The Future of Investment Management

Foreword Investment management firms face a period of fundamental change. A number of factors, such as tremendous growth in assets under management, globalization, dramatic proliferation of new products, changing client relationships, and advancing technology, are permanently altering the landscape of investment management. The presentations in The Future of Investment Management were given at four 1998 AIMR seminars and were selected for publication because of their common focus on the profession's future. The authors address such essential topics as the clientmanager relationship, strategies for managing investment professionals, and global portfolio management. They also consider how developments that occur independently of the financial industry, such as demographic shifts and changes in lifestyles, may affect investment managers. The result is a practical, thought-provoking vision of investment management in the next century. Although the authors' forecasts differ on details regarding the speed and direction of change, all agree that dramatic structural changes are inevitable. A unifying theme is the need for innovative strategies to meet the challenges of the 21st century. Size alone will not guarantee success. Firms of all sizes

must find profitable niches by identifying how the evolution of the industry and the global economy will combine with client needs to create new opportunities. An important ongoing challenge is to control costs while retaining and motivating the highly skilled investment professionals necessary to achieve strong performance. As several authors note, despite the prominence of recent merger and acquisition activity and the rush to develop new products, the crucial task is not adding assets but adding value. We wish to extend our thanks to the speakers for their valuable contributions: From "Investing Worldwide IX"-Michael J. Phillips, Frank Russell Company. From "Managing the Investment Firm"Norton H. Reamer, CFA, United Asset Management Corporation. From "Future of the Investment Management Profession"-Charles D. Ellis, CFA, Greenwich Associates; Richard M. Ennis, CFA, Ennis, Knupp & Associates; Alice W. Handy, University of Virginia; Patrick O'Donnell, Putnam Investments; Bluford H. Putnam, CDC Investment Management Corporation; William F. Quinn, AMR Investment Services; Langdon B. Wheeler, CFA, Numeric Investors Limited Partnership. From the "1998 AIMR Annual Conference"-Gary P. Brinson, CFA, Brinson Partners.

Katrina F. Sherrerd, CFA Senior Vice President Educational Products

©Association for Investment Management and Research

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Investment Management in the 21 st Century Gary P. Brinson, CFA

Chief Executive Officer Brinson Partners, Inc.

Investment managers face major challenges in dealing with unrealistic investor expectations and the trend toward borderless markets. At the same time, firms must enhance their business skills, as opposed to investment skills, in order to successfully manage the complex bureaucracy and structure of modern organizations. In addition, the industry standard of using capital market theory to create an "optimal" portfolio is no longer adequate and will be replaced by an emphasis on optimizing Sharpe ratios without regard to asset allocation.

nvestment management is in transition. The investable capital market is growing and changing in complexity, recent history may have distorted investor expectations, the business is becoming more complex, the industry is becoming more global, and the understanding of how to optimize portfolios is increasing. With these trends as a backdrop, this presentation addresses what the industry might look like in the 21st century and how investors will manage within it.

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Investable Capital Market The global playing field-that is, the aggregate investable capital market around the worldchanges over time in size and in composition. As shown in Table I, in 1969, the aggregate investable capital market was about $2.3 trillion, and among the various proportional weights of the market, U.s. equities were a nontrivial amount at 30.7 percent. By the end of 1997, the investable capital market was almost $50 trillion, which represents an annual growth rate of about 11.6 percent since 1969. Of this 11.6 percent growth, the rate of inflation accounts for about 5 percentage points, the net new issuance of securities is about 3 percentage points, and the real growth of asset prices makes up the remaining roughly 3.5 percentage points. The mix also looks different today. u.s. equities have done well as an asset class component, but their portion has shrunk from almost 31 percent to about 21 percent because of the increase in net new issuance ©Association for Investment Management and Research

of other types of securities and because of the expansion of the capital markets outside the United States. No doubt, the mix will be very different 10 years from now.

Setting Expectations Setting realistic expectations for the future will continue to be a big challenge in the 21st century. All too often, expectations are formed by one's most recent experience, which is often inconsistent with likely economic performance of the future. Figure 1 shows a fairly standard scatter diagram that depicts an upward drift in the risk-return position from cash to equity investments. Note that the risk-return position of each asset class in Figure 1 is a function of the time period. When people use charts such as Figure 1 to form expectations of the future, they are likely to set expectations and investment policy targets that will be inconsistent with future real economic growth. People's expectations for future economic growth rates often look like the returns earned in financial markets over the past few years, and in many cases, these return levels are not sustainable over time. For example, consider the expectations for future inflation. During the 1969-98 period, inflation averaged 5.1 percent in the United States-a level that is higher than current inflation levels and likely to be higher than inflation levels for the next 5 or 10 years. When the historical inflation rate is used in estimating returns, distortions occur.

The Future of Investment Management Table 1. Investable Capital Market: Size and Composition Market Value/ Asset

1969

Total market value ($ trillions)

$2.3

Asset U.s. equity Japanese equity Emerging market equity All other equity Dollar bonds Yen bonds High-yield bonds All other bonds U.s. real estate Private markets Cash equivalent

30.7% 1.6 11.2 22.3 1.3 14.3 11.6 0.1 6.9

1997a $49.1 21.1% 4.7 1.5 15.0 20.0 7.7 1.0 17.8 4.8 0.1 4.3

apreliminary.

The historical data for this period indicate that

u.s. equities have returned about 13 percent a year,

of which 5 percent is inflation and 8 percent is real growth. Given inflation of 2 percent and the assumption that the 8 percent real return is still possible, the expected return from U.S. equities is only 10 percent, but the 8 percent real return is probably also unlikely. Historically, about 4 percent to 4.5 percent of equity returns has come from dividend yield, and today's dividend yield is 1.5 percent. Adjusted for the lower inflation rate and lower dividend yield, expected U.S. equity returns

are only 7 percent-or about half of the 13 percent historical rate of return. Another example is the expectation for growth in corporate profits. From 1947 through the present, the real growth rate per share of corporate profits as represented by the S&P 500 has been 2.4 percent. If inflation is prospectively 2 percent, even an aggressive forecast of nominal growth in corporate profits will be 5 percent. Long-term nominal growth rates are typically from 7 percent to 10 percent-even as high as 12 percent-numbers that would be impossible to achieve consistently in a secular macro fashion. The expectations have not always been overly optimistic. In the late 1970s, after a decade in which real returns were zero or negative, most people forecasted excessively low returns. Real returns of 3.5 percent looked fantastic. Such return expectations, however, were significantly below the future reality. In short, one of the greatest challenges that investment managers face as they prepare for the future is helping people set expectations about the future that are realistic and not a simplistic extrapolation of their most recent experience. Most people do not make the types of analytical adjustments that are necessary in forming expectations for the future.

Business Management Managing the business effectively will be an important consideration for investment managers in the 21st century. As the industry has matured, the challenges

Figure 1. Historical Market Performance Characteristics, December 31, 1969, to March 31,1998 (in U.S. dollars) 20,------------------------------,

u.s.

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• Cash

5

Multiple Markets lndexe U.s. Bonds • • Non-U.s. • High-Yield Bonds • Bonds U.s. Real Estate

••

Private Markets

•

Non-U.s. Equity

• Inflation

0'-----------"'-----------'-------'-------'--------' 25 o 5 10 15 20

Volatility (%)a aStandard deviation of monthly logarithmic returns.

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©Association for Investment Management and Research

Investment Management in the 21st Century of managing the business have risen dramatically. The biggest challenges relate to the following trends: • Multiple portfolios, multiple channels, and multiple locations. Investment organizations today are very complex. Companies have many portfolio capabilities, or products, that are offered in various channels-mutual funds, separate accounts, commingled accounts-and they operate in many locations. • Global business coordination. Some businesses are now global and will face increasing demands associated with delivering their services around the world. • Cultural diversification. With the globalization of the industry come the challenges of cultural diversification. Such diversity is healthy but does pose real obstacles. • Generational shifts. The investment management industry is relatively young and thus does not have a good historical record of what to expect as generational shifts take place. A shift is coming as the people who formed the business in the 1960s, 1970s, and 1980s start to exit the business. The big challenge is to manage the generational shift so as to ensure continuity and the ongoing success of the business. • Evolving global markets. Global markets are evolving to transcend national boundaries and create a single global market. To manage these increasingly complex business challenges effectively and efficiently requires much more than investment skill. Investment skill is necessary to provide the portfolio capability, but in the future, organizations are going to need great business skills. Many of the people who grew up in this business on the investment side do not have particularly well-developed business skills, yet a critical task for the success of organizations going forward will be to bring in people who are highly skilled at running a business, as distinct from running a portfolio. If these business managers do their jobs well, investment professionals will be much less bogged down by the bureaucracy and the structure of organizations, which will allow them to be much more efficient. One change-and it is already taking place-will be that organizations increasingly will have business specialists whose job is to make the investment specialist operate at maximum effectiveness for the clients.

