Will was 51, and other members of their management team were in their late 40s. They wanted Tweedy, Browne to remain the same—an institution with a management team that applied the same deep-value Graham and Dodd approach that had made the firm successful for 30 years. They didn’t want to be acquired. They came to us and asked us to look at their financials, determine our interest in them, and recommend the most appropriate structure. The revenues were significantly higher than $20 million, and we split the revenues close to 60/40. The amount of ownership we purchased was a little more than 60 percent. Incidentally, the three senior partners who owned most of the equity did not retain 40 percent themselves. They retained about 30 percent and set aside 10 percent for the next generation of management to receive in an option structure. Tweedy, Browne has almost doubled since our involvement and continues to have vitality. The firm moved into a new office, acquired an entirely new technology system, brought in a number of young people, and has continued its European research and product development. Tweedy, Browne is a good example of why a firm that had several alternatives would choose (for the benefit of its clients, employees, the next generation of management, and the founders/owners) to partner with AMG. The three senior partners collectively took approximately

$300 million at the time of the transaction. The value today of the ownership retained by the affiliate management equity partners—the value of the equity that was retained by the management team —is worth, with subsequent growth, more than the initial three partners took out at the time of the transaction in October 1997. Question: When the put window opens after five years, do the original sellers continue to retain control of management or does the second generation take over management of the firm? Nutt: There is no single answer. When looking at a firm, we ask two broad questions: How is the firm being managed today, and how should it be managed for growth in the future? What is the ownership structure today, and how does the firm spread its equity? In almost every case, because new partners are being added, there are additional members to the management team. The three original partners of Tweedy, Browne make up the executive committee, but two more junior managers are part of that committee as well. At other firms, such as Rorer Asset Management and First Quadrant, the management team has been expanded. More than one outcome is possible, and we don’t dictate the result. All we ask is that the affiliate have a methodology in place that we can understand. Question: What is the incentive for managers to reinvest in the firm rather than squeeze the operating costs under the AMG structure? Nutt: When thinking about how you split the revenues, if you’re going to have a one-time liquidity event, you will capitalize the

©2002, AIMR ®

Aligning the Interests of Clients, Management, and Owners profitability of the business for purposes of the sale and drive down those expenses. If expenses are trimmed too much, the subsequent management team won’t have enough developmental capital for the continued growth of the firm. At AMG, the goal is to put more money into the operating allocation than is necessary. You put in enough to pay the expenses today and leave something for development and as a cushion against a downturn because five years later, assuming greater revenue growth, you take it out of the put multiple and the capital gains rate. This approach is much better than taking it out of salary and bonus. It preserves the incentive to continue developing the firm. One of the reasons the puts aren’t effective until after five years have passed is that there will be a need

©2002, AIMR®

for new offices, more technology, and so forth.

were rewarded with additional revenue growth and profitability.

Question: Is the 50 percent allocation adequate to fund a business when most pretax returns in the industry are less than 40 percent?

Question: What criteria would you use to sell your equity participation in one of your affiliate companies?

Nutt: In the clear majority of the 17 affiliate investments we have made, the split of revenues going to the operating allocation is far closer to 60 or 70 percent than to 50 percent. For some firms with higher margins, the split may be 50 percent or more, but in the majority of cases, the split is closer to 70/30 or 60/40. The split can be changed in subsequent years, and we have done so. In other words, when firms started with a split of 70 percent to the operating allocation and 30 percent to the owners’ allocation, they spent a lot of money but

Nutt: I can’t see a scenario in which we would sell our interest in an affiliate, certainly not to a third party. Our promise is that we have solved once and forever the issue of ownership structure. This promise is extremely important not only to the future generations of management but to their clients. They need to know that the individuals can sell back their equity and that we could resell it or give it to the next generation of management but that we would not sell all or any portion of one of our existing affiliates.

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Evaluating Business Models Charles B. Burkhart, Jr. Founder Rosemont Investment Partners, LLC West Conshohocken, Pennsylvania

In considering appropriate business models, the gap between the interests of those managing firms and those of clients seems to be widening. Although large firms have many advantages, growth often comes at a high price in terms of client satisfaction, investment performance, profitability, and productivity. Boutiques, however, still have a lot to offer because they put economics first and have far fewer constituents to consider.

huge and growing industry disconnect is under way. Global reach and power, earnings contribution, consolidation rationalization, and conglomerate culture/ownership have become a media focus and an asset management obsession for many financial services firms, but in most cases, these goals do not serve the needs of clients or shareholders. At the same time that firms are trying to extend their global reach and power, critical underlying issues are not being addressed. Because these larger conglomerates are not providing better investment performance, better economics, or stable and motivated employees, the clients’ best interests are not being well served.

A

Drive for Scale The quest for global reach and power drives companies to rationalize establishing a large consolidated culture that more frequently has one umbrella brand and aspires to rule the asset management world. To achieve global conglomerate status, the multiple acquisition route is preferred. At Rosemont Investment Partners, our research shows that 14 of the top 25 managers of investment management assets in the world have acquired (as opposed to having organically grown) more than 25 percent of their assets under management (AUM), and five of these managers (such as Deutsche Asset Management [DeAM]) have acquired more than 70 percent of their assets. These companies have become, in effect, composite Editor’s note: The joint Question and Answer Session of Charles B. Burkhart and Jeffrey S. Molitor follows Mr. Molitor’s presentation.

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managers. One of the great tests of a conglomerate’s success is being able to achieve strong organic growth as they bind together two, four, or eight investment managers. The pressures to excel and deliver the four P’s discussed by Molitor are much greater in businesses that have acquired 30, 50, or 70 plus percent of their assets.1 Not that long ago, as shown in Table 1, money managers valued anywhere from $1 million to more than $200 million traded in a relatively similar range of EBITDA (earnings before interest, taxes, depreciation, and amortization) or pretax revenue multiples. In recent years, that margin has widened greatly, with the larger firms commanding significantly larger multiples than the smaller firms. The drive for scale is evident; too many owners of investment management businesses cannot afford to be in the business if they do not have a scalable platform. But this drive to scale comes with great challenges. The Conglomerate Challenge. Conglomerates face numerous challenges to achieving stability and client satisfaction. DeAM is just one of the many conglomerates facing such challenges. Figure 1 shows the many businesses it has acquired. Think about what DeAM must do to hold everything together and build a company that satisfies clients, especially now with the recent acquisition of Zurich Scudder Group. If you were a client of Dreman Value Management before Kemper Corporation, Scudder, or DeAM, would you still be a satisfied client today? In some cases, the economics of buying a firm may seem to be a good deal for shareholders, but a better 1 See

Mr. Molitor’s presentation in this proceedings.

©2002, AIMR ®

Evaluating Business Models Table 1. Pretax Multiples and Transaction Values, 1993–2001 Firm Size (AUM) $1 million to $50 million

Years

$51 million to $200 million

More than $200 million

1993–1995

10.03

11.27

10.94

1996–1998

9.83

12.60

14.13

1999–2001a

11.76

14.47

21.11

a

Transactions through July 31.

measure of long-term success lies with the parent firm’s ability to retain key professionals. If DeAM can bind multiple client and employee bases together and meet the challenges of these many acquisitions, it may prove to be an enduring leader. For most conglomerates, however, many professionals have already been displaced in the aftermath of these acquisitions, and more are likely to leave as the businesses are further rationalized. Investment Performance. A long-term bias exists for better performance among smaller firms, generally those with less than $20 billion in assets. Firms with less than $20 billion AUM, and even those with less than $5 billion AUM, typically generate superior performance compared with their larger brethren. Table 2 shows the percentage of firms in each of those two size categories that are among the top managers in Nelson’s World’s Best Money Managers 2001 in four equity categories. Performance suffers, in part, because capacity, managers’ objectives, and attribution all change, sometimes dramatically.

Growth Rates and Margins. The ability of larger firms to deliver revenue growth, performance, and a favorable operating margin is often compromised. Table 3 shows that firms with less than $20 billion in assets have economies far superior to those of firms in the overall universe. Over the years, the notion that a greater percentage of each dollar drops to the bottom line as a firm increases in size is more often dispelled. The break-point used to be around $20 billion in assets (i.e., up to the approximate $20 billion mark, a greater portion of each dollar often dropped to the bottom line, but marginal profitability eroded beyond $20 billion); the break-point is now in the $20 billion to $75 billion range. So, depending on the firm’s product and fee mix, margins and growth rates usually grow, peak, and then decline. D i m i ni s h i ng P r o d uc t i v i t y . Productivity, measured in terms of assets per person per department, also varies by size. Table 4 shows that as firms grow from having AUM of under $5 billion to having AUM between $5 billion and $20 billion, they experience a huge increase in productivity. These firms become far more productive per person, across all functions. This advantage flattens out as firms grow beyond $20 billion AUM. Firms in the overall universe, whose average size (AUM) was just under $100 billion, were not operating at substantially greater productivity levels, if at all, than firms with $5 billion to $20 billion AUM! Economies of Size. One of the greatest, and almost unanswerable, questions in evaluating business models is at what point does too much ambition

Figure 1. Business Entities of DeAM DeAM

Zurich Scudder Group

B.A.T. Fund Management

Prudential plc (institutional business)

Scudder Kemper

Kemper Corporation

Morgan Grenfell Group Kern Capital Managementa

(Principal Financial Group)

Dreman Value Management, LLC a

Bankers Trust Investment Management

Daewoo Capital Management Co.

Threadneedle Scudder, Stevens & Clark, Inc.

Axion Funds Management (MG)

Bankers Trust Australia Group

Brown Investment Advisorya

Bankers Trust DefinedContribution Group

(Metropolitan Life Insurance Co.)

Alex Brown Capital Advisory

A lift-out/start-up firm.

©2002, AIMR®

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Organizational Challenges for Investment Firms Table 2. Percentage of Firms That Are Top Equity Performers by Firm Size Firm Size (AUM) Less than Less than $20 Billion $5 Billion

Product Class Five-year returns International equity

65%

51%

U.S. large-cap growth and value equitya

80

65

U.S. mid-cap growth and value equitya

90

80

U.S. small-cap growth and value equity

100

100

Note: Top 10–40 managers in each category. aAUM

for reporting firms only—does not include parents.

Table 3. Growth Rates and Margins by Firm Size Firm Size (AUM) Overall Universea

Category

Less than $20 Billion

Three-year average compound annual growth rate of assets (1997–2000)

19.8%

29.3%

Revenue growth (1999–2000)

22.6

49.3

Operating profit (EBITDA) growth (1999–2000)

29.5

151.4

Operating profit margin (2000)

31.4

37.1

aOverall

universe has an average size of $72.5 billion.

Source: Paul David Schaeffer, Competitive Challenges 1997–2001, Capital Resource Advisors’ annual best practices study.

Table 4. Median Assets under Management per Employee by Department ($ millions) Firm Size (AUM) Department

Less than $5 Billion

Investment management

$125.9

$439.0

$438.3

443.8

1,570.7

1,755.2

Sales

$5 Billion to $20 Billion

Overall Universea

Client service

472.0

2,689.8

2,258.5

Operations and administration

336.8

1,208.0

1,374.4

Note: The average total number of employees firmwide for firms with less than $5 billion is 42.1; $5 billion to $20 billion, 118.9; and overall universe, 116.4. a

Overall universe has an average size of $96.8 billion.

Source: Paul David Schaeffer, Competitive Challenges 2001, Capital Resource Advisors’ annual best practices study.

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have negative repercussions. I doubt any manager would say that they do not put their clients’ interests ahead of the interests of the firm, but one can judge by a manager’s size and composition whether that statement holds true. Growth rates and profit margins have always been much more compelling at the small and midsize boutiques than at the largest managers. Problems often arise as a firm grows because the firm’s focus moves from the clients to the shareholders, whether parent company or individual shareholders. A firm may demonstrate superior loyalty to its first 50 or 100 clients, but if those clients do not provide the necessary economics required by the owners, the firm must keep expanding. As some firms cope with demands and loyalties among a diverse set of clients, business segments, and distribution channels, scale often becomes more important than excellence. The pursuit of scale clearly has advantages and disadvantages.

Ownership Restructuring One of the causes of instability in the industry is the low level of employee ownership. Furthermore, among the firms that have employee ownership, it is often too little and too narrowly spread. For the firms that provide equity ownership, the median founder ownership level is 48 percent. And in these firms, nonfounder employees have a 17 percent median ownership share. The median total employee ownership of all managers in the 2001 study is 38 percent. The numbers for total employee ownership are low to some extent because many of these firms are publicly owned. Some financial services owners/acquirers are contemplating how to either sell back or create sufficient employee equity in their money management firms. For a human-capital-intensive business, this lack of ownership causes fracturing and destabilization. If motivated employees cannot own at least synthetic equity (if real equity is not available), they will migrate to other firms or start their own. Consultants fully recognize the importance of employee ownership for stability and are further focusing on this question in their questionnaires and due diligence. If a firm cannot offer substantial real equity ownership or surrogate ownership to its employees, it is handicapped versus those who do. The best people simply will not stay with firms that do not provide some type of ownership.

©2002, AIMR ®

Evaluating Business Models

The Future of the Boutique In the Goldman Sachs report on the future of the money management industry, small boutiques (then defined as firms with roughly $6 billion or less in assets) and very large firms (then defined as firms with greater than $125 billion in assets) were deemed to have successful business models.2 Those firms falling in between were expected to struggle. The small boutiques could succeed on alpha-generating performance alone, and the large firms would succeed on scale. Many owners appear to have accepted this opinion, as indicated by the number of $200 billion plus enterprises (42 as of December 2001) and the continuing battle for increasing scale. The notion that all firms between small boutiques and large firms would fail is greatly misplaced. They have hardly failed; some are among the most successful firms in the industry on the basis of growth rates and investment performance. Any of the databases on manager search activity prove that firms managing $5 billion to $100 billion have not been penalized or biased against in search activity. The economics of these midsize firms have not deteriorated. No threat of extinction exists. In contrast, one could argue that the execution risk of large firms— especially the composite large firm that is an amalgam of four, six, or more asset managers—is huge. They are saddled with the risks associated with melding different cultures, pay structures, and distribution objectives, as well as orchestrating leadership coordination transfer. These challenges always prove more difficult than owners are willing to believe. So, where does scale matter? Scale certainly rules in indexing and in bundled defined contribution. But in many parts of the business, ever-increasing scale— when a firm has no constraints and can manage immeasurable assets—is an illusory pursuit. Investment management is not inherently a scale-oriented profession. In large part, the enterprises that are built through acquisitions will disenfranchise many of their clients. In contrast, the firms that have grown organically, such as Fidelity Management & Research Company, Capital Group, and Putnam Investments, have created long-term enduring businesses. The Capital Group is the largest boutique in the world. Its culture, compensation structure, and client focus stand out above its global reach and power. 2 Investment

Management Industry Group, “The Coming Evolution of the Investment Management Industry: Opportunities and Strategies,” Goldman Sachs, October 1995.

©2002, AIMR®

Nonetheless, everything is not rosy for boutiques. Some boutiques suffer from client concerns that they are still at an early, vulnerable stage in their evolution and will suffer from arrested development. But execution risk is smaller for boutiques than for large enterprises. Boutiques can deliver alpha and business performance with far fewer constituents to consider. The problem is that smaller good boutiques cannot remain static, but how much execution risk can a boutique manage and still prosper over time? Once a boutique has figured out what it takes to run its investment discipline well, critical mass applies to (1) how large the business needs to be to satisfy the owners and (2) qualifying the firm for client prospects of increasing size. The owners have to figure out to what extent they will reinvest in the business versus recouping the return for themselves. On the one hand, owners that focus solely on their own return are not likely to be the most attractive employers. On the other hand, they will deliver some of the best economics because their focus is just that— economics first. Growth managers of all cap ranges and core managers have not outperformed since 1999, whereas small- to mid-cap value managers have shined the past two years. The future of a boutique therefore depends in large part on whether it has figured out how to pursue demand for its capabilities and how to manage the inevitable cyclicality of product and performance. One of the biggest challenges for boutiques is that as their offerings go through underperforming cycles, they have no other product to pick up the slack when their core offering suffers. The good boutique is neither static nor immortal. Boutiques will rise and fall and ultimately be bought by other firms or fade away. The business model of running a good boutique will endure. The boutique is the most powerful model, if firms can get it right.

Conclusion There are many strong forces pushing for global conglomerate objectives versus those championing the best interests of the employees and clients. The discrepancy between the goals of those managing investment firms and the goals of the clients seems to be increasing. Some of the blame for this widening gap falls on the clients. Clients in all segments of the business have not been vocal enough about protecting themselves against the negative aspects of global conglomeration. As a consequence, this industry disconnect will continue unabated until clients stand up and protect their assets.