Borderless Markets The capital markets of the future will be borderless. A single, global equity market will exist. This change may not happen in 5 or even 10 years, but it is inevitable. This global market will trade 24 hours a ©Association for Investment Management and Research

day, seven days a week, and the notion of borders, boundaries, and countries will become obsolete. Before dismissing this idea, consider how U.S. investors currently operate. If a portfolio manager reported to clients that they had 13 percent invested in California, 14 percent in Georgia, 29 percent in Florida, and 13 percent in New Hampshire, the client would ask, "Why is the state of incorporation germane to your investment strategy? What difference does it make that Coca-Cola is headquartered in Atlanta, Georgia? How does that have anything to do with forming an investment strategy?" The answer is, of course, that such a criterion is not germane-at least not in the United States. People do not optimize portfolios by state of incorporation. From this observation about U.s. investing, a big leap is not necessary to question why people optimize by country. Novartis is a multinational pharmaceutical company located in Switzerland. Novartis does a minimal amount of business in Switzerland, probably about as much as Coca-Cola does in the state of Georgia, so what then is the particular relevance of calling Novartis a Swiss company? The company would be exactly the same if it was headquartered in Georgia or New Jersey or Australia. Investors should think of Novartis only as a pharmaceutical company. Similarly, they should think of DaimlerChrysler not as a German company but as an automobile company that does business all over the world. The challenge will be to understand the competitive pressures that come to bear on institutions not from the area where they are domiciled but from where they are operating around the world. The value of a particular company will relate to its export capability, how it is doing business outside the boarders of the United States, and what the pressures and competitive forces facing the company are. This simple observation has dramatic implications for the way investment managers do business. Analysis will be done globally by industry. Client investment mandates will be assigned by industry or sector specialization without regard to international borders, as is already the case with state boundaries in the United States. Clients will not issue mandates for European equities or Asian equities or non-U.S. equities. The MSCI Europe/Australasia/Far East Index, which is now so popular as a global index, will become obsolete. In this integrated view, one global stock market will comprise individual stocks that have varying common influences, such as industry, currency, stock-specific, and country factors. Country-specific issues will not completely disappear, only the myopia of looking at the industry from a singlecountry perspective. 3

The Future of Investment Management One big step towards the integrated global equity market will occur in January 1999 with the advent of the European Monetary Union (EMU). The single, common currency, with its cross-border fluidity, will eliminate the importance of distinct borders among the participants in the EMU. So, investment professionals need to be alert to this development and be ready for substantial change in the way they think about the business and have tended to categorize investments.

out specifically determining an asset allocation. Figure 2 shows the global frontier portfolio risk-return combinations for the 1981-97 period. The squares represent all institutional bond, equity, and balanced portfolios. The portfolios on the frontier were created by bundling a set of assets that produce a high Sharpe ratio (that is, a high ratio of return per unit of risk). Note that some portfolios on the frontier have different risk profiles but do not represent a continuum of equity /bond allocations. Different risk exposures can be attained using leverage and swaps. In this environment, the success of active management will be measured in terms of how high the Sharpe ratio is. The result will be higher levels of return than can be produced with the conventional wisdom that focuses on allocations among asset classes and then optimization within the asset class. The technology exists today to deliver such portfolios, but doing so will require a major change in how people think about constructing portfolios and how clients and consultants accept the deliverability of portfolios.

Global Frontier Portfolio The way managers position portfolios vIs-a-vis a client's risk profile will change. For almost 40 years, investment managers have used capital market theory to combine financial assets together into the so-called optimal portfolio. Using this approach, managers follow an almost universal pattern: If the client wants a more aggressive portfolio, add more equity exposure; if the client wants a less aggressive portfolio, add more bond exposure. The portfolio is viewed in terms of allocations to the different asset classes in the investable capital market. This approach, however, is suboptimal. In the future, portfolios will be constructed using global financial assets to optimize Sharpe ratios with-

Conclusion Changes to the investment management industry are inevitable. The current market environment may be disguising the need for change, but change will come.

Figure 2. Historical Performance of the Global Frontier Portfolio versus Conventional Portfolios, December 31, 1981, to December 31, 1997 30

Global Frontier Portfolio Risk-Return Combinations

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15

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5 0 0

5

10

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20

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35

Risk (%)a aAnnualized standard deviation based on quarterly returns.

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©Association for Investment Management and Research

Investment Management in the 21st Century

Question and Answer Session Gary P. Brinson, CFA Question: In the increasingly global industry you describe, do stock pickers and boutiques have a place? Brinson: Yes, they do, but the nature of the boutiques will change from being asset oriented to being industry or sector oriented on a global basis. The business, economic, or investment rationale of boutiques will not be to specialize in local or regional mandates, because the industry will not need a good manager of growth stocks in Louisiana. Question: Does the investment industry have a year 2000 (Y2K) problem? Brinson: For all the hyperbole that surrounds the subject, the Y2K problem has not been hyped enough. People do not truly understand the implications of getting from December 31,1999, to January 1, 2000. For example, consider banks. In Switzerland, we talked toa bank vault supplier who said he did not have any Y2K issues-until somebody asked him about the computer that controls

when the vaults shut down and reopen. The truth is, that supplier has a big Y2K problem. Most supermarket owners believe they do not have a Y2K problem because all they do is sell such basic items as canned goods and produce. In reality, they do have a problem. When one supermarket checked their system, they found 47 problems, such as cash registers that could not record. People do not realize how many systems are based on computers, and they have not become aware enough of the issues that will complicate the changeover to the 21st century. For a financial institution such as UES AC, the number of items that have to be checked, tested, and rechecked is mind boggling. Of course, the firm is subject to what will be the weakest link in this chain. Question: What is your outlook for the Japanese equity market? Brinson: Japan has a tremendous financial burden to overcome, and working through the problem will likely take generations.

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Question: Is the U.s. stock market a bubble market? Brinson: This question is hard to answer because the word "bubble" means different things to different people. If your expectation going forward is an expected 6.5-7.0 percent total return, then the market is priced fairly and your expectations are consistent with the underlying economics. Many people, however, still expect returns of 8-10 percent, which creates a big discrepancy between expected returns and the underlying fundamentals. This observation does not mean that the current market has to end like October 1987, but we are clearly in a period in which we do not have comfortable alignment between expected future returns and the underlying economics that are in place to produce those returns. This misalignment inevitably will lead at some point in time-and everyone hopes this development does not go the way Japan's market did in the late 1980s-to a more normal equilibrating process.

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New Directions in Global Portfolio Management Michael J. Phillips President and Chief Executive Officer Frank Russell Company

Four major trends will dominate the future of investment management: globalization, strategic relationships, information technology, and dealing with conflicts of interest. A particular challenge will be serving individual investors, who hold great promise as a future source of revenue. Firms must develop a systematic investment model to meet multiple challenges imposed by an increasingly complex investment environment.

n the global business environment, investment management is out of the cottage industry stage of development. This industry is the focus of intense activity, with increasing numbers of financial and even nonfinancial companies identifying savings and investment deliverables as their core competence. Investment management is becoming a global industry in which scale, infrastructure, and particularly, information technology will be as important as, if not more important than, investment content as a determinant of financial success. The recent activity in the investment management industry has been driven by demographics, regulatory changes, the proliferation of new markets, the integration of markets, the information technology evolution, and above all, the unstoppable trend of individuals taking control over their financial destinies. The successful business model of the future must reflect the new reality. This presentation addresses some of the business changes occurring in the industry and some of the new tools available to support and enable changes.

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Industry Trends The successful business model of the future must address four key trends that are now affecting the investment management industry: globalization of fund management, strategic relationships (between plan sponsors and their investment managers), information technology, and dealing with conflicts of interest. Globalization of Fund Management. The in-

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vestment management industry is consolidating, and more global megamergers-such as Merrill Lynch/ Mercury Asset Management and Swiss Bank Corporation (and Brinson Partners)/Union Bank of Switzerland-are being reported almost daily. These global mergers are being driven by competitive pressures, proliferation of new markets and integration of markets, and revenue growth opportunities. First, competitive pressures, particularly the drive to control the interaction with the individual client, are clearly a dominant force in the industry today. For example, investment managers are convinced that they need enormous scale to justify the expenditure in information technology for the back office that is necessary to remain competitive. Second, the proliferation of new markets is leading to a lot more customers and a lot more places to invest. Firms feel that they need a greater presence to capitalize on these trends. Similarly, the integration of markets is making regional and national strategies less effective, or at least potentially less competitive. Finally, firms expect revenue growth opportunities to come through global alliances. A number of structural changes around the world are fueling these growth opportunities. Deregulation in Japan, for example, allows foreign investment management intermediaries to compete for domestic assets, whereas in the past, the Japanese trust banks and insurance companies had a lock on the business. In the pension area, countries all around the world are moving away from a pay-as-you-go model and toward a funded model for private and public pension arrangements. Many parts of the world are mov©Association for Investment Management and Research

New Directions in Global Portfolio Management

ing from a book-value model to a market-value model and from a defined-benefit model to a definedcontribution model. For large investment management organizations, these trends provide attractive revenue growth opportunities. Another potential source of revenue growth is demographic change. The 77 million Baby Boomers in the United States, for example, represent a demographic bulge of people with inadequate retirement funding. Not only is the government failing to provide adequate retirement funding, but this generation is increasingly seeking a retirement lifestyle richer than it was for past generations. They want to travel or go back to school, and such pursuits tend to increase the burden of savings on them and whatever institutions are contributing on their behalf to fund for their retirement. As a result, the Baby Boomer generation is looking at alternative and additional retirement funding mechanisms. Banks in particular see the demographic changes as a revenue growth opportunity and are considering the possibility of moving from interest-based revenue sources to fee-based revenue sources. This trend is not new at all, but it seems to be gathering momentum. The banks are concerned with the disintermediation that has been occurring for many years and are focusing on the high quality of earnings that stem from investment management fees, particularly if the fees are driven by the other growth factors. Such revenue growth opportunities have created the belief among investment managers that major players in the assets-under-management game of the future will need several characteristics. First, the major investment management firms will need scale-at least $250 billion-to justify the kinds of expenditures that will be necessary to compete. Second, they will need to have global reach and the distribution capability to reach individual investors, who will gain increasing control over their financial fates. As a result of the concern about reach and distribution, a lot of merger and acquisition activity has occurred in the industry. Further consolidation will take place, particularly mergers and partnerships in which non-U.s. entities (mostly continental European banks and insurance companies) seek to acquire what they will consider to be the jewel in their crowns-the U.s. money management component of a global business. Strategic Relationships. The second major trend relates to strategic relationships, a term that is really a euphemism for fund outsourcing. Clearly, the benefits of outsourcing relate to the ability of the company to concentrate on its core competence-building widgets, for example-and shift the management of the investments to professional money managers. ©Association for Investment Management and Research