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Evaluating Business Models & A Client’s View

Question and Answer Session Charles B. Burkhart, Jr. Jeffrey S. Molitor, CFA Question: With the pressure to reduce tracking error, what is the future of active management? Molitor: For managers who execute well, the future of active management is promising. At Vanguard, we think that a real need exists for portfolios that are, to some extent, benchmark blind. For example, the folks at PRIMECAP might look at a benchmark at the end of a six-month period to determine where they are, how they did versus the market, and whether the benchmark helps explain that performance. They never make a decision based on which stocks are in an index/ benchmark. Burkhart: The plan sponsor community, perhaps unwittingly, is driving the continued focus on relative performance. So, the concentration on relative performance has to be overturned at the sponsor level first. Managers can’t be revolutionaries without the approval of their employers. Interestingly, this focus on relative performance has created the massive hedge fund boom. As a result, a lot of long-only managers who have no experience shorting are entering the hedge fund arena because they want that hedge fund performance fee. Question: If managers are paid according to peer group performance and plan sponsors are pushing for minimal tracking error, isn’t there an incentive for all managers to be indexers? Molitor: Compensation schemes work in various ways, although we know that we have more performance-oriented fees than anybody ©2002, AIMR®

else. (We don’t call them incentive fees because we don’t think managers need the incentive.) Based on our experience, I don’t think all managers will be driven to become indexers. For example, we are starting up a fund that the advisor for our Windsor Fund will be running. Vanguard Capital Value will be a value portfolio, but its benchmark will be the Wilshire 5000 Index. Will it ever look anything like the Wilshire 5000? No, but having the Wilshire 5000 as the benchmark gives investors a sense that the manager believes he can beat the broad market. The fund manager expects to make a lot of money relative to the Wilshire 5000, which doesn’t mean the performance has to mimic it. Some managers see what their peers are doing and start going off in the same direction, even if they don’t necessarily think that is the best direction. We monitor that kind of situation and stay on top of it. I don’t want a manager to buy a telecommunications company just because someone at Fidelity likes it. Our clients are not their clients. We want managers who have a process and the discipline to come through with ideas on their own. Indexing will always have a role because of transaction costs and its inherent efficiency, but it is not going to be the entire business. Managers who can add value will definitely have a role to play. Burkhart: If we get more client attention on what I call the coreand-explore approach (in which a client has core, index-like products and then builds a clear alphaproducing strategy around the core), managers will be willing to have tracking-error dispersion. But

I go right back to the sponsors. Vanguard stands on its own on this issue. Not many firms are willing to tell managers to generate absolute returns and then not worry if they are down 25 percent when the index is down 17 percent. A lot of managers’ identities are inextricably linked to indexes. Question: A manager with an 8 percent tracking error and a real alpha of 2 percent has a 30 percent chance over 10 years of underperforming. Shouldn’t investors want to control that risk? Molitor: A lot of investors take the math too seriously. The math shows what happened in the past and is not necessarily predictive of a manager’s future performance. The probability exists that a manager will underperform at some point in time. But if clients understand that risk and they’re looking at the total portfolio, then some clients will be comfortable taking more risk and disregarding tracking error. Others, however, will still want tight tracking error and to control risk. Question: Will some of the investment talent move to hedge funds? Burkhart: Without a doubt, a widespread move of talent from traditional management to hedge funds is under way. A lot of the traditional long-only businesses are either creating hedge fund complexes within their own firms or building a hedge fund component. But there has to be some way for the stability of talent to be maintained, because when talent is undermined, huge problems arise. Unfortunately, good hedge fund

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Organizational Challenges for Investment Firms performance will not be successfully attained by most who start a hedge fund. It is a growing bubble—only a small percentage will stand out over time. Although at Rosemont we have not yet invested in a hedge fund, at least 15 firms will happily seed hedge funds or a fund of funds because they’re so excited about them. And for firms that can get it right, the economics are awesome. Molitor: Hedge funds are a phenomenon right now. Some will succeed, and some will not. Question: How do you structure a compensation package to keep your managers motivated? Molitor: Compensation gets back to the idea of the economics, and managers should feel as though they’re participants in the ownership of the firm. But no matter what, compensation has to be based on overall performance. Because fees are still paid on assets, better performance will lead to better revenues and some level of asset growth, assuming we get level markets. So, compensation can be based on performance versus peers or performance versus benchmarks; it can be calculated in different ways. We think it is important to have a rolling window for determining compensation. That is, a calendar-year approach does not work for us. Every fee schedule we have that has a performance structure is based on a rolling 36 months, so a manager cannot have a great 10 months and then lock everything on the index and go to the beach for 2 months. The incentives have to be long term because our clients are long-term investors. Question: How do you structure your performance fees to prevent the manager from staying too close to the index?

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Molitor: The incentive for the manager is that if he or she outperforms by a great deal, compensation can increase a great deal. We have some contracts in which the performance increment goes as high as 80 percent above base. (Our contracts are also structured symmetrically so the pain of underperformance is equal to the benefit of outperformance). We monitor performance and portfolio characteristics to see if a manager is getting too close to the index. In addition, we measure the expected tracking error. If the portfolio deviates significantly from what we expected, that is an issue. Most of our managers are accustomed to investing in a certain way, so a lot of them don’t tend to change their style by moving toward benchmarks. Burkhart: In addition to having a long-term focus for compensation, which not many firms have adopted yet, compensation needs to be team based and focused on the clients’ interests. It needs to be determined based on the performance of the entire investment team and within the firm’s business performance, not on a single individual’s performance. One of the problems I have seen as a consultant is that managers are getting paid outside the reasonable economic ratios of the firm. A firm makes a deal with a manager that flies in the face of the economics of the firm, and that deal can hold the firm hostage. But if the firm does not pay the manager, he or she will leave because another firm will always pay more. Keep in mind that the number one reason investment professionals leave their firms is that the compensation structure is murky, subjective, and/or at the whim of those controlling it. Question: When is equity distribution to employees appropriate?

Burkhart: If you’re sustaining a business, you don’t want to give away assets to people or situations that won’t be around for a long time. You have to have an economic core. To build that economic core, a certain amount of reinvestment in the business must occur. You can’t pay out all the profits. When we look at the profit-andloss projections for our investment prospects, we usually look at revenue, expenses, prebonus profits, bonus pool, reinvestment, any need for retained capital, and finally, distributions to shareholders. Question: What are the minimum size requirements for an outside manager? Molitor: The answer depends on the type of assignment—the character of the fund the manager will be managing and whether the manager ever managed at that scale before. It is tough for us to offer a portfolio if we don’t think it will get to at least $1 billion. If a manager has done a wonderful job managing trust accounts at $100 million but has never had an organization to support anything bigger, our decision on whether to go with that manager depends in part on whether the manager has the necessary infrastructure in place. So, the answer depends on the nature of the assignment as well as the firm, the people, and their experience. Question: Has pricing of firms changed recently? Burkhart: We have looked at this question carefully. Since mid-2000, pricing has not softened in the absolute, although earn-out consideration has become more material. And since September 11, we haven’t seen a backing off in pricing because a huge rift still exists between the number of willing and active sellers and the number of buyers. The number of buyers to

©2002, AIMR ®

Evaluating Business Models & A Client’s View sellers is at least 40 to 1; that is, there are 40 buyers for every legitimate seller. Anywhere near that ratio, prices will not suffer. Question: How do you handle the increasing “quarteritis” (i.e., short-term focus) of clients? Molitor: At Vanguard, we see ourselves as long-term investors. We’ve had managers who have had terrible runs, but we stick with them, which has paid huge dividends for our investors. One of the reasons we’re able to look beyond quarterly returns is that we are privately held. Our share price does not rise and fall on an ongoing basis. Public firms with share price pressure, however, easily get caught up in quarteritis. As far as the quarteritis of clients, we try to see clients on a regular basis, which is much easier on the institutional side than on the retail side. When we meet with clients, we explain where a fund fits into their overall investment strategy and what they can expect from it. It is really about setting expectations. It gets back to what Burkhart said about clients serving themselves poorly by having quarteritis. A number of clients, unfortunately, think quarter to quarter, as though it were an accounting type of issue, as opposed to weighing the effect of compound returns over the long term. Question: What are the valuation criteria for firms?

©2002, AIMR®

Burkhart: There are three basic measures of value in the industry that are applied in various degrees, and occasionally, one of the three does not have any importance in valuing a firm. The first is whether a public market exists for the firm. There are plenty of small, private, closely held boutiques that look nothing like even the smallest publicly traded money manager. Four or five investment banks publish, on a regular basis, the trading statistics as a multiple of revenue, income, and so on for the publicly traded managers. The second measure is discounted cash flow, which for many would-be sellers is the one measure they focus on to generate the highest value for their firm. This value is a derivation of how a firm’s asset and revenue growth will be offset by increases to expenses and compensation. And that discounted cash flow process often drives up the valuation. The third measure is comparables—trying to find 5, 10, or 15 of the most relevant private deals. What I am talking about is valuation for a potential sale. Valuations are done for all purposes—to gift stock or figure out ways to keep valuation down—so the comparables valuation has to be for a sale of a going concern. The second and third measures are the most important for valuing a private firm. Question: What do you see as the future trends in the investment management business?

Molitor: I hope more managers start their own firms. This business is dynamic and entrepreneurial. Managers are generally best served when they have the freedom to make investment decisions as they see fit and are well compensated for those decisions. Boutiques will continue to emerge, and the industry will remain dynamic. Furthermore, a number of people will probably move out of the mutual fund business. The 401(k) market, which is a capital- and people-intensive business, is wonderful, but investment managers don’t want to be in the record-keeping business. In addition, it’s tough to succeed if a fund has a solid but not spectacular record and the fund sponsor has to pay 40 bps to distributors for the privilege of being part of a supermarket. Burkhart: The past 10 years saw great aggregation in the industry, but now, great disaggregation is becoming a natural, evolutionary by-product. Very little consolidation has taken place recently, although many large-scale competitors remain fixated on consolidating multihundred-billiondollar franchises. Many more competitors now exist in almost every segment of the business. The often unmet needs of managing the business well and having strong leadership bode well for further disaggregation. Ultimately, firms will survive and prosper on excellence in best practices, regardless of whether they are far-reaching conglomerates or tiny boutiques.

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A Client’s View of Business Models in Investment Management Jeffrey S. Molitor, CFA Principal and Director of Portfolio Review The Vanguard Group, Inc. Valley Forge, Pennsylvania

The Vanguard Group contracts outside investment management services for a number of its funds. To ensure compatibility with these outside firms, Vanguard adheres to a thorough selection and evaluation process. Although a wide variety of business models are considered potentially viable, a firm must exhibit one essential quality in order to be chosen and retained: a keen concentration on client needs.

his presentation discusses what makes investment management firms successful from the client’s perspective. The Vanguard Group is one of the largest users (i.e., clients) of actively managed investment management firms in the mutual fund industry because of both our corporate structure and our philosophy of investing. Our funds own The Vanguard Group and we operate on an at-cost basis, so we have traditionally “outsourced” investment management services for funds when that makes sense. For other funds, investment management is done by Vanguard’s own Fixed Income Group and Quantitative Equity Group. We spend a great deal of time and effort monitoring and evaluating investment management firms. This presentation offers examples of business models that work from our point of view and examples of those that would not allow a manager to become an advisor for us. We have seen numerous models that can work. The common factor in these is a firm’s ability and willingness to stay focused on its clients’ needs.

T

Investment Management Structure To manage funds covering about two-thirds of our total assets, we use an internal quantitative equity group (one-third of assets) and an internal fixedincome group (one-third of assets). Our structure for managing the internal assets can be thought of as Editor’s note: The joint Question and Answer Session of Charles B. Burkhart and Jeffrey S. Molitor follows this presentation.

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applying consistent risk-control processes for each asset class. For example, all of our fixed-income portfolios make use of the same credit research and the same risk control (on a portfolio level) in terms of duration policy. The quantitative equity side is also risk controlled; roughly 95 percent of that money is indexed, or passively managed. In these investment areas, relative performance can be driven largely, although certainly not exclusively, by relative costs. Our shareholders are able to enjoy the benefit of our cost advantage only because of the noteworthy expertise and execution capabilities of these teams. The remaining one-third of our assets is in the hands of outside managers. In the beginning, Vanguard used only outside managers. When John Bogle left Wellington Management Company, he created an entity (Vanguard) whose sole purpose was to be a distributor of funds. At the start, all the assets at Vanguard continued to be managed by Wellington. Elements of that original model, including the basic corporate structure, are still in place. This structure dictates that we focus on providing the highest-value and best-quality product for our investors. In terms of investment management, our structure means we are free to seek the expertise of external firms. For our outside active equity managers, neither cost nor absolute risk control is our most important concern. Because money can be managed in many different ways, flexibility is required in determining whether a manager may be appropriate. We want to ensure that our clients have a wide choice of distinctive investments and are able to invest in funds that ©2002, AIMR ®

A Client’s View of Business Models in Investment Management will not overlap in terms of style or strategy. With our competitors’ equity funds, we often see huge overlaps in overall character, volatility, and performance because the same stocks are routinely held in many different funds. This overlap occurs because the research done by an analyst covering a company is fed to portfolio managers throughout Vanguard. One result of this overlap can be that similar holdings show up in all sorts of funds—growth and value, large and small. We work with 21 outside firms that are specialists in their respective management styles. This broad spectrum of managers provides real diversification and flexibility for building our business. Using external investment teams also allows us to close off a fund to new accounts, if need be, because of capacity or other concerns. We can then open a new fund managed by a different firm. One indicator of the extent to which we use outside firms is that we are a significant payer of fees, as shown in Figure 1. We currently pay about $200 million a year to outside managers.

Figure 1. Fees Paid to External Advisors, 1991–2000 Fees Paid ($ millions) 250 200 150 100 50 0 91

92

93

94

95

96

97

98

99

00

Selection of External Managers We evaluate managers, both the ones we currently have and the ones we are considering, according to the four P’s: process, people, philosophy, and performance. Although some investors look at a fifth P, packaging, we do not. The most important lesson we have learned from looking at the four P’s is that performance is simply the residual factor. If we get everything else right in evaluating a manager—if the right people are in place and they have an enduring investment philosophy and a sound investment process—performance takes care of itself. Of course, performance is a critical element. At the end of the day, we are in business for one purpose—to generate superior long-term investment results for our clients. Performance, however, is not our starting point in evaluating investment managers. ©2002, AIMR®

Process. The process element defines a firm’s investment approach and management style—in essence, how and why our stocks are bought and sold. Does the firm have a proven strategy? Does the strategy have a certain discipline associated with it? A disciplined approach does not mean that an absolute level of risk control must be in place. Discipline reflects the consistent application of a sound investment process. We apply more flexible—and, we think, realistic—approaches to assess our managers than many mutual fund industry watchdogs and consultants. For example, standard deviation as a measure of risk addresses only historical, not future, volatility. Risk is defined as much by the manager’s investment process and the people driving the decision making as by statistical measures. People. When evaluating managers, we spend a lot of time talking about the people who are part of the management process. Every month, we prepare a report for Vanguard’s Board of Directors in which we discuss every outside manager in terms of the firm’s business, people, performance, and portfolio. We are primarily concerned with whether these elements are consistent over time and grade these firms accordingly. The people element is the most difficult, but ultimately the most important, to judge. The people issue is integral to the culture and discipline within a firm: How are people compensated, how do they define their business, and how do they interact on both an internal and external level? Plus, the people in an organization tell everything about the overall depth and stability of a firm. For example, is a sound succession plan in place? Is the firm expending sufficient resources to groom young talent? One thing we have witnessed year after year, both at Vanguard and at other firms, is the itch for change. Changes in people often lead to changes in investment strategy or tactics, and integrating new players into a firm is generally a challenge. We therefore consider consistency in approach and in staff to be an essential element of the advisory firms we want for our clients. We want teams who can provide good results for our clients over the long term. This longterm orientation does not mean that the only firms we consider are those that have been around for 10, 20, 30, or 40 years. If a brand-new firm offers a team with a sound investment process and continuity, we will consider it. Philosophy. A firm’s investment philosophy has to have an enduring character. I use a simple test: If I cannot explain the philosophy to my mother-inlaw in about three sentences, it is probably too complicated. Our goal at Vanguard is to produce superior

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Organizational Challenges for Investment Firms long-term results, and the philosophy or the culture of our advisors is intrinsic to accomplishing this goal. What is the firm trying to produce? Does the philosophy focus on producing results for the clients? We seek firms composed of people who strive to get good results for their clients, rather than firms whose people are simply focused on preserving revenues. Performance. All this—the process, the people, and the philosophy—boils down to the residual, which is performance. Solid performance is vital, but it is the last factor we look at, because we know that performance evolves as a result of the decisions made by the people who drive the process and uphold the philosophy. Above all, we are interested in consistency when it comes to performance. We are not looking to hire a “hot” firm whose one right bet made performance soar for a couple of years. We want competitive returns and a long-term track record. Again, looking for a long-term track record does not mean we will not consider new spins-outs and start-ups, but we must have a reasonable basis for believing a firm’s record is representative of what it could do in the future. Packaging. We do not care at all about the fifth P, packaging, when selecting external managers. Packaging has two components. The first component is who owns the business. The right incentives must exist for the people who are running the money, but a lot of different structures can be used to create those incentives. We therefore do not focus on this aspect as part of our selection process. The second component of packaging is marketing, which we look beyond.

Business Models Any business model works as long as the firm is clearly, directly, and consistently focused on making the client successful. All of our clients have one objective—to meet their long-term investment needs. They are deferring current consumption to meet future consumption needs. Our job is to find ways to help them do that as efficiently as possible, whether through investing in stocks or bonds or in domestic or international, large-cap or small-cap, or growth or value funds. Therefore, an advisory firm’s business model is successful, from our point of view, as long as the firm’s ultimate objective is finding the right investments for the client. The 21 firms we work with typically fit into one of three successful business models—boutique shop, boutique firm within a holding company, and big firm with a boutique team:

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Boutique Shop. PRIMECAP Management Company is a boutique firm in Pasadena, California, that manages the Vanguard PRIMECAP Fund, a large-cap growth fund with $16 billion in assets, and Vanguard Capital Opportunity, an all-cap growth fund with $4.5 billion in assets (all data as of October 31, 2001). Not quite 20 years ago, PRIMECAP’s founders left Capital Group. They simply wanted to focus their time and energy on meeting the needs of a select group of 20 clients. The partners researched companies, talked to corporate managements, and built portfolios. The people at PRIMECAP did not want to talk to us at first because they thought the mutual fund industry was not the type of business they wanted to pursue. As it turned out, the people at PRIMECAP eventually decided to collaborate with us when they realized we were simply one more client and they did not need to spend time with wholesalers and brokers. With us, they could manage a mutual fund and still enjoy the small-firm culture they sought. The people at PRIMECAP have generated a terrific record for the PRIMECAP and Capital Opportunity Funds. One reason is that they care very much about the results they get for clients. When I talked to our managers in mid-September 2001, one characteristic that stood out about this firm was the genuine pain that the people in the firm were feeling at their clients’ losses as the markets tanked uncontrollably. They took no solace in their prior 10-year record, as good as it was. A lot of people in firms throughout the industry may have felt that way as well, but this firm stands out because it operates on a daily basis with this degree of concern for their clients’ wealth. Boutique within a Holding Company. Franklin Portfolio Associates is the advisor for the Vanguard Growth and Income Fund—a large-cap growth and income fund with $7 billion in assets (as of October 31, 2001). Franklin Portfolio Associates also manages a significant portion of Vanguard Morgan Growth Fund. Franklin Portfolio Associates was begun de novo by Mellon Financial Corporation as a quantitative manager in 1982 and operates as an independent firm, even though it is owned by a large company. One of Franklin’s distinctive characteristics is that it has successfully undergone a managerial succession to the next generation. John Nagorniak, who started Franklin, has retired, but John Cone, who worked with Nagorniak from the start and helped develop the models used by the firm, stepped in to succeed him. Franklin is unusual because it is a mature firm that has been able to bring in new people while retaining the same character and focus at every turn. The firm, now in its second generation of management, is a great success story in this regard. ©2002, AIMR ®

A Client’s View of Business Models in Investment Management Boutique Team within a Big Firm. Wellington Management Company (Vanguard’s predecessor firm) is a big firm that manages 15 assignments covering $93 billion for Vanguard. A boutique team at Wellington Management Company manages the bulk of Vanguard Windsor Fund, a value fund with $15.8 billion in assets (as of October 31, 2001). The Windsor Fund was probably the fund that put us on the map at a time when indexing was gaining adherents slowly. The record that John Neff and his team in the Windsor Fund generated helped to establish Vanguard’s name. Charles Freeman became Neff’s successor (Freeman worked with Neff and the other members of his team starting in 1969), and the team has continued managing the assets for the fund. (In fact, the team will start a new fund, Vanguard Capital Value, later this month). The Windsor team members do their own independent company research from their offices in Radnor, Pennsylvania, but they also talk to the Wellington analysts in Boston and to the Street. The Windsor team is part of a large and successful partnership but shares many of the attractive attributes of a focused boutique. So, even though this team is part of a large organization, it operates independently. Many benefits accrue to the Windsor team from being part of a large organization such as Wellington. Common Traits. Although our advisors are a diverse lot, they share a single focus: generating superior investment returns. All are willing to take risks—good, solid investment risks—to make money for their clients over the long term. Boosting revenue or sales on an incremental basis over the next quarter or two is not a major concern. Our advisors also have great depth in their investment decision-making teams. Interestingly, both the Windsor team and the PRIMECAP teams have chosen to add team members with little or no prior experience in the investment business. These people are then molded into analysts. The motivation for this hiring philosophy is that these management teams do not want to work with people who have been “contaminated” by other firms’ views. It is a remedy for making sure analysts fit into the team culture and philosophy and follow the firm’s investment process. Culture may seem to be a fuzzy term, but it embraces such critical elements as a firm’s investment philosophy, ethical standards, work ethic, and client orientation. It determines, for example, how the management team makes investment decisions and how it judges securities. Breadth in ability, knowledge, and experience of their employees and good succession planning are other traits these firms share. For us, these issues are vitally important, because our goal is to produce

©2002, AIMR®

funds that will serve as investment vehicles for our clients for several decades or more, not for only several years. Thus, we want the advisory firms we select to have similar characteristics, depth, and quality of personnel 10 and 20 years from now. Succession planning is vital, and we spend a lot of time on that issue, which is a primary concern of our board of directors.

Maturation Issues As firms grow, managements may stop putting the client first. Larger size means that more people need to be supported by the firm’s overhead, which puts pressure on firm revenue. Managements of growing investment firms sometimes respond to revenue pressures by taking actions to preserve revenue. These steps can conflict, directly or indirectly, with the best interests of clients. The focus of the firm can shift as these maturation issues emerge, which causes increased employee dissatisfaction and personnel turnover. Mergers and acquisitions are often seen as a resolution to these problems, even though such moves rarely benefit the clients. Consider a small innovative firm that evolves from a team of investors into a large, established firm that is in the “investment management business.” As the organization grows, its dependence on and loyalty to its long-term clients can erode. To us, loyalty is a key word, and for an investment management firm, the loyalty has to be to the clients and their longterm needs. Frederick Reichheld, a consultant for a number of years at Bain & Company in Boston, has written two books on loyalty.1 Loyalty is a powerful business concept because it keeps the focus of the firm on what is important to the client and on those products and services the firm can deliver well. As Reichheld said, leaders of high-loyalty firms “exercise superior discipline by strategically focusing only on business opportunities for which they can offer the very best value in the world so that both they and their partners can win. They know that real value, not superior salesmanship or brilliant advertising, is what generates winning growth and prosperity.”2 For us, loyalty to clients is a vitally important issue when assessing managers. And again, this trait does not depend on a particular business format or structure. It is an attitude that has to exist within the firm. One possible sign of a firm that is beginning to focus more on revenues than clients is a decision to focus 1 Frederick F. Reichheld, The Loyalty Effect: The Hidden Force behind Growth, Profits, and Lasting Value (Boston: Harvard Business School Press, 1996) and Loyalty Rules! How Today’s Leaders Build Lasting Relationships (Boston: Harvard Business School Press, 2001). 2 Reichheld, Loyalty Rules!, p. 63.

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Organizational Challenges for Investment Firms on “tracking error” relative to a benchmark, even if it means changing the investment process. Such a decision can reflect a focus on trying to avoid getting fired rather than producing superior results. The unfortunate outcome is that clients can end up owning an investment vehicle different from what they had initially purchased. In the end, both the firm and the client lose.

What Not to Do At Vanguard, we select investment firms that put the client first. Those firms that put other issues first should not expect to get hired by us. For example, Figure 2, which came from an international equity advisor, shows the firm’s performance relative to the Europe/Australasia/Far East (EAFE) Index. Before March 1994, the manager’s relative performance was volatile because the manager took some risks in managing assets. Although the manager’s performance relative to the benchmark was not predictable on a quarter-to-quarter basis, the long-term results were quite good. However, Figure 2 shows that after March 1994, the manager put in place tight risk control. We asked the people at this firm whether this shift reflected a problem with their process or a change in the investment team. They replied that neither was the cause and that consultants had told them to improve their risk control to attract a larger client base. Although this firm possessed some attractive attributes, learning of this shift in approach made us steer clear. Instead of focusing on the best interests of its clients, the firm shifted to a focus on building its business. If you had been a client of this firm from, say, 1988, how would you feel about its evolution to

running an index-plus kind of portfolio? Such a shift in strategy is of no benefit to the client. One of the best examples of what not to do if a firm wants to be hired by us came from a former Vanguard investment advisor. This firm was going through some changes. We asked several people at the firm to come in and talk about the changes and their implications. During a lengthy presentation, they stated their goals of becoming “the premier global institutional investment firm, with at least a top-five market share in core markets, a top-third position in long-term investment performance, profit growth momentum in line with the industry, and recognition as a thought-leader and trendsetter.” None of these goals said anything about achieving long-term superior investment results for the client. True, a firm can serve both its own shareholders and its clients, but for us, the primary focus has to be on serving clients. Everything else will take care of itself. Warren Buffett has commented to the effect that institutions are more concerned with form than substance. Substance in the investment management business is, quite simply, generating superior longterm results for clients. This is the reason we are in the investment management business. We want our clients to do extremely well and make money. Otherwise, they should not pay even a dime in fees. Problems arise when firms are stretched financially and focus more on the form rather than the substance of making money for their clients. From our perspective, the most successful investment firms are committed to meeting the long-term needs of their clients. The ownership structure does not matter as long as the firm executes its strategy well and remains loyal to its clients.

Figure 2. Fund Performance Relative to Its Benchmark, March 1988– September 2001 Relative Performance (%) 25 20 15 10 5 0

3/88

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9/89

3/91

9/92

3/94

9/95

3/97

9/98

3/00

9/01

©2002, AIMR ®

Evaluating Business Models & A Client’s View

Question and Answer Session Charles B. Burkhart, Jr. Jeffrey S. Molitor, CFA Question: With the pressure to reduce tracking error, what is the future of active management? Molitor: For managers who execute well, the future of active management is promising. At Vanguard, we think that a real need exists for portfolios that are, to some extent, benchmark blind. For example, the folks at PRIMECAP might look at a benchmark at the end of a six-month period to determine where they are, how they did versus the market, and whether the benchmark helps explain that performance. They never make a decision based on which stocks are in an index/ benchmark. Burkhart: The plan sponsor community, perhaps unwittingly, is driving the continued focus on relative performance. So, the concentration on relative performance has to be overturned at the sponsor level first. Managers can’t be revolutionaries without the approval of their employers. Interestingly, this focus on relative performance has created the massive hedge fund boom. As a result, a lot of long-only managers who have no experience shorting are entering the hedge fund arena because they want that hedge fund performance fee. Question: If managers are paid according to peer group performance and plan sponsors are pushing for minimal tracking error, isn’t there an incentive for all managers to be indexers? Molitor: Compensation schemes work in various ways, although we know that we have more performance-oriented fees than anybody ©2002, AIMR®

else. (We don’t call them incentive fees because we don’t think managers need the incentive.) Based on our experience, I don’t think all managers will be driven to become indexers. For example, we are starting up a fund that the advisor for our Windsor Fund will be running. Vanguard Capital Value will be a value portfolio, but its benchmark will be the Wilshire 5000 Index. Will it ever look anything like the Wilshire 5000? No, but having the Wilshire 5000 as the benchmark gives investors a sense that the manager believes he can beat the broad market. The fund manager expects to make a lot of money relative to the Wilshire 5000, which doesn’t mean the performance has to mimic it. Some managers see what their peers are doing and start going off in the same direction, even if they don’t necessarily think that is the best direction. We monitor that kind of situation and stay on top of it. I don’t want a manager to buy a telecommunications company just because someone at Fidelity likes it. Our clients are not their clients. We want managers who have a process and the discipline to come through with ideas on their own. Indexing will always have a role because of transaction costs and its inherent efficiency, but it is not going to be the entire business. Managers who can add value will definitely have a role to play. Burkhart: If we get more client attention on what I call the coreand-explore approach (in which a client has core, index-like products and then builds a clear alphaproducing strategy around the core), managers will be willing to have tracking-error dispersion. But

I go right back to the sponsors. Vanguard stands on its own on this issue. Not many firms are willing to tell managers to generate absolute returns and then not worry if they are down 25 percent when the index is down 17 percent. A lot of managers’ identities are inextricably linked to indexes. Question: A manager with an 8 percent tracking error and a real alpha of 2 percent has a 30 percent chance over 10 years of underperforming. Shouldn’t investors want to control that risk? Molitor: A lot of investors take the math too seriously. The math shows what happened in the past and is not necessarily predictive of a manager’s future performance. The probability exists that a manager will underperform at some point in time. But if clients understand that risk and they’re looking at the total portfolio, then some clients will be comfortable taking more risk and disregarding tracking error. Others, however, will still want tight tracking error and to control risk. Question: Will some of the investment talent move to hedge funds? Burkhart: Without a doubt, a widespread move of talent from traditional management to hedge funds is under way. A lot of the traditional long-only businesses are either creating hedge fund complexes within their own firms or building a hedge fund component. But there has to be some way for the stability of talent to be maintained, because when talent is undermined, huge problems arise. Unfortunately, good hedge fund

www.aimr.org • 37

Organizational Challenges for Investment Firms performance will not be successfully attained by most who start a hedge fund. It is a growing bubble—only a small percentage will stand out over time. Although at Rosemont we have not yet invested in a hedge fund, at least 15 firms will happily seed hedge funds or a fund of funds because they’re so excited about them. And for firms that can get it right, the economics are awesome. Molitor: Hedge funds are a phenomenon right now. Some will succeed, and some will not. Question: How do you structure a compensation package to keep your managers motivated? Molitor: Compensation gets back to the idea of the economics, and managers should feel as though they’re participants in the ownership of the firm. But no matter what, compensation has to be based on overall performance. Because fees are still paid on assets, better performance will lead to better revenues and some level of asset growth, assuming we get level markets. So, compensation can be based on performance versus peers or performance versus benchmarks; it can be calculated in different ways. We think it is important to have a rolling window for determining compensation. That is, a calendar-year approach does not work for us. Every fee schedule we have that has a performance structure is based on a rolling 36 months, so a manager cannot have a great 10 months and then lock everything on the index and go to the beach for 2 months. The incentives have to be long term because our clients are long-term investors. Question: How do you structure your performance fees to prevent the manager from staying too close to the index?

38 • www.aimr.org

Molitor: The incentive for the manager is that if he or she outperforms by a great deal, compensation can increase a great deal. We have some contracts in which the performance increment goes as high as 80 percent above base. (Our contracts are also structured symmetrically so the pain of underperformance is equal to the benefit of outperformance). We monitor performance and portfolio characteristics to see if a manager is getting too close to the index. In addition, we measure the expected tracking error. If the portfolio deviates significantly from what we expected, that is an issue. Most of our managers are accustomed to investing in a certain way, so a lot of them don’t tend to change their style by moving toward benchmarks. Burkhart: In addition to having a long-term focus for compensation, which not many firms have adopted yet, compensation needs to be team based and focused on the clients’ interests. It needs to be determined based on the performance of the entire investment team and within the firm’s business performance, not on a single individual’s performance. One of the problems I have seen as a consultant is that managers are getting paid outside the reasonable economic ratios of the firm. A firm makes a deal with a manager that flies in the face of the economics of the firm, and that deal can hold the firm hostage. But if the firm does not pay the manager, he or she will leave because another firm will always pay more. Keep in mind that the number one reason investment professionals leave their firms is that the compensation structure is murky, subjective, and/or at the whim of those controlling it. Question: When is equity distribution to employees appropriate?

Burkhart: If you’re sustaining a business, you don’t want to give away assets to people or situations that won’t be around for a long time. You have to have an economic core. To build that economic core, a certain amount of reinvestment in the business must occur. You can’t pay out all the profits. When we look at the profit-andloss projections for our investment prospects, we usually look at revenue, expenses, prebonus profits, bonus pool, reinvestment, any need for retained capital, and finally, distributions to shareholders. Question: What are the minimum size requirements for an outside manager? Molitor: The answer depends on the type of assignment—the character of the fund the manager will be managing and whether the manager ever managed at that scale before. It is tough for us to offer a portfolio if we don’t think it will get to at least $1 billion. If a manager has done a wonderful job managing trust accounts at $100 million but has never had an organization to support anything bigger, our decision on whether to go with that manager depends in part on whether the manager has the necessary infrastructure in place. So, the answer depends on the nature of the assignment as well as the firm, the people, and their experience. Question: Has pricing of firms changed recently? Burkhart: We have looked at this question carefully. Since mid-2000, pricing has not softened in the absolute, although earn-out consideration has become more material. And since September 11, we haven’t seen a backing off in pricing because a huge rift still exists between the number of willing and active sellers and the number of buyers. The number of buyers to

©2002, AIMR ®

Evaluating Business Models & A Client’s View sellers is at least 40 to 1; that is, there are 40 buyers for every legitimate seller. Anywhere near that ratio, prices will not suffer. Question: How do you handle the increasing “quarteritis” (i.e., short-term focus) of clients? Molitor: At Vanguard, we see ourselves as long-term investors. We’ve had managers who have had terrible runs, but we stick with them, which has paid huge dividends for our investors. One of the reasons we’re able to look beyond quarterly returns is that we are privately held. Our share price does not rise and fall on an ongoing basis. Public firms with share price pressure, however, easily get caught up in quarteritis. As far as the quarteritis of clients, we try to see clients on a regular basis, which is much easier on the institutional side than on the retail side. When we meet with clients, we explain where a fund fits into their overall investment strategy and what they can expect from it. It is really about setting expectations. It gets back to what Burkhart said about clients serving themselves poorly by having quarteritis. A number of clients, unfortunately, think quarter to quarter, as though it were an accounting type of issue, as opposed to weighing the effect of compound returns over the long term. Question: What are the valuation criteria for firms?