Other factors affecting the outsourcing decision are costs, risk-return considerations, and fiduciary considerations. First, outsourcing is often less expensive than in-house management because the investment management company carrying out this activity has scale economies that are available only to the very largest pension funds. Second, by delegating the investment decisions to an organization for which investment management is a core competency, the sponsor should realize enhanced return for the level of risk assumed. Finally (and very importantly), the sponsor may realize benefits in the due diligence and fiduciary areas. A sponsor can never delegate the named fiduciary position but can delegate much of the procedural due diligence. Unfortunately, a truism of the investment management business is that you can be as improvident as you like and lose as much money as you like, but if you are imprudent, you are dead. Over the years, the institutional fund management marketplace evolved to favor a specialist manager approach, and large funds now have dozens of manager relationships. Some people view this model as suboptimal and are moving towards a model with fewer relationships, perhaps only one relationship, in an organization that is multifaceted and handles a much greater number of roles than the traditional specialist manager. Nevertheless, the trend towards outsourcing is gathering momentum in the United States and around the world and will continue to do so. In this environment, implementing the strategy for a whole fund is best accomplished through a multimanager approach, and organizations that are comfortable with manager differentiation and manager research and can thus construct portfolios of managers are going to have an advantage. Information Technology. Information technology is clearly revolutionizing the business. Investment products are extremely amenable to electronic commerce-from initial inquiry to transaction. Because investment management is a content-rich deliverable, the idea of perusing a proposition on the Internet is quite attractive to the prospective client and to the vendor. The only limitation is bandwidth restrictions, but this problem will be resolved. Taking advantage of the technology, however, will require huge economies of scale. Traditionally, investment products have been sold, not bought, but this pattern will change. When a product is sold, the buyer has a trust relationship with the intermediary who makes decisions on the buyer's behalf. The typical person does not delegate this responsibility on decisions that are critically important, such as marriage, a house, or a career. Such decisions are "bought"-that is, people do the 7

The Future of Investment Management

homework and make the decision on their own. In the past, because investment decisions have been accorded relatively low importance by many individuals, the intermediary played a large role in the transaction. With the help of information technology and a growing awareness of the importance of investment decisions, more investors will educate themselves and buy, rather than be sold, investments. Some significant part of the population will be willing to go through the interactive process from inquiry to transaction, and when they do, players such as Microsoft may come into this business. Electronic commerce is enabled by the World Wide Web, and investment managers need to run their firms with the knowledge that "e-commerce" will be the pervasive context of their industry. All investment management firms will base their information technology applications-such as client communications, decision-enhancing tools, client contact-on this electronic medium. Firms need to remember that the Web is global, has no boundaries, and does not respect exclusive relationships. Firms that do not adapt will suffer a fate similar to companies in the 1920s that decided they could do business without using a phone. Information technology is a serious challenge to the status quo of the investment management industry.

sumed to have ethics and values, just as individuals are presumed to be innocent until proven guilty. Organizations are moving in this direction, as demonstrated in many of their value statements and mission statements, which show that companies aspire to a set of values or ethics that is higher than the standards required by law. Regulators should move from a presumption of guilt to a presumption of innocence for investment management companies and investment consultants, particularly if the same regulators are sanctioning the consolidation of the industry.

Financial Decision Model In the new environment a systematic investment model is important. An effective decision model must have four characteristics: goals and preferences, performance expectations, a description of the investment environment, and a solution mechanism that can use the other components to produce some kind of investment strategy or asset allocation model. Recent developments in technology, both for hardware and software, provide many opportunities to make the decision model more realistic and reflective of the opportunity set facing the investor. In the past, financial models had to be very reductionist in nature because processing power was insufficient to make them more realistic. Researchers and practitioners had to throw out all the extraneous stuff and come up with something simplistic, and although such models may have been very accurate, they had very poor explaining power. Now, investment professionals have the quantitative tools to be much more realistic in their models. For example, in 1989, a multiperiod stochastic optimization model took two days on a Cray supercomputer to converge the algorithms. Today, the same model can be processed on a couple of personal computers in several minutes.

Dealing with Conflicts of Interest. Although the regulators are still concerned about conflicts of interest, they are allowing the consolidation and deregulation of the industry to go forward, which creates still more conflicts. The barriers are coming down, and the industry has to deal with an increasing number of conflicts. Methods and approaches exist for dealing with this problem. Such matters have become prosaic in investment banking. If a broker/dealer wanted a money manager to buy General Electric, the manager would probably not be concerned that the same investment bank might be long GE stock in its market-making organization. The manager probably would not be concerned that a new issue might be in the offing or that some other corporate action might be occurring for which the investment banking organization was serving as an advisor. Most money managers are not concerned about conflicts between investment bankers, broker / dealers, and money managers. In general, they respect the integrity of the organizations they deal with and trust the firewalls. Just because a firm has a conflict does not mean that it will abuse that conflict. Rather than assume that a firm will do whatever it can to maximize return on shareholders' funds (provided the action is within the law), the industry needs to move to a norm in which organizations are pre-

Goals and Preferences. All investors should have realistic goals and preferences for their portfolios. The goals may be set relative to a terminal wealth objective, a rate-of-return objective, or perhaps achieving a financial goat such as buying a house in six years. Goals must also incorporate a definition of risk. Although many asset allocation models treat risk as if it were a single parameter, such as portfolio volatility, this approach does not represent the real world of the investment manager. Risk depends on liabilities or the end purpose of the wealth accumulation, and in particular, risk is not symmetrical. Losses, especially large losses, are probably regarded as bad more than gains are regarded as good in the

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New Directions in Global Portfolio Management investment business. Skewness and shortfall aversion are a part of investing. Multiple time horizons are also a reality. For example, an investment strategy for Europe should consider at least two time periods: pre-EMU and post-EMU. Investment models of today must consider the broader definitions of risk and also the multiple time periods that are likely to be involved. A statement of goals and preferences must include the relevant constraints on the portfolio, such as legal, regulatory, or liquidity needs. These constraints may compete with return objectives or volatility objectives for the portfolio, and thus all considerations must be factored into the model simultaneously. Finally, goals and preferences may change over different time horizons. One goal may be dominant today, but that goal may be less important in the future. Despite the difficulty of pinning them down, goals and preferences are an essential part of a decision model. Performance Expectations. The second essential input to a decision model is a forecast of the relevant capital markets. In the past, people used to rely heavily on historical data to generate forecasts of future risk premiums. Today, a variety of new forecasting approaches, such as GARCH (generalized autoregressive conditional heteroscedasticity) models and conditional asset-pricing models, seem to be more predictive than the older extrapolation models. The newer models can incorporate expected market reactions to, say, interest rate changes. Performance expectations should make sense for different time periods, asset classes, and countries. The ideal is to have multiperiod optimization and sensible forecasts for each period. In asset allocation, forecasts of the individual performance of assets are less important than the returns relative to the opportunity set. Typical static asset allocation models do not handle such dynamics very well, but the increased complexity is one of the hazards of using this or any model. Investment Environment. The investment environment of today is more complex and opportunities more multifaceted than in the past. The opportunities include new securities, new markets, new derivatives, and private equity. Some of the new opportunities lack liquidity. Although illiquid assets

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have higher expected rates of return, liquidity is a temporal phenomenon and many people buy illiquid assets on the expectation that they will become more liquid. An illiquid asset has two sources of incremental return: One is the higher premium for illiquidity, and the other is the capitalization "pop" that is gained when the asset becomes more liquid. The expected changes in an asset's liquidity must be factored into a multiperiod model. New Solution Mechanisms. Coping with the new trends and the complexities of the business models of today requires innovative solutions and sophisticated technology. The human mind alone cannot meet all of the challenges in this complex environment. The new solution mechanisms being developed are going to be used by individual investors as well as by institutional investors. The new asset allocation models will have to be user friendly, colorful, and interesting in order to appeal to the individual investors. They will need to be able to accommodate multiple decision-making horizons, reflect the real nature of the investment opportunity, use multiple measures of risk (including the skewness that comes with shortfall aversion), and handle multiple and often conflicting objectives. The new solution mechanisms will also need to accommodate dynamic and rapidly changing expectations, market conditions, and regulations. Current practitioners grew up in a world in which investment strategy was supposed to be relatively unchanging. In the future, however, investment strategies, like everything else, will need to be dynamic.

Conclusion The new business models will change the industry quickly and permanently. The winners will be large, global investment management organizations that can control distribution to the individual investor and provide extraordinary back-office and interactive capabilities. The tools will enhance decision making-for institutions and individuals. Given the complexity of the future environment, managing money by the seat of your pants will be increasingly hard to do, unless you are the next Warren Buffett or David Fisher. The rest of us mere mortals are going to have to be content to hunt and peck at our personal computers.