©2002, AIMR®

Burkhart: There are three basic measures of value in the industry that are applied in various degrees, and occasionally, one of the three does not have any importance in valuing a firm. The first is whether a public market exists for the firm. There are plenty of small, private, closely held boutiques that look nothing like even the smallest publicly traded money manager. Four or five investment banks publish, on a regular basis, the trading statistics as a multiple of revenue, income, and so on for the publicly traded managers. The second measure is discounted cash flow, which for many would-be sellers is the one measure they focus on to generate the highest value for their firm. This value is a derivation of how a firm’s asset and revenue growth will be offset by increases to expenses and compensation. And that discounted cash flow process often drives up the valuation. The third measure is comparables—trying to find 5, 10, or 15 of the most relevant private deals. What I am talking about is valuation for a potential sale. Valuations are done for all purposes—to gift stock or figure out ways to keep valuation down—so the comparables valuation has to be for a sale of a going concern. The second and third measures are the most important for valuing a private firm. Question: What do you see as the future trends in the investment management business?

Molitor: I hope more managers start their own firms. This business is dynamic and entrepreneurial. Managers are generally best served when they have the freedom to make investment decisions as they see fit and are well compensated for those decisions. Boutiques will continue to emerge, and the industry will remain dynamic. Furthermore, a number of people will probably move out of the mutual fund business. The 401(k) market, which is a capital- and people-intensive business, is wonderful, but investment managers don’t want to be in the record-keeping business. In addition, it’s tough to succeed if a fund has a solid but not spectacular record and the fund sponsor has to pay 40 bps to distributors for the privilege of being part of a supermarket. Burkhart: The past 10 years saw great aggregation in the industry, but now, great disaggregation is becoming a natural, evolutionary by-product. Very little consolidation has taken place recently, although many large-scale competitors remain fixated on consolidating multihundred-billiondollar franchises. Many more competitors now exist in almost every segment of the business. The often unmet needs of managing the business well and having strong leadership bode well for further disaggregation. Ultimately, firms will survive and prosper on excellence in best practices, regardless of whether they are far-reaching conglomerates or tiny boutiques.

www.aimr.org • 39

Views of an “Informed” Trader Harold S. Bradley Senior Vice President American Century Investment Management Kansas City, Missouri

The traditional and customary practices of order execution, including the use of soft dollars, are too often in conflict with achieving best execution for investors. Thus, these practices have come under scrutiny by the SEC and industry standard setters (such as AIMR) and firms have come under pressure to increase trade transparency and improve record keeping and accountability. Among the steps firms should take in this new environment is to demonstrate dedication to reducing trading costs, and among the best tools for that purpose (despite what many in the industry believe) is the electronic communication network.

s a former trader and portfolio manager at American Century Investment Management (ACIM), I have observed firsthand the difficulties involved in trading and the achievement of best execution. In particular, I have noticed how much of the investment management business uses the trading desk as a bill-paying function to support the business enterprise rather than as a mechanism for carrying out the fiduciary obligations owed to the client to provide best execution and to maximize the value of investment decisions. In this presentation, I will discuss the problems that stem from the myriad cross-subsidies that have been built into the commission stream and discuss how the current research payment systems may be subject to regulatory scrutiny and reform.

A

What Is Best Execution? A definition of best execution appears just about everywhere: due diligence manuals, marketing presentations, consultant questionnaires, and requests for proposals. No legal definition exists, however, or at least traditionally, there has not been one. Thus, the search for best execution has proven elusive, despite the many assurances otherwise. “We know it when we see it, but it is really hard to measure,” is an oftquoted expression on trading desks when alluding to the concept of best execution. Traders are not paid to make decisions that really work to achieve best execution and have disincentives to doing so: They have soft dollar chits to pay and shares waiting to trade for

40 • www.aimr.org

impatient, demanding, and often unrealistic portfolio managers. Traders operate under what I call “maximum risk aversion for maximum pay on the desk.” As a portfolio manager, when I made a bad decision, I blamed the trading desk. Trading is a function in which it is difficult to claim “value added” and easy to look bad in a handful of trades. As a result, it is no surprise that traders give the ambivalent answers they do when asked about best execution. New Definition. In 2000, before leaving the U.S. SEC, former commissioner Arthur Levitt started the process of articulating new standards for best execution. At the same time, both the Investment Company Institute (ICI) and AIMR were asked to convene best practices groups to help define best execution. At the December 2000 ICI Securities Law Development Conference, Gene Gohlke, associate director of the SEC Office of Compliance Inspections and Examinations, offered this definition of best execution: In placing a trade, the trading desk will seek to find a broker/dealer or alternative trading system that will execute a trade in a way that the trader believes will realize the maximum value of the investment decision.

Given the conventional wisdom surrounding best execution, this definition presents a challenge to the industry. The “investment decision” referred to in Gohlke’s definition pertains to the particular trade being executed—not to Goldman Sachs’ research yesterday, First Boston’s research last week, or a

©2002, AIMR ®

Views of an “Informed” Trader consultant who directs a lot of business to the firm. In terms of words, the change is minor, but in terms of policy, the change is rather substantial. And the addition of “alternative trading systems” in the definition is a big change. The use of electronic communication networks (ECNs) and nontraditional trading systems has exploded in the market in the past 10 years. Yet, I am told that on the buy side, institutional money managers still directly use these systems less than 7–8 percent of the time. In his presentation, Gohlke identified possible areas in which SEC auditors will spend more time. Note that he was not talking to investment professionals but, rather, to the lawyers who advise the outside directors who, in turn, advise funds and money managers. Investment managers have fiduciary obligations to boards as well as to investors in the areas of compliance systems, compliance evaluation procedures, and record keeping. Accordingly, the SEC is saying that the hiring of a consultant to measure execution quality is not sufficient proof that a manager is in compliance with getting best execution; the adequacy of order-handling systems, tradeerror experience, and timeliness of execution reports will be reviewed; and the allotment of initial public offering (IPO) shares against requested allocations will be assessed. Basically, the SEC appears to have serious concerns about how Section 28(e) of the Securities Exchange Act of 1934, which provides a “safe harbor” for firms to pay up for research, has been used and interpreted. In addition, the use of ECNs—as venues that provide greater liquidity, price improvement, and lower commission rates—will be evaluated. Many people on the buy side are not using ECNs, and this new mandate from the SEC means that the regulators want to know why. AIMR Trade Manageme nt G uideline s. AIMR’s proposed Trade Management Guidelines on best execution were announced in November 2001.1 The AIMR recommendations are consistent with the direction of the SEC. The guidelines recommend the establishment of trade management oversight committees that will be responsible for developing a trade management policy and a process to manage the efficacy of trades. Are you getting what you are paying for? Are you evaluating the service you received? And are you evaluating the providers of that service? Specifically, the implications of these guidelines are as follows: 1The

proposed guidelines are available at www.aimr.org/pdf/ standards/proposed_tmg.pdf, and the final guidelines are expected to be issued in May 2002.

©2002, AIMR®

•

•

•

• •

Substantial infrastructure spending will occur to build record-keeping and reporting systems to track and audit trading information appropriately because so many firms still operate with inadequate order management systems. The negotiation of acceptable commission ranges and documentation of the variance between negotiated and actual commission rates will become necessary. Commission rates that held at 5–6 cents a share for more than a decade should and will be negotiated down to a level closer to the 1.00–1.25 cents a share rate paid on ECNs for execution-only services. Trade management oversight committees will be established, and the internal documents prepared for these committees will be auditable by the SEC. The SEC has already been asking for these materials. Real and potential conflicts of interest must be documented. The choice of a particular trading system must be supported, and the review and evaluation of trades, broker selection, and execution performance can be expected.

What Are Soft Dollars Really Buying? In Gohlke’s definition of best execution, traders are charged with maximizing the value of the trade decision. But Robert Schwartz, the Marvin M. Speiser Professor of Finance at Baruch College, City University of New York, and Benn Steil, at the Council of Foreign Investors, have studied how little control traders actually have over the execution decision. They sent questionnaires to the chief investment officers of major investment companies that asked, “Who at your firm controls institutional commission payments?” They found that 62 percent of all trades are not controlled by traders.2 (This finding is consistent with my experience as a trader and portfolio manager.) The report also addresses how often commissions are used to pay for things other than best execution. And Steil, aggregating the information from a variety of reports on commission bundling, has stated that nearly two-thirds of soft dollar agreements are unwritten and more than one-third of brokers are a party to illegal soft dollar arrangements.3 2 Robert Schwartz and Benn Steil, “Controlling Institutional Trading Costs: We Have Met the Enemy, and It Is Us,” Journal of Portfolio Management (forthcoming). 3 Benn Steil, “Can Best Execution Be Achieved in the Current Market Structure?” Presentation given at the AIMR conference “Improving Portfolio Performance through Best Execution,” November 30–December 1, 2000, Chicago.

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Organizational Challenges for Investment Firms Clearly, soft dollar agreements play an important role in the execution decision and are often in direct conflict with an investment firm’s fiduciary duty to the client. What are soft dollars really buying? How extensively is soft dollar business affecting the trading decision and ultimately usurping the goal of best execution? Research. Investment managers pay up for execution and have a safe harbor to do so to some extent under Section 28(e), because in exchange for paying up, they receive company proprietary research services, including access to analysts and road shows with corporate executives. But now that these executives are subject to Regulation Fair Disclosure (FD), why are managers still willing to pay up? The willingness to pay up is especially thoughtprovoking because most investment management firms choose to “buy” their research from brandname companies (paying up relatively more), even when firm or brand name is obviously not a proxy for quality. Based on the following observations, this attraction to brand appears to be quite misplaced: Only 41 percent of analysts at the 10 largest brokers (what I consider the brand-name brokers) rank as StarMine four- or five-star analysts, compared with 35 percent of analysts at all firms having 10 or more analysts.4 Rankings are based on the earliest directional correctness and accuracy of the analysts’ EPS estimates for the trailing four quarters and two years as well as on the accuracy of buy, sell, and hold recommendations. The top five firms with the largest percentage of four- and five-star analysts are regional or niche research firms without significant investment banking activities, namely, Buckingham Research Group, Gerard Klauer Mattison, Pacific Growth Equities, U.S. Bancorp, and WR Hambrecht + Company. At the 10 largest brokers, 25 percent of the analysts ranked poorly, as one- or two-star performers. Obviously, the rationale that brand-name research is a worthy use of the client’s commission dollar is suspect at best. Yet, the industry persists in supporting the practice of “buying” research with soft dollars, which is a major factor in holding negotiated commission rates at the 6 cent level. ■ A safe harbor? In his speech to the Securities Industry Association in November 2000, Levitt asked whether portfolio managers were bringing to bear the pressure they should on brokerage commission rates and why the emergence of electronic markets had not driven full-service commissions lower. If a trade on an ECN costs a penny or less a share, why do most people on the buy side still pay 5–6 cents a share? Do portfolio managers and independent 4 StarMine

is an ACIM portfolio company.

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directors think 6 cents is safe, that it falls within the safe harbor exception of Section 28(e)? Levitt said that 6 cents is not a safe rate and that those who think it is should reexamine the part of their business that is predicated on 6 cents being safe. The status quo of the industry’s trading and execution practices is being seriously challenged by the SEC. And Figure 1 shows that, although the median commission rate has been steadily decreasing since 1989 because of technological advances and commission unbundling, immediately following Levitt’s speech in 2000, the median rate dropped below 5 cents a share. Apparently, the market heard and understood the message. ■ The real cost of research. Understandably, investors must pay a cost for block trading, capital facilitation, value-added research, and IPOs, but what is that cost (i.e., the real cost of trading)? Figure 2 compares average cost-per-share rates at ACIM with the industry median. The solid line depicts the rates our agency brokers have been willing to negotiate. The rate has not dropped significantly since 1989, even though we have tried, with minimal success, to move it lower. (Of course, with regulators and professional organizations like AIMR and ICI moving the issues of best execution and soft dollar business to the forefront, the tenor and tone of the market changed markedly in 2001.) The dashed line in Figure 2 shows ACIM’s average cost for using ECNs, where we do 35–40 percent of our business. The difference in the rate charged by our agency brokers and the rate charged by the ECNs can be thought of as a premium paid for research. In 2001, this premium is at an all-time high. When the value of research should be worth far less than ever before, given Regulation FD and the information overload via the Internet, the cost of soft dollar research is at a record high mainly because technology has lowered the real cost of trading while the “old rules” of trading and execution have kept the actual cost of trading artificially high. I used to be convinced that the more business we did on ECNs, the more our costs would rise (and the less the marginal benefit would be) because of a structural reversion to the mean. Table 1 illustrates, however, that the mean for all-in trading costs is down, not up. As our business on these nontraditional systems increases, our overall efficacy, as measured against other brokers doing similar business in the same time frame, has widened. ECNs are far more effective than the traditional exchanges. They remove structural, intermediated costs. The nontraditional players, highlighted in bold in Table 1, are important; in particular, B-Trade, Archipelago, and Instinet have helped lower our

©2002, AIMR ®

Views of an “Informed” Trader Figure 1. NYSE-Listed Share Trading Volume and Capital Research Associates’ Industry Median Commissions, 1989–2001 Annual Listed Share Volume (billions)

Cents Per Share

350

7

300

6

250

5

200

4

150

3

100

2

50

1

0

0 1989

1990

1991

1992

1993

1994

NYSE Share Volume (left axis)

1995

1996

1997

1998

1999

2000

2001

CRA Median Commission (right axis)

Note: Commission chart inclusive of ECN agency fees.

costs of trading. Broker 3, one of the most respected Nasdaq market-making firms in the business, produced costs equal to 2.03 percent of principal, roundtrip on Nasdaq trades, whereas Archipelago and Instinet both produced a negative cost. According to Capital Research Associates’ methodology, “negative cost” means that the day after our order is finished, the price of the stock we sold is still falling. In other words, we have not telegraphed our intentions to the rest of the market in moving big orders and we have succeeded in executing at a relatively fair price. Use of electronic trading for listed stocks has only recently begun to pick up steam; Archipelago linked into the Nasdaq system to display orders in the public market early in 2001. Traders can now put their order indications into the public quote system and split the spreads charged by the specialists. The ability to lower costs this way is compelling.

©2002, AIMR®

Market Stability. For decades, brokers have justified all types of structural cross-subsidies by claiming that when markets are under stress, the broker will help stabilize the market. The popular theory was that the ability to get best execution depends on a broker’s willingness to lay capital on the line during times of market distress, when that capital infusion is really needed. In their forthcoming article, Schwartz and Steil conclude, instead, that the buy-side institutions’ call on street capital for immediacy of execution is an insurance or option to protect the investment manager’s identity and order size from being captured by intermediaries and transmitted to competitors—to avoid being front-run. To support their contention, Schwartz and Steil point out that, based on the responses to their survey, portfolio managers only rarely create orders based on seeing the other side through a telephone call, trading activity, or order

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Organizational Challenges for Investment Firms Figure 2. Historical Commission Trends, 1989–2001 Average Cost Per Share (cents) 9

8 7 6 5 4

3 2 1 0 1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

Agency Brokers

CRA Industry Median

ACIM Average Rate

ECNs

1999

2000

2001

Table 1. Capital Research Associates’ Study of ACIM All-In Trading Costs Cost as Percentage of Principal

Broker

Dollars Traded

Average Market Cap (billions)

ACIM funds average

$47,607,820,875

$56.76

Broker 1

4,263,056,375

48.67

45

0.66

Broker 2

2,637,630,000

47.28

45

0.93

0.23

Broker 3

1,672,943,750

42.69

56

2.03

–0.40

Broker 4a

1,738,325,000

35.23

51

–1.00

0.24

Instinet

2,219,195,000

61.35

61

–0.23

–2.72

Average Volatility

OTC

Listed

51%

0.49 bps

0.32 bps 0.28

923,983,750

45.17

53

0.61

–0.25

B-Trade

3,697,211,250

56.24

63

0.84

–0.28

Archipelago

5,855,745,250

65.83

64

–0.06

–0.46

Traditional brokersb

10,311,955,125

43.47

49

0.66

0.09

Electronic brokers

12,696,135,250

57.15

60

0.29

–0.93

Crossing Network

Note: Data reflect non-dollar-weighted mean of 10 six-month periods, June 30, 1997, through June 30, 2001 (post-order-handling rules). a Negative bThe

OTC costs are a function of aftermarket IPO performance. “traditional brokers” category reflects four large brokers only.

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©2002, AIMR ®

Views of an “Informed” Trader flow in the market. Investment managers appear to be attributing their willingness to pay up for liquidity to a reason that is not borne out in practice.