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Thoughts about the Asset Management Industry of the Future Bluford H. Putnam President CDC Investment Management Corporation

The future challenges in asset management will be changing client demands and issues involving cost and revenue structures. Firms must accommodate the growing emphasis not simply on high returns but on high risk-adjusted returns, which means focusing on risk management and risk reporting. Because meeting new and specialized client expectations increases costs, asset managers will focus intensively on trying to control costs while enhancing revenues.

RiSk-Adjusted Returns. In the past five or six years, the institutional pension management and endowment communities have started desiring and demanding more than high returns; they are focusing on high risk-adjusted returns in excess of the performance benchmark The momentum toward riskadjusted returns-the focus on risk analysis that is coming from institutional investors-is somewhat amazing because a bull market as strong and as powerful as the one in US. equities from 1992 through mid-1998 tends to paper over a lot of investment sins. When equities are posting annual gains of 20-30

percent or higher, a few percentage points of underperformance can be forgiven. Institutional investors, however, have begun to focus increasingly on risk, even as they have watched their assets grow at an unexpectedly rapid rate. For asset managers, producing risk-adjusted returns in excess of performance benchmarks requires a disciplined approach that integrates risk measurement and risk management into every facet of the investment process. The need for an integrated, risk-adjusted approach to investing is taking place in the context of a revolution in risk-measurement concepts. Interestingly, the revolution started not in the asset management industry but in the banking industry with the techniques now grouped together under the label "value at risk" VAR techniques present a number of problems, but on the whole, they have been a powerful incentive for improved measurement of risk Banks, like many individuals, learn quickly when they lose large quantities of money in a short span of time. After experiencing a period in which a great deal of money has been lost, bankers often wake up the next day with the conviction that they do not want to do that again, and they ask themselves, "What did I learn?" Some very useful riskmeasurement tools have developed in the wake of massive losses. On the financial institution side, an early lesson came from the savings and loan institutions in the 1970s. S&Ls were borrowing short term, typically on six-month deposits, and lending long term, on 30-

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he asset management industry is changingagain. Institutional investors, specifically, are altering their requests and demands from the providers of asset management services. In addition, important issues are evolving in terms of the cost and revenue structures of asset management firms that have an important bearing on how these firms are likely to respond to the changing nature of their institutional investor clients.

T

How Clients Are Changing Institutional investors are changing the mix and type of asset management services that they are demanding from the asset management marketplace. This development is going to have significant implications for the structure of the asset management industry. Three key areas of change are the increasing focus on risk-adjusted returns, improving risk reporting, and providing broad-based asset allocation advice.

Thoughts about the Asset Management Industry of the Future

year mortgages. When interest rates went up in the late 1970s and early 1980s in response to rising inflationary pressures, the S&Ls were doomed, although they managed to survive a while longer by buying high-yield junk bonds. In response, financial institutions first introduced gap analysis and the concept of maturity buckets to measure interest rate risks. Then, they fell in love with measuring interest rate risks using"duration," a concept that was developed by academic researchers in the 1930s but had not been put into practice. Financial institutions were quite taken with the duration concept until 1987 when a large investment bank with a sizable portfolio of mortgages did an exciting thing: It made one pile of interest-only strips from the mortgages and another pile of principalonly strips. Because the financial marketplace judged that 10 strips were priced relatively cheaply, they sold quickly and the investment bank was left holding all the PO strips. The investment bank decided that interest rates were going down and that, rather than reprice the PO strips, it would hedge the interest rate risks using the duration concept. The duration-weighted interest rate hedge required the selling of U.S. Treasury futures contracts. Several things happened. Interest rates did continue to decline. The hedge position did lose the expected amount of money. The PO position, however, failed to earn an offsetting profit because the speed of mortgage prepayments accelerated unexpectedly with the fall in interest rates. Within about 10 days time, this "perfectly" duration-hedged position lost $250 million. The investment bank had learned several expensive lessons about the control of portfolio managers, and it also learned a lesson about the duration concept. Embedded options, such as the mortgage prepayment option, cause convexity. Convexity is a riskmanagement term that loosely means "everything we do not know about interest rate risk that duration fails to tell us." By losing money, bankers learned that embedded options cause all kinds of problems in risk management. The October 1987 U.S. stock market crash taught the investment community a few more lessons. At the time, the investment banking industry was keen on expanding the portfolio insurance business. BlackScholes option-pricing theory explains how to do portfolio insurance, but it also has 10 simplifying assumptions that investors ignore at their peril. The crash of 1987 proved that a couple of those assumptions are especially dangerous to one's financial health when they rear their ugly heads. One assumption is being able to trade at continuous prices. The crash showed that markets can and ©Association for Investment Management and Research

do gap down in prices, with no trading in-between. Another dangerous assumption is that volatility is constant. It is not. It can get very large very quickly, which dramatically raises option prices or the costs of an option-replicating portfolio insurance program. One well-known commercial bank with a welladvertised portfolio insurance product linking S&P 500 Index returns to retail certificates of deposit was reported to have lost about $80 million in its "hedged" portfolio insurance program in only the first few hours of the 1987 crash. The investment banking profession learned a new Greek letter from the 1987 disaster-vega risk (change in volatility)-and a new appreciation of all of the truly practical issues that academic theorists often ignore through the analytical simplification of assuming that the problems do not exist. Such assumptions make theory simpler and more intuitive and often more dangerous to the practitioner's financial healtho In fact, the world of risk management now requires a course in Greek to deal with the recognized complexities of options management. Investors and risk managers now need to know delta, gamma, vega, theta, and so forth. These developments occurred on the banking side of the financial business. More recently, a disaster on the funds management side focused people's attention on risk management. In February 1994, when the US. Federal Reserve Board tightened money policy for the first time in a long time and interest rates went up, bond markets went down 2025 percent all over the world. This event drove home the point that geographically diversified portfolios are not all that financially well diversified in a crisis. People who owned Australian, French, US., and Canadian bonds may have thought they were globally diversified, but the correlations were close to 1 for two months in 1994. The lesson was that managers must understand better how their various exposures fit together both in normal times and in a crisis. Correlations move the subject of risk management from the banking world, characterized by one transaction after another, to the investment management world, where transactions are put together into portfolios. Specific events in which money has been lost, such as the February 1994 episode, have brought the money management industry to the point of considering the risk inherent in the whole portfolio and turned the industry away from focusing exclusively on the risks in individual positions. Indeed, some argue that institutional investors reached the point of focusing on total portfolio risk faster than the asset management companies did, and many investors are demanding much more risk analysis and reporting from asset managers than the asset managers cur11

The Future of Investment Management Performance fees resemble call options. If the investment manager has a bad year, in certain cases, the structure of performance fees may, as some argue, provide an incentive for the asset manager to take more risk. This outcome need not be the case at all. Any appearance of an incentive to take excessive risk can be effectively eliminated in two ways. One way is for the investment manager to have a disciplined investment process in place that forces the asset manager to practice risk management in all stages of creating and managing portfolios. From the investor perspective, the asset manager has to prove that a strong risk-management process exists; typically, the process needs to be transparent so that the client is able to see and monitor it, which includes receiving regular risk-measurement reports. Another way to eliminate the potential for taking excessive risk is for investment managers to have their own money on the line with the clients' money, which can happen in several ways. At a minimum, both the firm and the portfolio managers should get paid on the basis of the excess return performance of the portfolio. If possible, the company should have its own funds invested with the clients. In our case, CDC Investment Management puts its own money in each of its products and each portfolio manager's compensation is tied to the performance of the product. In addition, the employees also have portions of their 401(k) plan and deferred compensation funds invested in those products. So, both the firm and the manager have their money on the line in several ways, which is a powerful and effective risk-control device. Incentives are a powerful management tool to focus portfolio manager attention on risk-adjusted excess returns. No matter what devices firms use to reward on the basis of added value, they should be using something. Investors are demanding superior risk-adjusted returns, and the industry must meet those demands.

rently are able or prepared to provide. A parallel risk-management revolution has transpired in the corporate finance industry. Companies are actually portfolios of various businesses, and different companies use different paradigms, or investment processes, to manage themselves. One of the hot topics in corporate financial management is the concept of Economic Value Added. EVA is not a lot more than Modern Corporate Finance 101 with a marketing label on it and a lot of practical considerations, but it reminds companies to think about the weighted-average risk-adjusted cost of their capital and about aligning shareholder interests with management incentives. The implica tions of EVA concerning aligning the incentives given to managers with the interests of the owners, the stockholders, is critical and highly applicable to the asset management industry. A corporate compensation scheme that is performance based and that considers the value added by management after adjusting for risk is a concept in the corporate community to which shareholders pay a lot of attention these days. Establishing compensation plans to appropriately reward superior riskadjusted corporate performance is one important part of the EVA message about the need to align the interests of the company's managers with the interests of the owners. Some outstanding firms have adopted this concept. Coca-Cola has been basing executive compensation partly on risk-adjusted corporate performance for more than a decade. The chair and CEO of SPX Corporation, John Blystone, is a disciple of EVA. Federal-Mogul Corporation is a company in a boring business-auto parts-but with an exciting stock price, and it uses the EVA technique to make sure that everything it does earns a proper risk-adjusted return and that all the managers get paid for adding excess return. Applying EVA concepts to the asset management industry means not only emphasizing riskadjusted performance measurement but also tying portfolio manager compensation to above-benchmark risk-adjusted investment returns and linking client interests to asset manager interests through the use of performance fees. For example, at CDC Investment Management, 98 percent of our clients pay us performance fees. We rarely take an account that does not pay performance fees, and we never take an account that does not have the long-run potential to pay performance fees. We do so because we want our interests aligned with the client's interests, which is part of building an asset management culture that provides strong incentives to deliver superior riskadjusted performance. Performance fees are not problem free, however.