Order Life Cycle Understanding how orders are executed and how the trading system is changing can shed light on the challenges of achieving best execution because of competing interests in the trading process. The life cycle of an order at the NYSE follows a convoluted route littered with at least seven intermediaries: An order travels from a portfolio manager to the trader, to a broker sales trader, to a “block,” “position,” or “upstairs” trader, to a floor broker, and finally, to the specialist post. Here is how it works. A portfolio manager decides to buy a stock and calls his institutional trader at the trading desk. That trader then tries to figure out which broker she might have heard from in the last two days that might have an order in that stock or, as likely, identifies a broker to whom the manager owes a consultant bill or who holds a soft dollar chit. She then gives the trade to the trader at that brokerage firm. The broker sales trader is the most frequent and trusted point of contact for the institutional sales trader. But then there is the broker “upstairs” trader, whose job is to trade the firm’s block capital. The reason brokers staff a sales trader position is ostensibly to protect the investor from the upstairs trader. For example, if the investor gives a 500,000-share order to the sales trader in Chicago, a trusted sales trader will not immediately disclose this information to the upstairs trader in New York. If the upstairs trader communicates this information throughout the system and is then asked to bid someone else’s stock, that information alone might trigger “go along” activity and have an unfavorable impact on the price of the first trader’s order. Investors need protection from the upstairs trader, but that upstairs trader is also the broker’s representative for the investor’s interest with the NYSE floor broker. The floor broker may be representing not only the firm representing that investor but also other firms and, therefore, other investors. The floor broker then goes to the specialist, who posts the order to the tape as part of the National Best Bid and Offer (NBBO) system, as seen on Bloomberg. The whole process is repeated on the other side of the trade. Now consider order half-life. Orders travel from investor to specialist, with successively smaller order amounts passing from trader to trader within this sort of “bucket brigade.” Everybody buys and sells exactly the same way. After an investor gives the institutional trader 500,000 shares to trade, that insti©2002, AIMR®

tutional trader gives the sales trader 250,000 shares to trade. The sales trader gives the upstairs trader 125,000 shares to trade, and the upstairs trader, through the floor broker, tells the specialist to post 25,000 shares. With such a system, no wonder traders believe that trading is a win–lose function. In a market driven by eighths (before decimalization), commissions and trading spreads were plentiful and the mix of traditional roles in the execution process was sufficient assurance that everyone on the sell side would do well. In a market now driven by decimals, the life cycle of an order has not changed but the economics of the business certainly has. In the retail universe, a theory exists that payment for order flow and internalization of orders has been a large part of the profits of the business. This precedent is collapsing because both ECNs and decimalization have so markedly changed the economics of the execution process. T h e S p e c i a l i s t . Because of the completely counterintuitive auction rules that govern trading on the NYSE, getting the best price in the market is often difficult. Let me explain what I mean with the following example. Say I go to a wine auction to buy a special case of wine. I want this wine badly because it is rated as one of the top wines of the new vintages; in 10 years, it will be worth a bundle, plus I will have good wine in the cellar. The bidding starts and quickly rises to $3,000 a bottle. I know I should not pay that much, but the auctioneer calls the bid and says I just purchased the wine. The case is opened, and I am handed four bottles—and then four bottles go to a person who was sitting three feet away from me who never opened her mouth, and another four bottles go to someone on the telephone. Before the bidding started and unknown to me, these two people said that they wanted to participate in the trade and buy at the highest price that cleared the supply. Such are the rules of trading at the NYSE. The rules allow free options to third parties, so despite the theory published in the academic literature on auction markets, serious obstacles exist to discovering an appropriate clearing price. As long as a third party is allowed to forgo the risk of price discovery, that third party gets a free option on whatever is being traded. I find that situation fundamentally wrong. In my earlier example, the wine seller did not get the right price because I, as an interested buyer, was not allowed to bid for all the bottles I wanted and the other bidders were essentially removed from the bidding process altogether. Little information is available on the profitability of specialists. A major NYSE specialist firm, LaBranche & Company, did recently go public, however, which provided some clues. The initial offering

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Organizational Challenges for Investment Firms prospectus showed that LaBranche consistently earned more than 75 percent of its profits from dealer trader activity, had been profitable every quarter for 22 years, and averaged consistent returns on capital and equity of more than 70 percent. If LaBranche’s numbers are typical of the economics of NYSE specialists, are investors benefiting from the intervention of the specialist, or do specialists simply impose another layer of expense? Clean Cross Rule. The clean cross rule (Rule 72[b]) at the NYSE also grants a free option for liquidity takers and proprietary interests. A clean cross is a trade involving a matched pair of buy and sell orders of 25,000 shares or more that cannot be broken up (that is, disclosed floor interest is not included in the trade). Rule 72(b) currently gives priority to clean crosses at or within the prevailing quotation, and crosses are not allowed if any part of the cross is an order for the account of a member or member firm. An amendment to Rule 72(b) filed by the NYSE provides for clean crosses even if all or part of the order is for a member or member firm. Say you are a buyer bidding for 25,000 shares at $20 and the order is on the book as a limit order displayed for the whole world to see on Bloomberg. A broker has a customer who wants to sell 100,000 shares at $20 and another customer (or the broker himself) who wants to buy 100,000 at $20. They trade with each other, and your order remains unexecuted. Such a situation is worse than the situation with the specialist I just described because under the amendment, a broker can trade proprietarily on one side of a block trade and ignore preexisting orders on the trading floor. The rules of trading are designed for the intermediaries and grant absolute free options to limit order traders in the market. Transparent limit orders provide the basis for price discovery in listed equities markets. I believe limit orders are an endangered species. Institutional Xpress. The NYSE has finally paid attention to the ICI, which has been saying for a long time that limit orders are being subjected to free options. Accordingly, the NYSE established Institutional Xpress, which is designed to allow the institutional investor to take an offering or hit a displayed limit order through the NYSE DOT (designated order turnaround) system without an attempt to gain price improvement. Ironically, the rules governing Institutional Xpress provide an opportunity for, instead, price improvement of a market order. This is but another example of rules beneficial to brokers and inimical to the interests of buy-side traders.

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Why Not ECNs? ECNs improve the traditional execution mechanism and eliminate the requirement of dealing with the specialist. An ECN is a limit order book, and limit orders have primacy. The most important aspects of primacy are price priority, time priority, anonymity, and an order cancellation privilege—absolute control over entry into and exit from the market. The ability to cancel orders at will establishes a potential time value on options; they are no longer free. Nicholas Economides and Schwartz found that investors appreciate the motives for trading on ECNs but that the soft dollar arrangements that traders must satisfy may stymie ECN use.5 Nevertheless, despite the electronic trading systems’ proven advantages, the buy side still has not welcomed ECNs with open arms. Ian Domowitz and Steil concluded: An examination of total trading costs, inclusive of commissions, reveals electronic trading to be superior to traditional brokerage by any measure of trade difficulty for buy trades and to be comparable for sells.6

Traders give several reasons for not trading on ECNs. Traders claim that large orders cannot be executed efficiently on ECNs and that executing through ECNs conflicts with the immediacy required to execute before an anticipated market move. Traders need to recognize that, in fact, ECNs not only offer the anonymity they seek but can also effectively execute large orders through rapid-fire small, block-equivalent trades—as do brokers and market makers today. Anonymity. Above all, both buy-side and sellside traders seek order anonymity in the market. Yet, the identity of the firm, the size of the firm, and its trading practices are all known by the intermediary chosen to execute an order for a buy-side client. That intermediary has a relationship with at least 200 other high-commission-paying firms. Certainly, a relationship with some degree of trust exists between the trader and the sales trader, but that trust can break down rather easily. Because of the very nature of the system, then, believing that a firm is working just for you or not leaking information about your order into the system is naive. ECNs, however, are the very definition of anonymity in trading. 5 Nicholas

Economides and Robert A. Schwartz, “Equity Trading Practices and Market Structure: Assessing Asset Managers’ Demand for Immediacy,” Financial Markets, Institutions & Instruments (November 1995):1–45. 6 Ian Domowitz and Benn Steil, “Automation, Trading Costs, and the Structure of the Securities Trading Industry,” BrookingsWharton: Papers on Financial Services, edited by Robert E. Litan and Anthony M. Santomero (Washington, DC: The Brookings Institution, 1999):33–81.

©2002, AIMR ®

Views of an “Informed” Trader Size. Traders have been heard to say, “Look at these screens. The orders are all for 1,000 shares, and on Nasdaq, they are offering 100 shares; there is no liquidity.” This liquidity argument is largely moot; large, hidden limit orders, which are basically reserve quantities, exist on ECNs. The Nasdaq has just petitioned for a rule change that would allow market makers to show only 100 shares of an order to the market while at the same time placing as much as tens of thousands of shares in a nontransparent order queue. A benefit of this capability is that to trade 1,000 shares, you can execute 10 trades of 100 shares electronically and virtually simultaneously without advertising to adversaries what you are doing. Buy-side traders prefer to trade large blocks of stock because blocks are easier to account for and to book. The typical trader’s viewpoint is that block trades cannot be executed on ECNs. But we find that when we use an ECN for listed trades and an order is published and highly visible, we tend to attract the other side of an order more easily. That advantage has interesting implications, especially considering the recent merger between Archipelago and REDIBook and the SEC’s approval of Archipelago becoming a fully electronic exchange. With the emergence of a fully electronic exchange, the buy side will apparently be able to drive the best price in the market while avoiding unnecessary intermediation. A block trade that uses a broker’s capital is not a charitable gift. Brokers traditionally “rent” capital when trading a block because natural counterparties are said to occur only about 20 percent of the time. Brokers regularly make capital for block facilitation available only to payers of the largest commissions— which is functionally identical to offering a commission discount. Then, if they lose money on the trades, they earn full “rents” from smaller full-commission players, so they are making up the difference with commissions from the smaller firms that do not have that same kind of leverage with the broker. This “loss ratio” is a major component of the cross-subsidies that underpin the soft dollar business. Ultimately, the little guy loses. Historically, brokers served as “small order aggregators” working off negotiated block transactions in small increments over the phone, SelectNet, or ECNs. ECNs, however, eliminate the risk premium that institutions pay to trade; technology replaces capital in the aggregation process. Our traders work aggressively to get the best price for block size on ECNs. At ACIM, we use FIX technology, the financial information exchange protocol, to send orders to ECNs, and we have been successful in trading extremely large orders on ECNs; we regularly execute orders of more than a million ©2002, AIMR®

shares. Surprisingly, the average trade size for a Nasdaq stock on an ECN is fewer than 1,000 shares. We use DOT and Archipelago to access the liquidity on the NYSE, and we are increasingly successful at trading large orders in NYSE-listed securities on ECNs. A good example of our success in trading blocks on ECNs is what we were able to accomplish during the period from June 1 to August 31, 2001, the summer doldrums, when the entire equity market’s volume is at its lowest level. We averaged on a daily basis more than 13 orders of more than 50,000 shares; 6 orders between 50,000 and 100,000 shares; 4 orders between 101,000 and 250,000 shares; and almost 2 orders between 251,000 and 500,000 shares. And these trade sizes are fairly conservative in terms of what can be executed on ECNs. For example, during the same period, we used ECNs to trade 12.1 million shares of AOL with an average order size of 202,000 shares and a total principal value of $526 million. We also traded 12.1 million shares of Pfizer ($494 million of principal and average order size of 181,000 shares). We chose to make these trades on ECNs because we wanted anonymity. When the market sees you trading in a name, the other buyers immediately look to see how big you are in the name and make inferences about why you are selling or buying. That is how the Street anticipates price action. Immediacy. Another buy-side trader objection to using ECNs is the need to implement a trade “right now” in one block at a single price. Part of the trader’s demand for immediacy is the culture of blame transfer—that is, portfolio managers blaming traders for the portfolio managers’ own mistakes. When the buy-side trader hands an order to a broker, the trader has someone to yell at on behalf of an impatient portfolio manager. Schwartz and Steil surveyed portfolio managers and chief investment officers about how much weight they give in stock purchase decisions to an estimate of share price in one day, one week, one quarter, one year, or two years or more. Most managers profess that they do not care what the share price will be one day or even one quarter out but do care about the price at one to two years out. That finding has profound implications. Why would portfolio managers, who may take days or weeks to make a purchase or sell decision, expect a trade to be done “right now” unless their ego is heavily invested in micromanaging the trader? Schwartz and Steil also asked how soon the managers expected a price correction to occur when buying or selling a stock that was believed to be mispriced. Most answered one month to one year or more than one year, not less than an hour or one week to one month. So, again, managers’ timing

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Organizational Challenges for Investment Firms expectations do not appear to align with their demands. Immediacy is simply not the impetus for trading that many managers claim.

Changes Affecting ECNs In 1975, the Exchange Act called for a linked national market in which prices in one market would be respected in other markets. More than 20 years passed before the SEC took another major step toward encouraging market linkage with the enactment of the order-handling rules in 1997. These rules were an attempt to tie together markets fragmented by Instinet and other ECNs. It required ECNs to include orders in the public display of the NBBO. Although the Nasdaq intermarket gives ECNs a path to the listed market and exchange-traded funds, barriers to unification of the markets exist, such as the access fee the ECNs are charged. Archipelago chose to voluntarily comply with the order-handling rules but is the only ECN to have done so. The SEC has suggested that the application of the order-handling rules and Regulation ATS (alternative trading systems) to listed stocks is unfinished business. ECNs, however, represent an estimated 40 percent of Nasdaq volume, and ECN quotes drive the inside market. The intermarket trading system (ITS)/Computer Assisted Execution System (CAES) link to the NBBO offered by Nasdaq to its members, who include Archipelago, is rapidly changing the marketplace. For the 62 days ending March 31, 2001, before Archipelago linked to the market through ITS/CAES, we traded only 35 orders for NYSE-listed stocks, compared with 121 listed orders in the 65 days after the linkage on August 31, 2001. Pre-ITS/CAES, these orders were excluded from market quotes, but postITS/CAES, the orders were transparent as limit orders to all market participants. We can now advertise our intention to trade. Nevertheless, some traders are expressing frustrations similar to those expressed about Nasdaq trades before the instigation of the order-handling rules. The complaint is about “trade-throughs” and “backing away” (the latter occurs when one linked market trades at an inferior price to another market’s price—say, the NYSE— as reflected in the NBBO). We started putting our listed orders into the system, and because of trade-throughs, we could not get some trades executed without compromise. As a result, Archipelago and Nasdaq built so-called “whiner” software (because we whined a lot). The “whine” is automatically triggered when (1) the public quote exceeds 100 shares at a price in the NBBO and (2) the order in Archipelago’s ARCA book is at a superior price to the competing exchange and (3) the ARCA

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order is displayed for 15 seconds before a trade takes place at the inferior price in the NYSE and (4) the trade remains unexecuted for at least 10 seconds after the trade at the inferior price. Whining is a frequent occurrence. The specialists believe the market resides with them, and an imputed belief is that the regional exchanges are not contributing to price discovery, which has, in fact, been true historically. Prior to decimalization, the regional exchanges were used primarily by retail firms, such as Charles Schwab & Company, to maximize profitability by routing orders and earning payment for order flow from the regional exchanges. Since decimalization, the practice of payment for order flow appears to be breaking down, which has changed the economic structure of many order flow arrangements. Now, as real electronic orders flow through Nasdaq (and soon, through the Pacific Coast Exchange), the NYSE is trying to make sure orders have to come to it. A good audit trail does not exist that reveals the primary exchanges’ failure to recognize better prices on regional exchanges. But from mid-June through August, Archipelago and Nasdaq recorded more than 1,500 NYSE whines a day, which is a big concern. It means that either the specialists cannot keep up with both an electronic market and a physical market, which is a reasonable explanation, or that they are ignoring the electronic market because they are granting free options to the floor crowd. Until the market adjusts to a more integrated system, these whines have important implications for how managers manage, especially given the environment of 2–4 percent real expected stock returns suggested by Robert Arnott and Peter Bernstein7 and the fact that the cost of trading is estimated to be 1–3 percent for small- and mid-cap stocks. The impediments to trading are regulatory— that is, driven by market regulations designed to protect the owners of the marketplace. I am a big fan of Archipelago’s move to partner with the Pacific Stock Exchange to form a new for-profit stock exchange. A for-profit stock exchange is not owned by intermediaries and not run for intermediaries; it is owned by and run for the stockholders.

Conclusion The problems with achieving best execution cannot be separated from the existing economics of trading systems and the reluctance of traders and portfolio managers to change the way they approach the trading function. Roughly 65 percent of ECN users are broker/dealers and hedge funds and 25 percent are 7 Robert D. Arnott and Peter L. Bernstein, “What Risk Premium Is ‘Normal’?” Financial Analysts Journal (March/April 2002):64–85.

©2002, AIMR ®

Views of an “Informed” Trader day traders. As I mentioned earlier, only about 7–8 percent of ECN users are on the buy side. Schwartz and Steil wrote: Survey results clearly suggest that the traditional explanation for immediacy demand . . . is overstated. We conclude that the buy side’s demand for immediacy is in appreciable part endogenous to an intermediated environment that is characterized by front-running.