Improved Risk Reporting. In addition to superior risk-adjusted performance, investors want improved risk reporting. They want to know more than they did in the past about what is happening in the portfolios. Asset management companies have come a long way in reporting returns in excess of benchmark returns. The next step is reporting how the firm manages risks: How does the firm measure risk? What is its tracking error to its benchmarks? How does the firm know where its risk exposure is at any point in time? Asset management firms increasingly need to explain to clients on a regular basis how they are practicing risk management. CDC Investment Management gladly sends its risk reports to the several clients that want to see such reports on

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Thoughts about the Asset Management Industry of the Future

a regular basis. On an industrywide basis, the next few years are likely to see a sharp increase in requests from institutional investors for detailed riskmanagement reporting to be provided with the monthly investment performance reporting. Asset Allocation Advice. Beyond risk reporting and high risk-adjusted returns, clients are seeking advice from their asset managers in the asset allocation process. How clients carry out asset allocation will probably be one of the biggest changes in the future. Today, many pension funds follow the hierarchical model in asset allocation processes-and follow it to the extreme. In various discussions, William Sharpe has contrasted the hierarchical model of decision making on asset allocation with modern portfolio theory. In the hierarchical approach, institutional investors divide the world first into equities and fixed income. On the equity side, they divide the world into large-capitalization and small-capitalization sectors and then divide their approaches into active management and indexing. None of those decisions has any bearing on what happens on the bond side, for which they divide the world into domestic versus international, currency overlay versus no overlay, high yield versus investment grade, and long duration versus short duration. Moreover, in the hierarchical model, whether on the bond side or the equity side, decisions on outer limbs of the decision tree do not depend on the decisions made before them on lower limbs of the decision tree. This condition means that the decision tree process of the hierarchical approach to asset allocation is implicitly assuming that the correlation between each pair of decisions is zero. That is, institutional investors are not taking the existence of nonzero correlations into account, and in terms of modern portfolio theory, if correlations are not taken into account, allocations are being improperly done. The lesson of modern portfolio theory is that the investor needs to understand returns and risks and correlations. Harry Markowitz won the Nobel Prize for understanding correlations, but although he did that research in the 1950s, the profession is only now properly applying his ideas. More and more clients are accepting the modern portfolio approach, and they are going to be asking their investment managers to help them in that process because asset managers are supposed to be managing portfolios, not simply doing trades. Investment professionals, therefore, need to move away from the hierarchical approach and toward the portfolio theory approach. To make such a move, firms will need a decision structure in which the bond people talk to the equity people. In that way, the various decisions get a full discussion of how they affect each ocher. ©Association for Investment Management and Research

This transition is another case in which a parallel change is occurring in corporate finance. Corporate managers like to divide bonds from stocks and think of them as two separate methods of financing the operating business and new investments. The capital structure of a typical corporation, however, is a risk continuum. On one end of the continuum are the wage earners, who get paid first; then comes the senior debt to the banks; followed perhaps by senior bondholders, who get paid before junk-bond owners; followed by the holders of preferred stock, who are paid before the common stockholders. Then, options and warrants take up the residual risk on the common stock. The capital structure involves a complex correlation-and-risk relationship among all these instruments. As an asset manager focused, for example, on corporate bonds, one would want to know more than pieces of information about bonds; one would need to know what the stock price is doing. Common stock represents a claim on corporate cashflow that is junior to corporate bonds in the capital structure of a company. If a problem is occurring in the cash flow prospects of a company, the stockholders will be the first to panic. If the stockholders panic, then the bond holders are likely to panic right after them. In short, investment professionals and corporate managers need to be thinking of stocks and bonds as different points on the continuum of capital structure alternatives and should be using an overall approach to asset allocation and stock-bond analysis that incorporates this modern vision of corporate capital structure and its implied interrelationships between equity and debt as means of corporate finance. In theory, the large asset management firms ought to be able to provide high-quality asset allocation consulting for institutional clients. The term "consulting" is misleading in this case because asset management firms do not get paid for such consulting; it is part of providing the investment management service and something the client expects. That is, if a firm has products in different asset classes, clients expect the firm to explain how the products relate to each other. This conversation is often difficult for the large firms, because their organizational structure often totally separates equities from fixed income, which makes understanding asset allocation much more complicated than it needs to be. But asset management firms must come to grips with this client demand if they are to effectively cross-sell their different products. One model of asset allocation advice that firms may choose-partly to save costs and partly to meet client demands-is to change the chief investment 13

The Future of Investment Management officer (CIa) function. Today, firms generally have one CIa for fixed income and one for equities. In the next 20 years, this split may disappear. Instead, firms will have one CIa for asset allocation to handle the big decisions, such as how much should go to equities, how much to bonds, how much to international, how much to domestic, and how much to alternative strategies. Another CIa will handle micromanagementwatching the trading, the individual risk management, the analysis of individual stocks and bonds. One of the reasons the industry may use two CIOs is that the two kinds of talents-asset allocation and micromanagement-do not combine well. For example, one reason US. active equity managers do not perform well relative to the S&P 500 Index on average and over time is that good stock pickers think they can also time the market. Normally, they cannot. Stock picking and market timing are separate skills. Similarly, good international stock pickers think they know about exchange rates, but they rarely do. They may be glib talkers on the subject, but their results are generally dismal. Understanding the management of a global or international company-how it is built, prospects for its products, cost structures, corporate culture issues, and so forth-is a very different skill from being able to figure out whether interest rates are going up or down and what is happening to the inflation rate, which are the things one needs to know to forecast exchange rates or time a broad-based market index.

Client demands raise certain issues for asset management firms. One issue is costs. Good portfolio managers are expensive, but bad portfolio managers are even more expensive because, with them, the firm loses business. To meet client demands and keep costs from growing too rapidly, firms may turn to using more and more quantitative tools. The tools are intended to leverage the work of good portfolio managers, but using quantitative tools is not easy. The industry makes many mistakes with its quantitative tools. A firm may hire a lot of fancy mathematicians and statisticians and may build some interesting models, but then, the models do not work. Any good statistician who is told the answer someone wants can build a model that will produce it. So, building statistical models that have some marketing impact is easy. If the goal is excess returns over a long period of time, however, a firm must be careful. Building quantitative tools is like building an airplane: An engineer (statistician) can build it, but running it properly takes a pilot. No matter how good the quantitative tools are, human beings must run them, human

beings must make some judgments. So, quantitative tools offer some cost savings, but firms have to make sure the process incorporates plenty of human judgment. Another problem on the cost side is that many clients want their own special guidelines-for example, "managers cannot have more than X amount in a certain position" or "managers cannot buy certain stocks" (because, perhaps, the clients do not like the companies' social policies). I hope the acceptance of VAR will remove some of these individual and position-specific guidelines, because they cost the client money in terms of subpar performance. Asset managers should manage risk from the top, using a fullportfolio approach, then the only guidelines needed are to be within a reasonable total-risk framework and to have an appropriate tracking error to the benchmark. Whether special guidelines fade away or not, asset managers must be able to manage the investment process effectively while being responsive to other client needs and preferences. Clients have tax issues, regulatory issues, and risk-tolerance issues. So, the asset manager's assignment is to have a disciplined investment process that is flexible on those issues. One way investment managers achieve the dual goals of effectiveness in terms of performance and responsiveness to different guidelines is to develop a consistent investment process, then use financial engineering to work with the various risk tolerances and different guidelines. In addition, some asset management products may also use innovative capital structures to solve the tax and regulatory issues without damaging investment performance. For instance, insurance companies, which are essentially large piles of institutional money, often use special capital structures that are friendlier from an accounting perspective than simply investing in the portfolio management product directly. In this new world of risk-adjusted performance, institutional investors are providing investment managers not so much with cash or capital as with risk tolerance or risk-bearing capacity, and the asset managers' job is to put the investment process into a flexible structure that can deliver what the client wants. To achieve those goals at reasonable cost requires that the management firm, while staying focused on the basic investment processes, allow a lot of creativity to the team that structures the legal vehicle. Another issue affecting costs is client demand for more risk reporting. If clients are demanding more service, client-service costs will rise. In addition, risk reporting requires highly educated client-service

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Cost Structures

Thoughts about the Asset Management Industry of the Future

people. Talking about returns is hard enough; talking about risk management is a new and complex area of expertise for the marketing team. So, firms are going to be spending money for the training of marketing and client-service staff. Risk reporting also raises the risk of back-office mistakes, and back-office mistakes can be extremely costly. Much of the focus on the asset management industry, therefore, will be on trying to manage back-office costs in order to meet the client demands for enhanced risk reporting and analysis.