Although some may find this view to be too cynical, the statement summarizes the behavior and rationale that I have witnessed over the course of my career. Is unbundling of commissions and research and other soft dollar services desirable and feasible? In the same Schwartz and Steil survey mentioned previously, they found that 51 percent of managers believe unbundling commissions from the research process is desirable and only 8 percent believe it is undesirable. The bundled process, however, has a major positive impact on the earnings stream of many investment managers. In the United Kingdom, Paul Myners, chairman of the Gartmore Group and one of the most respected money managers in the United Kingdom, was asked to investigate the inefficiencies of capital formation for small- and mid-cap U.K. firms. One of the recommendations he made was that all commissions be paid by the manager out of the management fee. U.K. firms have been given two years to respond to and implement the recommendations. Although such action is a long way off in the United States, in light of the SEC’s direction and AIMR’s new guidelines, U.S. firms should begin to address the following questions: • Is the commission you pay really protected by the safe harbor? It probably is not safe at 6 cents, or even 5 cents. • Do you use ECNs? When? How much? How do you make that choice? You must first give your traders permission to be traders. • Do you pay the same brokerage rate to all vendors and the same rate on all trades? If so, why? Lower negotiated rates alone are not sufficient. The SEC is looking for some variance within the rates paid to the same broker among trades. Some firms are paying 2–3 cents for taking the other side of a trade and paying 6 cents for capital

©2002, AIMR®

commitment. These investment management firms have a formula for determining what they pay for various kinds of trades. • How do you measure best execution? Whether you use Capital Research Associates, Plexus Group (implementation shortfall methodology), or volume-weighted average price, part of the answer to achieving best execution lies in having a process to measure it. • Have you invested in sufficient trading technology? Or are your traders bill-paying order clerks? • Do you know where your orders go? The order execution process is, in my opinion, sausage making at its worst. It is where the source of performance resides, especially in a potentially low-return environment. • Regarding step-outs, are the rates and best execution promises consistent with what your marketing agent tells the sponsor? A lot of firms use step-outs and think they are getting best execution by using them. But almost everybody I talk to on the sell side tells me they have an A list and a B list, and the firms that step out are on the B list. If you are calling a potential buyer with merchandise and you know there are three or four buyers around and you have a seller for something that is hot, you call the buyer that will maximize your income. You cannot maximize your income on that trade if 40 percent of the trade is going to be stepped out to a third party. Attention to these issues will help firms get on the right track and avoid problems in the future. The bottom line is that trading decisions are not driven simply by the search for best execution. Too many conflicting economic currents and motivations affect the execution decision, which more often than not, is made by someone other than the trader. Paying up to execute is a function of the traditional and customary practice of buying broker services— research and market stability—with soft dollars, but this practice has been targeted by the SEC and industry standard setters (such as AIMR) as needing increased transparency and improved record keeping and accountability.

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Organizational Challenges for Investment Firms

Question and Answer Session Harold S. Bradley Question: Should soft dollars be outlawed? Bradley: That is a complicated question. The answer is not simply yes or no, which is why the SEC changed the standard in 1986. It did not want to get into a categorical approval or denial of a specific use of soft dollars. As a firm, we have relied on the pre-1986 standard for a long time, which says that if a service is available for cash, pay cash. We think that practice is consistent with our clients’ interests. Many smaller firms have said that they have to use soft dollars, which I would categorize as paying third parties for services that are allowed under Section 28(e). The real key to the appropriate use of soft dollars is commission rates, which explains why Levitt said 6 cents is not safe. Question: What do you think about the AIMR soft dollar standards? Bradley: AIMR has had a tough time establishing soft dollar standards because of the diversity of opinions in the business. What bothers me about the AIMR guidelines are the complex issues, such as mixed use. How am I going to audit and control whether 40 percent of my computer system is related to benefiting the investor? In addition, Section 28(e) gets a different spin when you have to answer Gohlke’s question: Have you maximized the value of this trade decision? That’s a far different question in terms of paying up than the old 28(e) safe harbor, which said you can pay up as long as you are benefiting your investor.

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Question: How does ECN use affect how large-cap stocks or small-cap stocks are traded? Bradley: We started relying on ECNs in 1992, and we’ve found tremendous value in using them for small-cap and illiquid securities. Telegraphing a 10,000-share order to a broker was far more damaging in those stocks than it was in, say, Microsoft. Using ECNs to trade in small-cap, illiquid stocks provides the most value because then people do not know who you are. With ECNs, you can disguise the size and reserve order requirements and control the market impact going in. Brokers don’t commit their capital for free. When you give them a 10,000-share order on small-cap stock, they know they’re going to lose money if they don’t price it high enough. Question: What is your opinion of the mergers, actual or potential, between the exchanges? Bradley: Through my private equity activities, I have been close to Tradepoint in the United Kingdom and the Swiss exchanges. I was on the Tradepoint board and serve as an advisor to the Archipelago board. That said, I see these trends as an inevitable consolidation process that will affect both ECNs and exchanges. Last week, Archipelago, by some measures the fourth largest ECN, announced a merger with REDIBook, the third largest ECN. REDIBook is owned by Spear, Leeds & Kellogg, or was until Goldman Sachs bought Spear Leeds in 2000. REDIBook is also owned by Charles Schwab and Fidelity. Archipelago is owned in part by J.P. Morgan Chase & Company, American Century, Merrill

Lynch & Company, Goldman Sachs, and E*Trade. A month ago Archipelago was granted stock exchange approval by the SEC and will be operational as a fully electronic stock exchange, the only one of its kind in the country. In merging with Archipelago, REDIBook is choosing to make a bet that it can produce a book for exchanges much like existing exchange structures in Europe, which provide limit order primacy, ease of entry and exit from the market, and multiple points of technology failure. This merger has major implications for both the Nasdaq and the NYSE, both of which have been slow in responding to some of the technological changes that threaten to remake the basic infrastructure at the management level and the trading level. The biggest change in the next couple of years will be the payment structure. Decimalization is happening at the same time that commissions are starting to fall, so the Street is losing a primary source of revenue. The commission structure has been a major source of cross-subsidies, and its change will also have an impact on research, so it bears watching. This merger creates an interesting exchange opportunity. Archipelago, a shareholder in Tradepoint, has also been engaged globally for some time, so electronic markets can be global. The problem in terms of cross-border investing is that the SEC’s rules have kept foreign non-GAAPdenominated shares from being traded electronically in the United States. Ironically, I can call a broker to trade non-GAAP issues; I just cannot do it on a computer screen.

©2002, AIMR ®

Technology, Data, and Experts: The Factors in Industry Change Ronald Layard-Liesching Chief Research Officer Pareto Partners London

The key factors of future industry change will be technology, data, and experts. Technology will pose a serious threat to active risk budgets, will be central to efforts to cope with the exponential increase in data, and will weaken the “symbolic barrier” that has made investment management such a lucrative industry. Because firms will tend to move away from homogeneous areas of investment (less profitable) and toward heterogeneous areas (more profitable), firms will need to make more effective use of experts (otherwise known as human capital), but doing so will mean helping them surmount their own cognitive biases. Many of these trends will be brought into play by the global privatization of fixed-income markets, which will have major investment implications.

y presentation outlines six major themes regarding trends in financial markets and investment management. First, technology presents a serious threat to active risk budgets. It will disintermediate global financial intermediaries and transform their economic model in the next 5–10 years. Second, investment management is knowledgedirected search. The challenge of managing the exponential data rate depends critically on technology. Third, the investment profession has historically been protected by a “symbolic barrier.” This barrier allowed financial experts to enjoy highly favorable comparative compensation. Technology poses a serious threat to the maintenance of this barrier. Fourth, the world’s fixed-income markets are undergoing privatization. Fifth, cognitive biases can cause investment managers to misuse their risk budget, so steps must be taken to mitigate this potentiality. Finally, organizing an investment management business is becoming more challenging—as both clients and the investment management process have become much more sophisticated.

M

The Technology Threat to Active Risk Budgets The technology threat to active risk budgets is shown in Table 1. During the 1996–2001 period, the median

©2002, AIMR®

manager did not add much value relative to the tracking error: There was little return for the active risk budget spent. At Pareto Partners, we find that in North America, our large clients (who are all big institutional investors) are tidying up their domestic manager lineup. Change is mandated by poor performance and the time demands of managing the managers. For example, one of our U.S. clients had $4.5 billion with 13 active U.S. equity managers. The entire portfolio earned an aggregated return of –40 bps a year versus the benchmark. As a result, this client has cut the number of active managers and is spending the active risk budget elsewhere. Because of the risk budgeting framework, risk attribution software is becoming a critical factor in the investment management and evaluation process: Is the portfolio risk taken by managers being adequately rewarded? The U.S. equity market is the world’s most liquid and information-rich market with 14,000 registered investment advisors. Should sufficient inefficiencies be expected in the large-cap sector so that active, long-only managers can generate great added value? I would suggest not. In my opinion, risk-attribution software is a threat to the livelihood of active longonly selectors in liquid and efficient markets. Once clients have the tools to monitor how their risk budget is being spent, active investing in large liquid markets will be viewed less positively.

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Organizational Challenges for Investment Firms Table 1. Median Manager Performance, 1996–2001 Return

Value Added

Median managera

10.54%

0.32%

S&P 500

10.22

Investment

Tracking Error

U.S. equities 12.90%

U.S. fixed income Median managera

7.92

Lehman Aggregate

8.05

–0.07

1.06

2.77

10.05

0.71

0.92

International equities Median managera MSCI

2.63 –0.14

Currency overlay Median managerb

0.71

a

Based on Callan Associates data for performance to third quarter 2001. bBased on Frank Russell Company data for performance to third quarter 2001.

One way to address this threat is to become less benchmark focused and return to the original principle of investing: maximizing the efficient use of risk. Table 1 shows that the median fixed-income core manager has “added” about a –0.07 percent return compared with the Lehman Brothers Aggregate Bond Index. Of course, the reason for the negative number is the three-year bear market in high-yield bonds. Managers experience difficulty adding value within the U.S. government sector. This fixed-income market is the most liquid in the world. It is a market for which everyone has an “arbitrage-free” model. Therefore, one would expect that within the fixedincome world, managers would overweight spread product. Consequently, when spread product blows out, the fixed-income managers underperform. Managers employ such systematic tilts in equities as well. In international equity management, the results are better, with the median manager adding 2.77 percent for the 5-year period. Half of this alpha, according to the analysis of Dr. Peter Rathjens at Arrowstreet Capital,1 comes from systematic tilts: underweighting Japan and overweighting emerging markets. The other half is genuine active stockselection alpha. The world financial markets are moving toward both the U.S. investment model and U.S. valuation criteria. This shift means that U.S. analysts/investors have a comparative advantage relative to non-U.S. analysts/investors—because they are already familiar with how the model works. For example, each country in continental Europe used to have its own central bank. This meant that 1 Dr. P. Rathjens, “Managing Active Tilts,” Arrowstreet Journal (Winter 2002):www.arrowstreetcapital.com.

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the 11 different central banks jealously guarded their own banking systems. One expects excess capacity in European banking because of this regulatory barrier. Now, with the arrival of the euro, as well as improved technology and Internet banking, the equilibrium number of European banks should be reduced. There are currently some 10,000 banks in Europe. It is safe to forecast a decline in this number. U.S. analysts are better positioned to isolate the winners and losers than are the local analysts because the world is moving to the American model. Concepts such as riskadjusted return on capital and economic value added were not invented in Portugal. Although our firm does not manage international equities, this sector represents an excellent alpha opportunity for our clients. Another area of added value is currency management. The median manager, according to the data in Table 1, has provided 71 bps a year in added value through currency overlay. In one sense, this added value is surprising because foreign exchange is the most liquid and, theoretically, efficient market in the world. As in the hedge fund world, issues of reporting, emergence, and survivor biases exist. Nonetheless, value has been added by currency management, and investor interest in currency strategies has risen rapidly around the world. A fund with 20 percent of its assets invested internationally must develop a currency management policy—half the fund’s return (whether positive or negative) in an average year comes from currency moves. The currency risk is too material to be ignored. The U.S. investment approach of taking an active long-only portfolio (in any activity) and decomposing it into a passive index fund, which can be ©2002, AIMR ®

Technology, Data, and Experts managed at a low cost, and an active set of (portable alpha) long–short positions works equally well in any country. With a conventional active long-only mandate, with conventional tracking-error limits, and with conventional turnover limits, an active manager will lose 30 percent of the active information ratio.2 In other words, turnover restrictions, concentration restrictions, and the constraint of not being able to short stocks by more than their weight in the index, causes a 30 percent reduction in the potential value added by an active long-only manager. The enormous possible rewards arising from the decomposition into passive management and active long–shorts (e.g., hedge funds) are a key reason for the very rapid unbundling of the investment industry. The passive index fund is a homogeneous low-fee product. Active long–short portfolios are heterogeneous highfee products. Talent migrates into areas of high added value and high margin. Net capital must be invested in a passive longonly strategy. The return on this capital can be measured in a straightforward manner. If you earn $5 on a $100 investment, the return is 5 percent—this is the capital return premium. But net capital is not invested in a long–short strategy. The cash generated by shorting can be used to buy the longs. With such tactical assets (as opposed to investing capital in strategic assets), the manager is being given a risk budget of contingent capital. The same is true of currency management, in which the manager is allowed to take foreign exchange positions to reduce the risk associated with international investments. In long–short activities, value is added not by actively investing capital but by taking risk in deploying contingent capital. Thus, returns in long–short activities must be measured relative to the contingent capital invested. That is why investors in hedge funds are concerned about analyzing the contingent capital exposure (i.e., the risk of loss associated with a particular strategy). The measurement of added value through unbundled investment management is the combination of the capital alpha (on the passively managed portfolio) and the information alpha or manager alpha (on the portable alpha, active long–short portfolio). An active manager should not be rewarded for the benchmark index return on capital, but rather for the incremental return he or she delivers. Technology has facilitated this unbundling of investment management strategies and services. This development poses a threat to the active risk budgets of tactical 2 This is based on research by S. Thorley, R. Clarke, and H. de Silva,

“Portfolio Constraints and the Fundamental Law of Active Management,” Financial Analysts Journal (forthcoming).

©2002, AIMR®

managers. Risk budgets must be used efficiently as investors become more sophisticated in their expectations and monitoring capabilities.

Knowledge-Directed Search Investment managers face a major problem: data overload. Modern information technology floods managers with reams of data. The Wilshire 5000 Index contains more than 6,500 stocks; the Lehman Aggregate contains 6,685 bonds; and the Merrill Lynch High Yield Index contains 1,340 bonds. Behind each of these numbers lie annual reports, earnings comments, analysts’ opinions, and so on—huge databases of quantitative and qualitative data. Investment management firms must organize themselves to deal with this glut of data. Clearly, neither the amount of available data nor the speed at which it arrives is going to decline. Efficiency of data production and delivery will only rise in the future. This trend threatens to endogenize market instability because all analysts receive the same data and analyze it similarly. As a result, risk management will become even more important than it is today. Investment management is knowledge-directed search, and the business of investment management is the management of complexity. Recognizing these facts and preparing to meet the associated challenges is a critical factor for investment management firms’ success.

The Symbolic Barrier A symbolic barrier exists that divides activities between areas of numeric processing (homogeneous tasks) from areas of symbolic processing (heterogeneous tasks), as shown in Figure 1. Computers or machines can more easily replace workers in numeric processing activities (for example, manufacturing, telecommunications, and chemicals) than those in symbolic processing activities (for example, law, investment banking, accounting, education, and medicine). Numeric processing, which deals with commodities and commoditized behavior, does not produce great added value. The experts associated with symbolic processing deal with and process qualitative information. The greater the degree of symbolic processing (in any activity), the greater the added value one would expect to find. The symbolic barrier is often connected to a regulatory barrier, or wedge, which maintains excess margins. The salary level for post-doctoral scientific researchers is a fraction of the level for finance professionals. What magic makes a finance expert worth so much more than, say, a genomics expert? Although finance experts may not be considered as

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Organizational Challenges for Investment Firms

Margin

Margin

Figure 1. The Symbolic Barrier

Telecommunications, Manufacturing, Chemicals, etc. Numeric Processing Telecommunications, Manufacturing, Chemicals, etc. Numeric Processing

brilliant as genomicists, they enjoy the protection of a symbolic barrier: the jargon that is representative of the unique knowledge requirements for participation in the industry. Unfortunately for those in finance, technology is pushing this barrier further along the x-axis. Technology is an unambiguous threat to financial intermediation, particularly to the banking sector. BIS II, the new set of risk-based capital changes proposed by the Bank for International Settlements in January 2001, will turbocharge the changes now occurring in the global banking sector. Historically, a bank’s regulatory capital requirement was unrelated to the riskiness of its lending. In the future, a bank’s regulatory capital requirement will be linked to the measurable credit risk of its lending. This change will ultimately lead to total transparency in credit pricing, and all loans will be marked to market. So, loan pricing will be determined by the market, not by bank loan officers. The bottom line is that, eventually, banks will originate and service loans, not hold them. Institutional investors will own the liquidity and the credit risk, not the banks. These changes are another example of the unbundling of financial services spurred by technology. Regulatory change is not the only thing driving this development: Also pushing this megatrend in the banking sector are credit pricing, excess competition, and stock market pressure on the risk-adjusted return on capital. Figure 2 shows the value-creation spectrum for homogeneous and heterogeneous activities in the context of finance. The margins shoot up in heterogeneous activities. Pareto’s Law, the 80/20 rule, states that 20 percent of the firms harvest 80 percent of the value added. So, 80 percent of the firms harvest only

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The Symbolic Barrier Media + Regulatory Barriers Medicine Investment Banking Education Legal Profession Finance Media Insurance Brokerage Medicine Accounting Education Finance

Symbolic Processing

Insurance Brokerage Accounting Symbolic Processing

20 percent of the added value. At Pareto Partners, we do not want to be one of the 80 percent firms. Nearly every firm in the investment industry is trying to move toward heterogeneous activities. The reason is that the homogeneous activities, such as index funds, are dominated by a few firms. They have huge economies of scale that make them impervious to competition. So, firms are attempting to unbundle their services and products, outsource their back offices (and any other function where they do not add value), and focus on endeavors in which they can add value. In the context of Figure 1 and Figure 2, technology has inexorably driven to the right the symbolic barrier within the industry. The extreme left side of Figure 2 shows that the largest, most liquid and homogeneous market in the world is the foreign exchange market. In the foreign exchange market, the turnover, as surveyed every three years by the BIS, is $1.1 trillion a day. Such a large number is difficult to comprehend, so I will put it into context. Five currencies account for 80 percent of this $1.1 trillion in turnover. How does daily turnover of $1.1 trillion compare with the daily turnover in the equity markets? The world equity markets— including all developed and emerging markets— have approximately 35,000 shares quoted on exchanges around the world. The daily turnover in all those shares combined is equal to about 1/20th of the turnover in the foreign exchange market. When equity managers venture into the currency markets, they typically do not do so well. Currency markets are a different game at a different level; going from equity markets to currency markets is like going from youth football to the Super Bowl. One of the reasons for decomposing investment management functions is to unbundle portfolio risks so that ©2002, AIMR ®

Technology, Data, and Experts Figure 2. The Value-Creation Spectrum The Symbolic Barrier + Regulatory Barriers

Margin (bps)

4,000 2,000 1,000 10 2,000 0 Finance 1,000

Foreign Exchange

10

Government Bonds

U.S. Equities

High Yield

Homogeneous

Hedge Funds

Priva Equi

Heterogeneous

0 Foreign Exchange

Government Bonds

U.S. Equities

Homogeneous

they can be managed more efficiently by qualified, specialized experts. Next on the spectrum are government bonds. How many managers would expect to add huge amounts of alpha within the U.S. or euro government bond markets? Like the foreign exchange markets, these are liquid markets in which technology aids comparative analysis; low margins of mispricing are to be expected. The more heterogeneous activities, such as high yield, hedge funds, and private equity, provide more opportunities to add value than the homogeneous activities. This is because they are innately more difficult to analyze. The goal is to add value, and more value will be found in the heterogeneous end of the spectrum than in the homogeneous end of the spectrum. Naturally, talent goes where the money is, so a lot of talent, expertise, and resources are going to the right end of the spectrum, beyond the symbolic barrier.

Privatization of Global Fixed Income We believe that by 2010, private credits will account for half of the global fixed-income market, a dramatic change from the current level of about 13 percent. This development is good news for bond managers because private credits are heterogeneous, whereas government bonds are homogeneous. The chance of adding value by investing in the government bond market is not great, but in the private credit market, ©2002, AIMR®

High Yield

Hedge Funds

Private Equity

Heterogeneous

experts have a good opportunity to find gems or, perhaps more importantly, avoid the dogs. This trend toward private credits is irreversible. If a manager is going to forecast, he or she should forecast the inevitable. So, what are the implications of this shift from a fixed-income market dominated by government bonds to a roughly equal makeup of government and private debt? Universally, managers use the same concepts and statistical techniques to manage government bonds. Everyone agrees on the formula for yield to maturity. This is numeric processing. In contrast, there is not even an accepted framework for analyzing credit. This fact moves credit analysis further out on the x-axis of Figure 2 and into heterogeneous territory. An expert who has superior insight into credit analysis can add value. Credit analysis involves a knowledge-based search. Experts are needed for this search, and they receive great rewards for digging through all of the qualitative and quantitative data involved with credit analysis. This scenario would be equally true for any other heterogeneous activity, such as mergers and acquisitions, small-cap equity, or private equity. Type I versus Type II Errors. Credit analysis is all about minimizing Type I errors. A Type I error is making a choice that results in a big loss. A Type II error is making a choice that results in inadvertently missing out on a good outcome. This concern over what is called the “loss function” comes from the Neyman–Pearson branch of statistics. In the bond

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Organizational Challenges for Investment Firms world, a Type I error underestimates the risk of an adverse outcome (e.g., purchasing a bond that subsequently defaults) and a Type II error overestimates the risk of an adverse outcome (e.g., not purchasing a bond that gets upgraded by the market). The key point is that the Merrill Lynch High Yield Index has 1,340 bonds. Not buying an individual bond cannot cause major underperformance, but buying a lot of one bond that goes to zero will hurt performance. Credit analysis, in which the upside is limited, must focus on controlling downside risk. In other words, fixed-income managers must focus on Type I errors. Credit analysis is performed by rating agencies, which try to be conservative and avoid rapid changes in credit assessment of default risk. Rating agency ratings are used for long-term policy purposes (e.g., exposure limits). Credit analysis has historically also been used by bank credit departments for establishing fixed notional lending limits. Banks have tended to use credit analysis for establishing credit ranking, not credit pricing. In the future, however, banks will use credit analysis to establish the market price of the credit. Bond investors use credit analysis to estimate risk-adjusted holding period yield. Because credit is seen through so many different lenses, a great opportunity exists for adding value in credit markets. In this sense, credit is one of the most intrinsically inefficient markets. Credit Modeling Approaches . The development of credit models is a very hot area in finance at the moment. Fundamental analysis, examining a credit’s financial ratios (such as the famous Altman Zeta score), is one classic approach to credit analysis and is obviously a bottom-up approach. Other types of approaches compete with fundamental analysis: the Merton framework, reduced-form models, and top-down macro analysis. In the fashionable Merton framework, equity is viewed as an option. The implied distribution of future equity values provides an estimate of the probability that liabilities will exceed assets. This shortfall probability can be mapped to give a credit risk estimate. Reduced-form models estimate the market credit price embedded in all traded securities of an entity. Macro analysis, which all analysts use, looks at the top-down macro impact on sectors and corporations (e.g., the McKinsey model). Note that these different credit models often generate conflicting outputs, whereas a government bond yield is a government bond yield. Ambiguity in government bond pricing is nonexistent. Data Fusion. The heterogeneous credit information sources are noisy, incomplete, and often contradictory. For example, in looking at corporate bonds, investors must consider the company funda-

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mentals, the macro environment (i.e., sector analysis), equity and debt pricing, credit spread pricing, security details, market liquidity conditions, and forecast return distribution. This complexity represents good news. It means that experts are needed to perform “data fusion.” The term data fusion comes from the field of artificial intelligence, in which researchers study how the human mind fuses complex and often contradictory information from the different senses. In the field of artificial intelligence, the goal is to enable computers to fuse complex, multi-sensory data. The situation is analogous to finance: We are managing assets in a complex environment. We are trying to synthesize data to make the best decision regarding the use of assets. Accordingly, the more complex (or heterogeneous) the market, the more value experts can add.

Cognitive Biases of Experts Unfortunately, experts, like all humans, have cognitive biases. Humans can have great insights, but evolution (the innate predilection for species survival over individual survival) means that individuals do not necessarily make optimal investment judgments. Much of the literature in behavioral finance is based on the work of Kahneman and Tversky, who did brilliant research starting about 25 years ago. The original research on cognitive biases, however, dates back more than a century to early work by German psychologists exploring how humans process information. Psychologists discovered many consistent cognitive biases, such as accommodation bias, magical thinking, conjunctive fallacy, ownership bias, the magical number seven, and so forth. For example, accommodation bias occurs when a person is sitting in a hot bath. Soon, the water does not feel as hot, because of the body’s acclimation to the temperature. An investment equivalent of this behavior does exist. Because of the long equity bull market, investors became accustomed to unbelievably high P/Es. Many people now see today’s “comparatively” lower P/E levels as a buying opportunity. But when one considers the amount of U.S. earnings that have been lost through executive stock options and that will be lost through pension funding needs,3 perhaps the wiser conclusion is that the U.S. equity bath is still rather hot! Another cognitive bias is “timid choices and bold forecasts,” which is the title of an article by Daniel Kahneman and Dan Lovallo that discusses one aspect of the conjunctive fallacy:4 As people acquire more information, they become so confident that they 3

Ron Ryan, “Pension Alert!” Ryan Research (December 2001):www.ryanlabs.com/Research/pdf_files/pensionAlert.pdf.

©2002, AIMR ®

Technology, Data, and Experts ignore the laws of probability. Thus, as active managers gain more and more information about a company, they become subjectively overconfident in their assessment of the company. Consequently, they underdiversify. This behavior is a by-product of evolutionary genetic tendencies that encourage the species, rather than the individual, to survive. Nature “programs” a small percentage of humans to take big risks. This trait ensures that the human species will continually explore new options, but a significant percentage of these bold individuals will die. This behavior is great for the evolution of a species but bad for portfolio management: You do not want your manager taking crazy risks. When people become overconfident, they make poor investing decisions. In an investment context, overconfidence is a key reason for underperformance. Underperformance is also tied into ownership bias. Investors think, “I bought this share because I analyzed it thoroughly before I made the decision to buy it. I know it better than anyone else.” How often have you heard people say that they will only sell an investment once it comes back to their purchase price? This belief is crazy. Anchoring and ownership bias also ties into the work by Diaconis on magical thinking. In magical thinking, once people have analyzed and bought into a theory, they cannot abandon “their” ideas. No actual evidence will refute a theory once an “expert” believes it. Another cognitive bias is the magical number seven, plus or minus two. We can keep in our mind only seven numbers, plus or minus two. This research was first presented in a famous paper by George Miller.5 Managers or investors often make inaccurate or poorly considered investment decisions simply because they are inundated with too many numbers. Their mind may lock into the wrong seven items. The point is that as a result of cognitive biases, expert decision makers often misuse their risk budget. Behavioral finance suggests that when experts deploy a risk budget as fiduciaries, processes must be in place to ensure that they are taking risk in an efficient fashion. Accordingly, organizations must support experts by helping them compensate for their innate biases. Technology is a key aid in this respect. Whether or not we like the technology, it allows us to efficiently address the two major issues: first, a growing data production and transmission rate, and second, the biases of experts. When unaided 4 “Timid Choices and Bold Forecasts: A Cognitive Perspective on Risk Taking,” Management Science (1993):17–31. 5 George A. Miller, “The Magical Number Seven, Plus or Minus Two: Some Limits on Our Capacity for Processing Information,” Psychological Review (1956):81–97.

©2002, AIMR®

investment experts make decisions under conditions of a high data rate, poor signal-to-noise ratios, conflicting objectives, and personal stress, they often create portfolios that make very inefficient use of risk. Experts are scarce, expensive, and have personality side effects. So hiring more human experts, therefore, is not a scalable solution. Hence, technology is needed to leverage their expertise. Investment management firms tout their investment committees spread around the world and their regular meetings with them to establish global investment policies and strategy. But the committee members may totally disagree with each other, and the consensus output is likely to be dominated by the seniority, and personality, of the group members. I suspect the consensus process used by large organizations is often designed to support the power structure of the organization rather than to add value for the client. Two characteristics of an expert are feature extraction and use of reasoning paradigms. Feature extraction is the ability to sort through tons of data and reduce that data to the three or four key points. Feature extraction increases the expert’s noise immunity (the nonexpert is confused and distracted by irrelevant items). An expert’s reasoning draws from different reasoning styles, often in combination. This sort of reasoning is extremely difficult to model. For example, one common reasoning style in finance is script-based reasoning. This concept was developed by Roger Schank, then at Yale University. This type of reasoning involves a “script.” For example, ordering a meal in a restaurant is a classic example of a script-based reasoning situation. Patrons enter a restaurant. They expect to be welcomed and given a menu, have a waiter take their order, and so on, in an unfolding time script of events. A script for investing might flow as follows: After a period of financial exuberance, the economy will inevitably enter a recession. As a result, the central bank will ease policy, so equity and bond returns will improve. So, scripts involve the concept of a time cycle of events that is sequentially unfolding. Some reasoning styles are not appropriate for finance. For example, classical logic is a true/false logic, with the first order predicate calculus, and has limited value in finance.6 The idea is to lever the expert’s reasoning paradigm through the use of technology; this is knowledge engineering. An Example of Knowledge Engineering. The Bundesbank built a credit-default model that was a combination of qualitative and quantitative analyses. Why would the Bundesbank build a credit-default 6

In finance, we are not faced with a bivalent (true/false) world, but at least a quadrivalent (true/false/not known/unknown) world.

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Organizational Challenges for Investment Firms model? It invests in prime corporate paper. But as a government agency, it has to be fair and make sure it does not discriminate among issuers. Therefore, the Bundesbank has to analyze over 50,000 companies. How many credit analysts would be needed to analyze 50,000 companies in a fair fashion? Would the resulting evaluation exhibit bias? To combat this challenge, the Bundesbank built a system that takes in annual account data, in this case 50,000 accounts, and extracts the key features. It then synthesizes the key features using a reasoning technique called discriminate analysis. Out of this feature extraction and reasoning analysis comes a classification, which is then reviewed by the human experts. This framework allows people to systematically go through a huge amount of data with output consistency. The Bundesbank example illustrates that systematic encoding of experts’ “insights” is a highly valuable technology. It provides a mechanism for bringing together all the data in a systematic fashion and reducing it to those seven numbers that the human mind can handle. Pareto Partners has created the same type of model for credit spread analysis. The inputs to our credit model include financing conditions, company health indicators (such as earnings), and liquidity conditions. To determine financing conditions, for example, we look at the equity market and credit supply, which allows the model to forecast the cost of capital. In analyzing the cost of capital, for example, the P/Es used are symbolic descriptors—they are not numbers. Experts do not think of the P/E as a specific numeric value; rather, they think of it in symbolic terms, as being high or low in some context. The goal is the same: operating a tool to systematically encode expert insights. Increasingly, the investment industry is using technology in this way. Technology provides the ability to synthesize the data so that market opportunities will not be missed. The model’s output allows analysts and managers to make predictions about likely outcomes. For example, if there is a 55 percent chance of a 30 bps tightening in the spread level, then this is viewed as a scenario, not as some black box forecast. The model provides a way of synthesizing a huge amount of data for efficient presentation to the expert human decision makers. This synthesis enables them to estimate the risks of a particular strategy. The decision makers are spending the client’s risk budget. Therefore, they have to be able to assess not only the best forecast but also the risks in that environment.

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Organizing Investment Management Organizing an investment management firm—dealing with the heterogeneity of the client base, egos of experts in an organization, and compensation structure—is an extremely complex task. The financial behemoths, firms that try to be all things to all people in all time zones, are fundamentally not actually in the investment management business. Rather, they are in the distribution business, where the goal is not investment excellence but low manufacturing and distribution costs. For this reason, polarization in the industry is occurring rapidly, with the big distributors at one end and the niche firms at the other. The one rule for niche firms is focus. If a firm is going to be a niche player, it must be the best in its sector in order to survive. This is the only rule that I have had beaten into my head over and over again during the 11 years that we have run our business. The most difficult aspect of investment management is neither the technology nor the markets. It unambiguously is managing the business. In investment management, we are trying to fashion a scalable, sustainable environment in which human capital can be turned into added value for our clients. This task is extremely challenging. The key is always to remember that the central goal is to add value for our clients. Anything else is secondary. Historically, investment management operated like a cottage industry. The successful firms would be run by the successful investment manager(s). However, the attributes for successful investment management (in particular, the belief that one is right and often a strong disregard for others’ points of view) are exactly the wrong attributes for managing a successful firm. Our industry is littered with examples, both large and small, of very successful firms that lost their way as a result of ego-driven, and totally ineffective, business management. Large firms generally make the mistake of believing that investment management is a process and that the investment experts are replaceable. They profoundly underestimate the key value of human capital. Small firms often do not realize their potential, because they do not develop a scalable management approach for developing the next generation of human capital and the systems and support needed for a business. There are no simple answers in managing investment management firms. Everyone knows that unbundling is inevitable, which means that one must ruthlessly focus on how the organization can truly add value for clients. In our view, it also means that ©2002, AIMR ®

Technology, Data, and Experts successful organizations have to be a hybrid of an institution and a boutique. Both structures exist in our industry—for good reasons. Talent is drawn to boutiques, where people can focus on excellence and have some control over their own destiny. But institutions provide the stability and scalability that is important in developing a long-term business. The importance of good business management in the investment management industry cannot be overstated.

Conclusions The preconditions for market efficiency are irreversibly increasing in every market in the world. The U.S. investment model is rapidly emerging as the dominant global model. The net result is that adding value from active management will only become more difficult. The investment management industry is unbundling. It is polarizing into big commodity players/distributors and specialized firms. Specialized, niche firms have to be category killers, the best in their niche, in order to survive. Firms that are not

©2002, AIMR®

category killers will be toast. To be successful, firms must choose a narrow niche or have a geographic niche. Firms that aim to be number three in a broad style category cannot succeed: Global competition is too strong. The privatization of fixed-income markets is inevitable. A new asset class (private debt) is emerging, as can be seen in the definition of the fixedincome aggregate indexes now versus the definition of even five years ago. The fixed-income markets have changed in a profound way, and increasing allocations into the private debt sector are occurring globally. As a result of these global investment management and market trends, technology is both leading the way and being forced toward greater development and expansion. Knowledge-based systems are the key to managing the inevitable data overload. These information management tools and models are invaluable for assessing how the client’s risk budget is being used. This is not a forecast. It is inevitable.