Revenue Structures Several trends are affecting revenues in the investment management industry. Among the most important are the rise in the use of performance fees and increasing diversification in products. Performance Fees. Increasing use of performance fees will solve many of the problems associated with increasing assets too quickly. A strong case can be made that one of the most important reasons the u.s. equity mutual fund industry fails to deliver excess returns over the S&P 500 Index is that it has grown too big too fast for the typical investment styles used. This problem of persistent underperformance is emphasized when asset managers are paid fixed fees based on assets under management. More assets mean more fees. Poor performance may not hurt so much in terms of lost business if the whole industry is making the same mistake. In contrast, the profit picture of asset management firms is dramatically affected by underperformance when performance fees are paid. Firms will take steps not to increase assets beyond their capacity to manage them successfully if their performance fees are disappearing faster than their base fees are growing. The growth in performance fees as an industry trend, if it occurs, will probably motivate investment managers to focus more on excess returns and less on growth of assets under management, and this development will be a very good thing. Product Diversification. If a firm has a lot of products, one of them is likely to be a winner, but this aspect is not the only issue. Clients happy with one product may be ready to buy the next product from

©Association for Investment Management and Research

the firm because they trust the firm and believe in its disciplined investment process and risk management. Moreover, they have already accepted the firm's fee structure. When clients have bought into the firm in this way, not to have another product to sell them is a crying shame from a revenue perspective. Even a small asset management firm can get 60-70 percent of new sales from existing clients, assuming the clients are happy, which brings us back to performance and to the decision of whether to practice passive versus active management. The index business is basically a commodity business. When an institutional investor makes a decision simply to be in an asset class, the client wants to do so as cheaply as possible, which implies passive indexing. Clients who are seeking higher returns than index returns will choose active management. Within the active-management sector, the trend is likely to point toward institutional investors insisting on performance fees. They do not want to pay if there is no excess return over the benchmark. This problem also gets to the heart of the passive versus active debate. In the end, therefore, the profession is going to answer the index versus active question as follows: Clients should index if they are not willing to pay performance fees. If they are willing to pay performance fees, then some portion of their portfolio should be in active management.

Final Thoughts All these trends-seeking risk-adjusted returns, demands for high-quality and transparent risk reporting, increasing needs for asset allocation advice, splitting the CIO function, increasing use of performance fees-will accelerate in the future. Several potential catalysts could make these trends happen faster. One interesting catalyst would be the end of the bull market in equities. Another would be a heightened awareness-by pensioners and other beneficiaries of institutional investor holdings-of the long-run consequences of underperformance by typical asset managers. Whatever the catalyst is, there is little doubt that the asset management industry is going to change much more quickly than some of today's players would like or would be prepared to admit.

15

Structure and Competition Richard M. Ennis, CFA Principal Ennis, Knupp & Associates

The 1990s have been characterized by the remarkable movement of assets from active to passive management and the phenomenal proliferation of new products. The former trend will intensify; the latter likely will continue, with new-product development becoming more selective. Segmented markets offer the best opportunity for active management.

rowth in assets under management is mind boggling, products are proliferating, and firms are adopting a product focus rather than an investment focus. What do such developments mean for the structure of and competitive opportunities in the investment management industry going forward? The purpose of this presentation is to set the stage for considering the future of the investment management profession by taking a macro view of investment management as a business-the economics of the business, growth and its consequences, and commercial opportunities. The final section presents specific conclusions about the structure and competitive opportunities for the investment management industry.

G

Economics

inefficient markets should generate moderate concentration. That is, assets should be concentrated in the superior active managers that could be identified. "Operationally efficient" markets are ones in which investment managers are not able to outperform the market net of active-management fees. As a result, investors are constantly chasing investment managers who can provide performance over time. In operationally efficient markets, the investment management industry is not concentrated. No economic basis for concentration exists: Assets tend to follow past performance, and past performance tends not to persist. Atthe far right of the spectrum is the economist's notion of a "perfect" (or perfectly efficient) market, in which all asset prices, even before the investment profession gets to work, reflect all the information available. In principle, in such a market, any expense for active investment management is a waste. This relationship between market efficiency and concentration leads to the industry structure theorem: The investment management industry is only as concentrated as the information advantage. At least in the U.s. market, this theorem tends to hold in the real world.

The structure of the money management industry is directly related to the efficiency of the investment market. Figure 1 summarizes this relationship. At one end of the efficiency spectrum is what might be described as "grossly inefficient" markets. Such a market is totally foreign to U.S. investment professionals, but if it did exist, it would be characterized by a relatively small number of managers with a virtual monopoly on information. In such a case, who the superior managers are would be very obvious and management services would be highly concentrated. The industry would have very high feesalmost certainly in the form of a percentage, and probably a high percentage, of the return. In "marginally inefficient" markets, not everyone can identify superior active managers, but careful research on the part of investors can help them identify such managers-those who can outperform a market over time with some reliability. Marginally

Active Management. Consider the traditional active-management segment of the business in the United States. Figure 2 shows the fraction of total taxexempt assets under management being managed by the 10 largest active-management firms and by the 10 largest passive-management firms. Figure 2 depicts an active-management business that has been and remains very unconcentrated. Moreover, the market leadership has not been stable: Of the 10 largest firms that existed in 1987 with 20 percent of the market,

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Structure and Competition Figure 1. Market Efficiency and Industry Structure Grossly Inefficient

Marginally Inefficient

Opera tionally Inefficient

Concentrated

Perfect

Fragmented

only 3 were among the 10 largest firms in 1996. In short, because assets chase performance and this market segment has shown little evidence of persistence of performance, the industry is unconcentrated and market share rankings tend to be unstable. Since 1990, the number of firms in the activemanagement segment of the industry has fallen. As Figure 3 shows, after a period of growth from 1987 to about 1990, the number of firms actively managing tax-exempt assets began to decline and has declined fairly steadily ever since. The reduction in the number of firms in this segment has been about 30 percent since 1990. Indexing. The index fund side of the business serves as a counterpoint. Figure 2 shows that the passive segment of the U.s. tax-exempt business has been consistently concentrated in the 1987-96 period. Some 55 firms were listed as offering classic passive index fund services in early 1998. The top 10 have consistently had about a 90 percent market share. Indeed, the top 5 have fairly consistently had 80 percent of the market. Moreover, the market share

ranks of the top 5 have been highly stable from year to year in this 10-year period. The indexing business is a classic oligopoly. Essentially undifferentiated products matching standard market indexes are offered. The indexing business makes possible significant economies of scale that do not exist in the active business. As a result, this segment is highly concentrated, with stable market shares. Strong incentives exist-not only fee considerations but economies in asset transfer and other economies-for clients to consolidate their assets with a single firm. Marginal costs are practically zero in this segment. As long as competition exists in the indexing business, prices will continue to decline as the assets under management grow. One of the most significant trends in the business in the past 15 years has been the movement of assets from active to passive management. As Figure 4 demonstrates, in 1980, about 2 percent of the assets of large defined-benefit plans were indexed-that is, invested through classic indexing, excluding immunized portfolios and dedicated portfolios. After 17 years, that percentage had grown to 27 percent, with no indication that the percentage is leveling off.

Growth Between 1975 and 1997, adjusted for GOP growth of 88 percent and the loss in market share to indexing, the demand for active management increased by 600

Figure 2. Percentage of Tax-Exempt Assets Managed by Top 10 Active and Passive Managers, 1987-96 100 , - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - ,

90~ 80

Passive Segment

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60

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.

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oL-----"----------'--------'--------'----------'---------'---L----'------------' 87

88

89

90

91

92

93

94

95

96

Note: Enhanced index funds are in the active segment. Source: Based on data from Pensions & Investments.

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The Future of Investment Management

Figure 3. Contraction in Number of Active-Management Firms, 1987Mid-1998 1,100

r-----------------------------~

1,000

§ P:;

900

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~

800

Z 700

600 1/87

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1/89

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Source: Based on data from Pensions & Investments.

Figure 4. Growing Market Share of Indexing 30 25

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Note: Percentage indexed of total assets for 200 largest US. defined-benefit plans. Source: Based on data from Pensions & Investments.

Product Focus. The focus (and structure) of investment management firms is changing. Twentyfive years ago, firms focused on investment research.

They had simple product lines-say, an equity portfolio and an equity portfolio with some bonds. The firm I worked in at the time had about 20 people in the organization: 10-12 portfolio managers and analysts, a chief investment officer, traders, a chief economist, and one marketing person. The portfolio managers carried out client service on the side. A significant change in the business in the past 25 years has been a gradual but steady shift in allocating resources from investment research to product development, marketing, and professional client services. The critical trade-off is that, because of limited capital, an investment firm can either invest in its existing products (to try to make them more competitive or to make any existing advantage, such as an information advantage, stronger and more robust) or it can develop and market products. It cannot do both on an unlimited basis. Most firms do

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percent-a more than sixfold rate of growth in demand for traditional money management services. A 600 percent real growth relative to an 88 percent growth in the economy helps explain why some money is staying with active managers, even those that have not performed. If vast amounts of money are coming in, money managers can ignore certain competitive problems and the loss of market share to indexers is relatively painless. This growth in assets combined with efficient markets has led to a transformation in the investment finn over the past several years: The investment management firm of the 1990s has evolved from a focus on investment research to one of new-product development, which is leading to rapid product proliferation.

Structure and Competition some of both, of course, but what has been occurring is a transfer of resources from strengthening existing products/skills toward product development, marketing, and client service. The structure of most investment organizations today reflects that shift. Product Proliferation. The focus on product development has produced one of the most striking characteristics of the money management business in this decade-an unprecedented proliferation of products. One of the reasons for the proliferation is the recognition that markets are hard to beat and investment firms that put all of their eggs in one basket face risks that firms with a broad product line do not face. For illustration, Figure 5 shows the relationship between product-line breadth and the probability of success (defined as a 10-year record of outperforming the market, the benchmark, net of fees). The figure assumes that a market is efficient and that any product, on average, will outperform the market by slightly less than 50 percent in anyone year. The top line graphs the probability of success of at least one winner, and the bottom line, of at least three winners. For example, the top line indicates that a one-product firm, under the assumptions, has about a 37 percent chance that its one product will have a positive record, net of fees, after 10 years relative to its benchmark. If the number of products increases to five, then the probability rises sharply to almost a sure thing, about 90 percent. The bottom line shows that the likelihood of having at least three winners also increases sharply with the number of products. A firm that is offering 10 products has an 80 percent chance that three of the products will wind up with successful records.