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Organizational Challenges for Investment Firms

Question and Answer Session Ronald Layard-Liesching Question: If academic studies are correct in finding that currency effects wash out in the long term, why should anyone do currency overlay? Layard-Liesching: The long term is not the issue. There is a 1 in 4 chance that you will lose 25 percent of your international assets if the currency risk is left unmanaged. There is no expected return associated with this large risk. No one would ever take unmanaged currency risk by itself. Actively managing currency risk adds value and also reduces a preexisting risk. This is the reason for the very rapid growth in currency management around the world. Question: Are there any models that would have identified the problems within Enron? Layard-Liesching: The Merton model of looking at equity price would have given you some warning. Of course, you can always find some warning in one of the models in retrospect, but it is interesting that the Merton framework would have indicated the need for caution. Question: What is the value of an innovation that distinguishes a company from the pack, and how do you value such an idea?

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Layard-Liesching: The value of such an idea is potentially enormous, and publishing that idea would be a bad move. One of the problems with this era is that everyone doing research is electronically connected. Because our clients are paying for the benefits of our research, we don’t publish a lot of it. Why should we send our findings to anyone else? This phenomenon is occurring increasingly in other areas, such as medicine, and will make people more secretive. Secrecy is appropriate because human capital is the source of alpha. If you have a good idea, keep it close to the vest. Question: How does a small firm without appropriate resources handle information overload? Layard-Liesching: Many vendors now offer all sorts of very powerful analytic systems. If you buy a system off the shelf, everyone else will also have it and will be doing the same thing. Orthogonal logic combats this situation. This is not contrarian logic (in which one simply goes against the consensus). Orthogonal logic means that in order to have a different outcome from everyone else, you have to think differently from everyone else. This approach has

three rules: One, think differently in order to have a better outcome. Two, be right. Three, be right in your lifetime. Your lifetime, in investment terms, means three years! Therefore, if you have superior insights, encode them systematically and be humble if they work. Question: Could you isolate the key principles from the explosion of opinions in your presentation? Layard-Liesching: A key point I wanted to make is the partnership with clients. We are all fiduciary agents. The money we manage is not our money. Another major point is risk budgeting. We have to redeploy the risk budget to more independent sources of return, which is the direction that the most sophisticated institutions around the world are heading. Another key point is that there is a better information alpha on the short side. If you are constrained to shorting the weighting in the index, you will limit the alpha opportunity. As the world ages, and huge sums of money are being spent to find undervalued opportunities, losers will be easier to find than winners.

©2002, AIMR ®

Demographics: The Driving Force in the New Millennium Robert J. Froehlich Vice Chairman, Chief Investment Strategist, and Managing Director Scudder Investments Chicago

Demographic trends have numerous implications for investment management. The senior boom, birth bust, and Baby Boomer generation will shape future economic activity in the United States. The financial services industry stands to benefit significantly from such demographic effects.

emographics will be a major influence on the future of the financial services industry, even though many people have not yet recognized its importance. One of the issues that must be faced to appreciate the power of demographics is the negative bias against it. Demographics is not an accepted science in the United States and, unlike beta or P/E, is not one of the investment principles investors worry about. To circumvent this built-in bias against demographics and help build my case for its significance, I will discuss demographics in terms of age characteristics and illustrate how they can help pinpoint relevant investment themes for the future.

D

Influence of Age Characteristics Age characteristics—or demographics—can drive the market and turn some industries upside down. Before looking at the influence of age characteristics on investing, consider how the age characteristics of the population affect the following aspects of the U.S. economy: • What people buy. Not many 16-year-olds shop for reading glasses, and not many 60-year-olds purchase acne cream. • How much people save. As the Baby Boomers (those born between 1946 and 1964) reach age 50, they can afford to save more: Their children are usually out of the house, their houses are usually paid for, and their salaries are usually good. The aging Baby Boomers are having a tremendous influence on the amount of money being saved.

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Number of households (and their composition). Not many 60-year-olds are looking to start a household, yet that is what everyone wants to do in their 20s and 30s. • Government policies. When a nation is young, recreational and educational programs are popular, whereas in a nation composed primarily of senior citizens, medical and retirement programs predominate. The influence of demographics on the market can be illustrated by looking at three industries: the discount store industry, the food industry, and the pharmaceutical industry. Discount Store Industry. The discount store industry, which has existed for only about 15 years, struggled for the first seven or eight years. For the past five years or so, however, discount stores have been lucrative investments. The only factor that can be identified as having been capable of turning the industry around is demographics. Fifteen years ago, older people did not want anything to do with discount stores, and no one expected these stores to last. Now, merely because of demographics, not because of any particular marketing plan or inventory strategy, the number one shoppers in discount stores are people age 65 and older. Food Industry. In the United States, the first group of 18- to 24-year-olds raised by working mothers has entered adulthood. Accustomed to meals on the run, these young adults bypass all the basic cooking ingredients in the grocery store and go straight to the salad bar or prebaked-goods section. They know

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Organizational Challenges for Investment Firms an oven can be used for something but have no idea what. Only 50 years ago, the average homemaker in the United States spent 2.5 hours a night preparing dinner, but in 2000, the average time amounted to 18 minutes; by 2005, a majority of households in the United States will never have had a meal cooked from scratch. Needless to say, the food industry has been completely transformed as a consequence of the acquired habit of eating on the run. Pharmaceutical Industry. The explosions in the food and discount store industries have already happened and will not really help anyone now in terms of investing. One industry on the verge of evolving, however, is the pharmaceutical industry, which I believe will take off in the next 10 years. Demographics will have an enormous effect on the pharmaceutical industry as the population of the United States grows older. On average, children, for the first five years of their lives, take eight prescription drugs a year, but from age 5 to 45, prescription drug use trends down. Around age 45, prescription drug usage again increases, and the trend line never breaks until it reaches a plateau at age 76. In 2000, the average 76-year-old in the United States used 18 different prescription drugs a year. The ramifications are clear. Although the United States constitutes less than 5 percent of the world’s population, we consume almost half of the world’s prescription drugs. A common mistake for those analyzing the pharmaceutical industry is trying to find the company that will discover a cure for cancer, but a cure for cancer will not be available for a long time. To understand the pharmaceutical industry, you need to start at the bottom of the food chain because the pharmaceutical industry is an annuity industry. Take, for example, high blood pressure. In the United States, more people die every year from high blood pressure than in any other nation. The typical candidates for high blood pressure in the United States are males in the 35–55 age range. No magic pill will cure high blood pressure. Rather, high blood pressure can only be controlled by taking a pill four times a day, seven days a week, for the rest of your life. And people who live longer by taking these pills are virtually guaranteed to acquire another illness, such as arthritis, that also requires treatment. Being treated for one illness therefore makes you a candidate for another one, for which the pharmaceutical industry will provide yet another pill. Given the aging population, the pharmaceutical industry is poised to experience a 10-year period of unprecedented growth.

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Demographic Trends Demographics influences the market not because of any one particular demographic trend but rather because of three demographic trends, each occurring at the exact same time. In the United States, in addition to the aging of the Baby Boomers, which tends to monopolize most discussions of demographic trends, we are in the midst of a senior boom and what I call a “birth bust.” The unprecedented confluence of these three developments is really changing the way we determine what an attractive investment is. Senior Boom. In the Stone Age, the average life expectancy was 20; when the United States was founded in 1776, it was 35; by 1876, the average life span had risen only to 40; today, it is 76. Retirement is thus a new phenomenon. To understand the significance of this sudden increase of seniors, consider that two-thirds of all the people in the history of time who have ever celebrated a 65th birthday are alive today. Historically, only 1 out of every 10 people ever lived to celebrate their 65th birthday. Today, in the United States, 8 out of 10 people will live long enough to reach a 65th birthday, and for people who live to 65, their life expectancy increases to 86. We hit a crossroads in the United States in 1983 when, for the first time, we had more senior citizens age 65 and older than we had teenagers. That trend will probably never reverse itself, at least not in the near future. Never before has the number of people age 65 and older exceeded the number of teenagers. So, how does the number of senior citizens affect investing? Peter Lynch’s philosophy probably states it best: Sometimes the best investment ideas are those things that are staring you in the face, and yet you will not even look at them. For example, in the United States in 2000, the average age of the domestic-built luxury car buyer was 65 and 42 percent of all toys purchased were bought by a grandparent. Given the influence that gray-haired people driving Cadillacs with Wal-Mart bags in the trunk can wield on certain companies and industries, unearthing investment themes should not prove to be a struggle. B irt h B us t . Another unique development in the United States is the birth bust. The birth rate in the United States is not keeping pace with the number of aging senior citizens. Twenty percent of Baby Boomers have no children, and another 25 percent have only one child. Theories regarding this dearth of children seem to revolve around the impact of the Vietnam War and the women’s movement, but I believe the birth bust is a consequence of the evolution of the economy. ©2002, AIMR ®

Demographics In simplistic terms, the U.S. economy has evolved from being based on agriculture and industry to being based on service and information. In an agricultural economy driven by the farm, the most important asset was cheap, unskilled labor, so having large families was an economic necessity. Over time, however, the cost of raising children has grown more and more prohibitive, and I do not see that cost decreasing anytime soon. Economics, then, has more to do with causing the birth bust than anything else. And as women enter the work force in ever greater numbers, the cost of child care looms as an even bigger factor in the diminishing birth rate. Baby Boomers. In addition to the senior boom and birth bust, the third demographic trend is the aging of the Baby Boomers. One-third of the U.S. population can be categorized as Baby Boomers—the 76 million people born between 1946 and 1964. When one-third of any nation can be categorized as something, not only will it be important, it will probably turn just about everything it touches upside down. Because the Baby Boomer phenomenon is relatively recent, its significance may not be wholly appreciated. Each decade since the 1950s, however, provides evidence of the Baby Boomers’ economic clout. When the Baby Boomers arrived on the scene in the 1950s, the disposable diaper industry prospered. Along with this explosion of children, the camera industry took off in the late-1950s. All of a sudden, young children were driving what was happening in the markets and determining the success rate of certain industries. During their teenage years, the Baby Boomers populated the fast-food restaurants that were popping up on every street corner, thus helping that industry skyrocket in the 1960s. In the 1970s, when Baby Boomers became young adults, they wanted to settle down. Accordingly, the real estate boom in the 1970s was about one simple thing—76 million people wanting to buy a house—and the value of real estate increased in every single state in the United States. By the 1980s, the Baby Boomers wanted to figure out how to get ahead in the business world and make more money. Not surprisingly, that is when CNN and CNBC found a loyal audience and the Wall Street Journal, Forbes, and Fortune hit all-time subscription highs. Then, during the 1990s, financial products and markets multiplied as Baby Boomers began to focus on saving and investing. Part of what drove the markets in the 1990s was the demographic influence of the Baby Boomers, who had become more interested in what financial service companies had to offer. Now, in the new millennium, Baby Boomers are becoming senior citizens. Everyone assumes they will focus on retirement. Indeed, for the first time in ©2002, AIMR®

their lives, Baby Boomers will be turning their attention to the same thing for two decades in a row because retirement really means making sure you have enough money for retirement—saving enough and investing wisely. For those who might think that the U.S. market is going to run out of steam and that another 10-year trend like that of the 1990s cannot possibly occur, consider the following fact. For the 10-year period starting in January 1, 1996, every minute, every day, someone turns 50 in the United States. Again, contemplate the impact of the Baby Boomers turning 50 and being in the position to save and invest for their retirement. Something else happens to people at age 50. Their mind-set changes, and they no longer have to be convinced that they should be fully funding their 401(k) plan or investing in an IRA, even if they do not get a tax deduction for it. Demographics will thus be a driving force in the overall market as these Baby Boomers enter their 50s, and the financial services industry will play a major role in the economy over the next 10 years.

Implications for the Financial Services Industry The financial services industry stands to benefit from two distinct features of changing demographics. First is the challenge of dealing with a 24-hour-a-day market. Every minute of every day, a market is open somewhere that can potentially affect the value of someone’s investment. Because the market never closes, investing must be considered in a much different way. Many investors are therefore likely to choose a financial services professional to help them manage their investments. The complexity of products offered in the financial services industry also bodes extremely well for those in the financial services business. The multitude of available products, not to mention what can be done with individual securities, is daunting. Consider the mind-set of the Baby Boomers. They were not brought up with much complexity, yet that is what they now confront everywhere. For example, people used to drink coffee either black or with cream and sugar. Decaf or artificial sweetener did not even exist. Now anyone who walks into a Starbucks, for example, faces myriad choices; a Baby Boomer might come out after about 15 minutes with a double mocha latte with whipped cream. Yet most Baby Boomers prefer greater simplicity in their choices. Their aversion to complexity and their desire to always have things “their way” bodes well not just for the financial services industry but for any industry that offers a service that will simplify Baby Boomers’ lives and give them more free time.

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Organizational Challenges for Investment Firms

Conclusion I do not mean to say that the market will simply go straight up without any major corrections. The market will have down years as well as up years, but the demographic fundamentals I have discussed will be the single greatest influence on the market. Many watch with bated breath the actions of the Federal Reserve Board, and rightly so, because the Fed helps determine the short-term volatility of the market. Yet individual investors and financial services professionals alike sometimes get so fixated on the short-term

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issues, which do nothing more than drive volatility, that the long-term issues, which are easier to predict, are forgotten. Forecasting the outlook for the economy or unemployment is difficult, but when there are a couple million 10-year-olds, predicting how many 11-year-olds there will be is a rather straightforward endeavor. I therefore urge you to occasionally step back from the day-to-day noise to weigh the influence of demographics—that is, the age characteristics of the majority of people in the United States—not only in the long run but sometimes in the short run.

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Demographics

Question and Answer Session Robert J. Froehlich Question: Could the European economy eventually outpace the U.S. economy and attract more investors? Froehlich: That could happen, but I believe the United States remains the investment vehicle of choice around the world. I don’t care what Europe is doing with the euro. Even in light of the Enron scandal, we still have the best accounting standards in the world. The United States will continue to attract money. I don’t want my comments to be misleading, however. The next 3–7 years may have periods of major disappointment, but in 10 years, people will think that investing in the U.S. economy was a wonderful move. This view is based on my undying belief that everyone still wants to retire—and with a better quality of life than their parents had. That said, yes, some people will get out of the U.S. market and some will lose money, but fundamentally speaking, there is more strength in the U.S. market than in Europe. Question: Now that people are living longer, would it not be a mistake to focus only on conventional areas associated with senior citizens? Froehlich: Yes, everyone thinks funeral and nursing homes are the place to be, but you will see highend consumption too. Harry Dent wrote a book on demographics called The Great Boom Ahead.1 If you haven’t read it, I encourage you to do so. He focuses on the consumption side of demographics. People are making more money now than 1 Harry S. Dent, The Great Boom Ahead: Your Comprehensive Guide to Personal and Business Profit in the New Era of Prosperity (Hyperion Press, 1993).

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ever before, and if the house is paid off and the children are on their own, people will spend more on high-dollar items. Dent mentions jewelry and other luxury items, such as boats and RVs, as having great potential. Question: Now that the concept of retirement has changed and people often elect to continue to work, won’t the effect of senior citizens in the market be magnified? Froehlich: Sure, you hit the nail on the head. People are not going to retire at age 65, as they did 20 years ago. This change means that they will stay active in the business, although perhaps in a parttime capacity, by continuing to contribute their experience and understanding of the culture and values. But if I am wrong and people elect to completely retire, no one knows the extent of the effect on our industry (or on others for that matter). Question: Do you think the threat of inflation will dampen productivity growth in the United States? Froehlich: I believe inflation will be minimal. I don’t know enough about technology because I’m not a technology analyst, but every company that wants us to buy its stock can’t wait to tell us what it is doing in technology. Every improvement with technology tends to put a lid on inflation. I don’t see the productivity boom slowing down. Will every year be as good as the next? No. But the explosion in technology keeps a lid on inflation. Question: What about other influences on the economy, such as energy prices?

Froehlich: A lot of other influences besides demographics influence the market, but they will not drive the longer-term picture because they tend to disappear. For example, the price of natural gas has a great influence in the short run, but unless the price moves to an extreme position (say $10) and stays high, it tends to have little long-term influence. And regardless of these other influences, demographics serves as the longterm backdrop for all of them. Its influence must be taken into account above and beyond what’s happening with interest rates, commodity prices, inflation, and so on. People tend just to look at all those change agents and ignore the one constant, which is demographics. I’m asking you to make demographics the foundation and to supplement it with the other relevant factors. Question: Does the Asian market, particularly China, offer greater potential than the U.S. market in terms of long-term growth? Froehlich: The Asian market will replace it completely because the consumption explosion that is currently driving the U.S. economy will turn into the Asian consumption explosion in the future. Of the 2 billion people in China, a billion are 10- to 24-year-olds. Think of what they would do if they had money. That’s the real issue. Quality of life has improved, and young people tend not to save money; they buy cosmetics, cigarettes, automobiles, and so forth. As the Asian economies open up and more capital flows into them, they have the one thing we don’t have— young people. In 15 years, the demographic influences that will really be the drivers around the

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Organizational Challenges for Investment Firms globe will be in Asia (particularly China and India), as long as they open up their economies and embrace free trade. A country with

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2 billion people who have no money will not have a great influence on the global economy. But if that nation’s economy opens up

and it is even a little bit successful, its influence could be outstanding.

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