These probabilities are not surprising, and to the extent that markets are efficient, this phenomenon accounts, I believe, for the significant product proliferation of the 1990s. Between 1993 and 1996, Nelson's Publications which reports on products for taxexempt investors, went from listing 6,000 products available to pension and endowment funds to listing 9,000 products. Hedge funds, which were all but unknown in 1975, are now reported to be 4,000-5,000 in number, and a whole cottage industry has grown up to keep track of them. A look at changes in the number of products per management firm also sheds light on product proliferation. Table 1 reports such statistics for the mutual fund industry. Between 1985 and 1995, the number of fund managers more than doubled, although the rate of growth slowed in the second half of the period. In the same period, the number of mutual funds that the industry offered increased from about 1,500 to nearly 5,800. So, the number of funds offered per manager increased from 6 to more than 10, despite the number of managers in the business more than doubling. These figures provide a striking example of product proliferation and the advent of the multiproduct business strategy. Efficient markets have been the prime progenitor of the multiproduct firm. Many money management firms apparently have the (unwarranted) view that introduction of a new product is a competitive panacea, and the market in the institutional business is experiencing a glut of products that are only superficially differentiated.

Figure 5. Relationship between Probability of Success and Product-Line Breadth over 10 Years 100 90 ~

'"'"u

;:l

At Least One Winner

80 70 60

[f}

'0 50

g 40

At Least Three Winners

:0oj

.n 30 0 l-<

P-.

20 10 0 1

2

3

5

4

6

7

8

9

10

Number of Products Offered

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The Future of Investment Management Table 1. Product Proliferation Year

Number of Mutual Fund Managers

Number of Mutual Funds

Funds per Manager

1985 1990 1995

252 423 558

1,528 2,917 5,761

6.0 6.9 10.3

Source: The Investment Company Institute.

Opportunities

Global Fixed-Income Market. Most people, if asked what is the best benchmark or index for bonds, would probably answer something like the Lehman Brothers Aggregate Bond Index or the Salomon Broad Market Index. Neither one, however, is a comprehensive index of the bond market. For example, Figure 6 compares the Lehman Aggregate with an estimate of the global fixed-income market. Even though the Lehman Aggregate is much more inclusive than the old Lehman Government/ Corporate Index, which represented only two particular slices of the Aggregate pie, the Lehman Aggregate leaves out a staggering array of investment opportunities. The market pie on the bottom includes those segments of fixed-income markets that Ennis, Knupp & Associates clients invest in. It does not include every conceivable kind of fixed-income category (tax-exempt municipals, for example, are not included). High-yield bonds and non-U.s. dollar bonds as listed in the "Other" category, for example, are regularly found in our client portfolios. The three categories that make up the total Lehman Aggregate are only 25 percent of the market pie ("Public Corporates" in the market pie is the "Corporates" in the Lehman Aggregate pie). Many of these fixedincome market segments by themselves-the U.s. Treasury segment, for example-may be highly efficient, but the total market is not. Opportunity lies in global fixed-income investing because it is not obvious how to compose a portfolio that might invest in all of these categories. Our clients typically say something like, "Well, let us have a portfolio that is not any more volatile than the Lehman Aggregate, but we would like to add some value." One of the prime opportunities for adding value is for the management firm, if the managers understand what causes market segmentation and what besides information influences pricing, to apply their intelligence and investment expertise to construct a portfolio that brings together a disparate collection of elements within the fixed-income opportunity set. An implication of this opportunity is that some of the most successful investment management strategies require broad, rather than highly specialized, mandates.

The greatest opportunity today in the active segment of the investment management business is associated with segmented markets-not inefficient markets versus efficient markets and not market inefficiencies but market segmentation. Economists see the existence of market segmentation when environmental factors cause two equally well-informed investors to pay different prices for the same or equivalent securities in different markets. So, whereas the notion of efficiency has to do with the speed and cost with which information finds its way into prices, segmentation has to do with the circumstances of the investors and the markets that cause different assets to predominate in different investors' portfolios. The typical sources of segmentation are differences in rates of taxation, liquidity preferences, a number of international factors (such as foreignownership restrictions), currency risk, different costs of obtaining information from country to country, legal restrictions (primarily in the insurance industry), multiple classes of shares issued, and differences in risk tolerances. One indicator of a segmented market is that investment professionals will have a hard time agreeing on the best index for that total market. For example, the u.s. stock market is not segmented; it is a highly efficient and integrated, or coherent, market. If asked what is the best index of the whole market, investment professionals do not pick the DJIA or the Value Line index; they pick a broader index, such as the S&P 500, the Wilshire 5000, or the Russell 3000. They do not disagree wildly about characterizing the equity market. In an integrated efficient market, the textbook market portfolio becomes the agreed-upon benchmark. The types of competition are also different in integrated versus segmented markets. In a segmented market, because money managers cannot agree on a benchmark and cannot identify the single best index, passive investment strategies are difficult. Indexers are at a competitive disadvantage. Two examples of segmented markets today are the global fixed-income markets and the international equity markets.

International Equity. The other example of segmented markets is the international equity markets. As with fixed-income investing, clients tend to hire for their international equity investing, not specialists, but managers who can bring coherence to the overall portfolio-managers who are capable of integrating the equities of developed markets and emerging markets and can cope with currency, information-cost differentials, and the rather illogical character of capitalization weighting found in indexes such as the MSCI Europe/Australasia/Far East (EAFE) Free Index.

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©Association for Investment Management and Research

Structure and Competition Figure 6. Comparison of Lehman Brothers Aggregate Bond Index and Estimated Global Fixed-Income Market

Lehman Aggregate as of September 30, 1997 (market capitalization = $4.9 trillion)

Mortgage- and Asset-Backed Securities (MBS and ABS) $1.5 trillion

Government $2.5 trillion

Corporate $0.9 trillion

Estimated Global Fixed-Income Market for 1997 (total market size = $18.6 trillion) Treasury/Agency 13.2%

Other

Non-U.s. Government 22.1%

Eurobonds 3.5% Other~

6.2% Public Corporates 5.1% Private Corporates " 4.3% N onagency MBS 3.0%

The Future In the traditional money management business, the investment management industry structure is as concentrated as the information advantage. Although the marketing of past performance plays a role in clients moving assets from one place to another, performance alone causes the clients to stay put. If performance does not persist, the market will become less concentrated. This conclusion flies in the face of the conventional wisdom that the money management business is consolidating. I do not see the consolidation. Certainly, contraction is occurring in the number of active-management firms. The contrac©Association for Investment Management and Research

Brady Bonds 0.7% Other Emerging Market Debt 0.5% Commercial MBS 0.5% 144a Securities 0.4% Taxable Municipal Bonds 0.5%

tion, however, is largely a result of a significant part of the market moving into index funds, not of concentration among active managers. The traditional business has experienced a significant loss of market share, but the phenomenal asset growth in the past 25 years is masking this loss. The indexing business, on the other hand, is an oligopoly, a highly concentrated business with steadily falling prices. The indexing business will become a four- or five-firm business. Individual firms will handle upwards of $1 trillion each. (Barclays Global Investors recently hit $0.5 trillion.) Prices, however, will continue to fall as long as competition continues. 21

The Future of Investment Management

The emphasis on new products forces firms to reduce investment research and has led to a proliferation of (mostly undifferentiated) products. I believe clients and consultants are overwhelmed today by the sheer number of products. The result is that the investment manager search is becoming increasingly superficial. Clients are guessing in their manager selections. As a consequence, when they make new manager appointments, they have less confidence in their decisions than in the past, and when manager performance disappoints, they have a shorter fuse. I am skeptical about opportunities in the U.s. equity market for narrow specialists. Zillions of products specializing in increasingly narrow areas and benchmarked against increasingly tailored benchmarks are available, but I believe investment managers are going to have a hard time consistently adding value and retaining assets in this integrated and highly efficient arena. Segmented markets offer investment managers today the greatest opportunity. The greatest growth thus will come in assets allocated to global fixed-income and international equity markets. Segmentation provides investment management opportunities-but not necessarily forever. As segmentation diminishes, as fundamental factors change, some of the opportunities caused by segmentation disappear. In international equities, for example, the segmentation was much more extreme 10 years ago than it is today. When the Japanese market was more than half of EAFE, when foreign currency risk was perceived to be significant, and before investors could diversify extensively into emerging markets, many investors were apprehensive about making significant investments into non-U.s. markets on the basis of an index. The indexes simply did not reflect the realities of the global marketplace. Now that Japan has shrunk to about 30 percent of EAFE, emerging markets are routinely added for diversification, and currency risk seems to have lessened, more people will be embracing indexing in the international markets. N ow for other specific predictions:

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•

•

•

•

•

I foresee more indexing of U.s. equities. Indexing in the institutional area will probably reach an equilibrium level of about 50 percent (compared with about 27 percent in early 1998). Fee levels on the active side of the business will not be the problem. Keeping money for active equity investing at all will be the problem. Product development, marketing, and building strong client relationships will continue to be vital components of strategy. New-product introduction, however, will have to become more selective. The phenomenal growth in assets has made possible the proliferation of products: The money has had to go somewhere. The business has been in a stunning period of asset growth, and if that asset growth does not continue, the rate of new-product development will have to slow. Mergers are inevitable and will continue. They will contribute to the formation of new investment firms and will also probably produce more indexing. Finally, strategic alliances-if defined as something more than a simple cordial customer relationship-will be atypical in the traditional investment management business. Strategic alliances are relationships in which both parties give up one benefit for another benefit. For example, a client may receive reduced management fees by signing a long-term contract. The firm gives up income; the client gives up flexibility. (A client that simply wants a lower fee is looking for a discount, not an alliance.) The fiduciary requirements of managing these funds make such an arrangement impractical. An investment management agreement is cancelable on 30 days notice because the client has a duty to the plan participants and has to have control over the assets. Assets, therefore, will tend to follow performance. Strategic alliances are a bit more likely in the index fund business because the product is clearly deliverable and clients receive certain benefits by tying in with a single firm.

©Association for Investment Management and Research

Structure and Competition

Question and Answer Session Richard M. Ennis, CFA Question: The mutual fund business seems to be becoming concentrated on the basis of distribution and marketing considerations (rather than information advantage). How does this perception square with the notion of an unconcentrated industry? Ennis: The statistics were for the traditional institutional market. In the course of this research, I did do the same type of analysis of the mutual fund industry, which is moderately concentrated. In 1987, the percentage of the mutual fund industry held by the 10 largest firms was about 50 percent-in between the concentration of the passive and active segments shown in Figure 2. During this 10year period, the mutual fund industry has become not more but less concentrated. In fact, at the end of this period, the 10 largest firms held 40 percent of the mutual fund market. Even in the mutual fund industry, the market shares of the leaders, such as Fidelity Investments, have eroded. My major point is that economics determines industry structure as much as or more than all the marketing activity. Money is going to go where it perceives performance to be. If a performance advantage doesn't come with concentration, there simply isn't any economic basis for concentration. Question: What is the potential for vertical integration in the passive, indexing segment? Ennis: Some vertical integration has already occurred in brokerage within the large index firms (in the sense of trading through internal markets), but beyond that level, the potential for vertical integration is

limited. The fiduciary duties of the people who place assets with investment managers limit the extent to which services can be bundled. Fiduciaries are not going to put money in places where they can't take it apart in the way they want. Question: How do you define enhanced index funds, and what are the opportunities, fee structures, and main players in that business? Ennis: Enhanced indexing is nothing more than active management-pure and simple. It is highly risk controlled. It is an active product that comes with a benchmark built in. From a commercial standpoint, another characteristic of enhanced indexing is that it is offprice active management. Enhanced index products sell at about a 40 percent discount to traditional products. Offering enhanced index products is one way investment managers can compete on the basis of fee. The players include just about everybody. For commercial reasons, big players will be the traditional indexers. For indexers to offer an enhanced index alternative to everyone of their 40-60 products is a brilliant strategy for indexers, similar to the strategy you see in grocery stores: "While you're here for one thing, you might as well get everything else you need. If you want small-cap / growth active equity, you might as well get it here. We will give it to you cheaply." Even though enhanced indexing has nothing to do with indexing, expect to see a lot of it under the tents of the big integrated indexers.

©Association for Investment Management and Research

Question: What will the role of consultants be in the future? Ennis: Consultants try to be helpers to their clients, to help clients adapt to the environment. In the future, consultants will need to emphasize investment policy issues-that is, help clients structure portfolios at the asset level. They should place less emphasis on manager selection and more on manager selection in segmented markets. I have advocated indexing over the years, but we are increasingly suggesting active management in fixed-income markets and international equity markets. A combination of a focused manager search and serious investment policy research will help clients structure efficient programs. Question: Might the number of management firms increase as the present firms grow and spawn successful managers who want to strike out on their own? Ennis: Yes, even though I said that I expect contraction to continue, this point is well taken. Indeed, the mergers are going to produce a lot of parties setting out on their own. The barriers to entry are small in the investment management business. The junior partners in these large, successful firms, who don't make megabucks, have a certain amount of self-confidence, are mobile, and are independent. So, among the existing firms, there will be contraction, but new firms will clearly be spawned at the same time. Question: How much of what you have described is a result of the great bull market we've been in? 23

The Future of Investment Management Ennis: The bull market has been a significant factor in the product proliferation. The tremendous asset growth financed it. When the bull market stops, product proliferation will be arrested because of

24

the margin pressure investment management firms will feel as assets diminish. Those who were in this business before the bull market began are stunned to discover how few people remember what it was

like in 1973 and 1974. It will be interesting to see what austerity does to the investment management business.

©Association for Investment Management and Research

Lessons from the Warwick and Chateau Chambord Charles D. Ellis, CFA

Managing Panner Greenwich Associates

As many managers continue to underperform the market and as active management becomes less effective, firms should consider the alternative of investment counseling, in which investment professionals attempt to add value by helping clients set objectives and policies. "New paradigm managers" would combine investment skill and multiproduct capability with the willingness to develop complex, long-term client relationships. Such organizations could reap great rewards by managing more funds for and thus earning more fees from each client.

ad taught lessons in a memorable way. We children came home at the end of a winter's Saturday afternoon of movies at the Warwick Theater on Pleasant Street in Marblehead, Massachusetts, and Dad asked, "Enjoy the movies?" "Yep." "What'd you see?" "John Wayne." "What does the Warwick charge?" "121t under 12 and 351t over 12." Then, Dad asked one of those questions that starts a lifetime of pondering: "Why?" The easy answer was easy: "Because we're kids, Dad. And they charge only 121t so lots of kids will come." But easy answers would not do, and Dad persisted, "Why does the Warwick charge only 121t when the truth is they don't make any money showing movies?" "Dad, is this a trick question?" "No, it's not a trick question, but getting the right answer will take some careful thinking." And that is how Dad got us to work it out with him that the folks at the Warwick were willing to show John Wayne movies at a loss because they were making a real profit selling cokes and popcorn at very high prices. Dad wanted us to learn to separate appearances from realities. Several years later, Mom and Dad invited us to join them in New York City for dinner at a very special French restaurant named Chateau Chambordo As we examined the enormous menu, we could

D

©Association for Investment Management and Research

not help commenting on how wonderful the dinner would be-and how very expensive it was. Then Dad asked another of his probing questions, "How would you explain the fact that this fine restaurant continues in business if I told you something I happen to know: They don't make any profit selling this wonderful food?" "Dad, is this a trick question?" "No, it's not a trick question, but getting the right answer will take some careful thinking." And that is when we learned that the profits at a great restaurant are not from gourmet food but from drinkscocktails and wine. Dad was again teaching us to think about the salient differences between appearance and reality. (J.P. Morgan had the same idea in mind when he said that for every important business decision, there are always two reasons: One is readily recognizable as a very good reason; the other is the real reason!) Dad's philosophy was simple and profound: Whatever you are doing, be sure you recognize what is really going on. Do not get confused. In investing, we are learning that the best way to achieve long-term success is not in stock picking and not in market timing and not even in changing portfolio strategy. Sure, these approaches all have their current heroes and "war stories," but few hero investors last for long and not all war stories are entirely true. The great pathway to long-term success comes via sound, sustained investment policy: setting the right asset mix and holding on to it.

25

The Future of Investment Management

A Brief History

Current Reality

Most of the most important developments in the macro-environment of investment management within which we practice our profession and build our businesses can-with only moderate outrage to the data-be described by using one all-purpose chart, Figure I, which summarizes our apparent "reality"-ever upward over many years. This one chart can be used to support each of these 10 key propositions: • Institutional assets have grown substantially. • Market valuations, particularly of equities, are up substantially. • Trading volumes are up substantially. • Hiring of investment managers by institutional clients has increased substantially. • Information access has certainly increased substantially. Count the Bloomberg terminals. • The numbers ofM.B.A.'s,Ph.D.'s, and CFAcharterholders have increased substantially. • Use of investment consultants has increased substantially. • Fee schedules for both mutual funds and institutional accounts have increased for more than 30 years-substantially. • Profitability of investment firms and compensation of investment professionals have increased substantially. • The valuations at which investment firms are bought and sold have increased substantially. The typical macro chart of customers' aggregate experience will also look like Figure 1 because a majority of the funds supervised by professional investors are up-substantially. However, Figure 1 may concentrate on appearances and hide some important realities. Dad would want us to search out the realities.

The realities are different. Professional investment managers are not "beating the market." More and more annual data are confirming the grim reality: The professionals are lagging. 1 The data are even more disappointing when the length of time for which results are reported is extended to cumulative 5- or lO-year evaluation periods. In these rather more important time periods, even fewer professionals can keep up with the market averages. Equally disconcerting, the overarching reality of performance data is that it is not predictive. The past is not prologue. So, even the manager with a "good" record is often not a good bet to outperform in the future. Results are closer to random than we would like to believe. Figure 2 depicts the long-term experience of investors with the active portion of their portfolios-after deducting the index-fund equivalent so we can examine just the incremental consequences of active management. The picture is grim.

Figure 1. One Chart Tells All: Growth of Investment Management Business and Profession

Figure 2. Incremental Value Added by Active Managers

Do you recall Fred Shwed's wonderful story about the innocent out-of-towner being driven past the yacht basin on the East Side of Manhattan? With pride and enthusiasm, his host and guide pointed out the largest boats: "Look, those are the bankers' and brokers' yachts." His guest asked, "Where are the customers' yachts?,,2 So far, clients have not focused on the inability of professionals to add value through active management because they have been looking at the overall experience. "A rising tide lifts all the boats," and the tide in our market has been rising very favorably. Our clients' views might be very different if we did not have the rising tide. So, now is the time for 1And the data we use are moderately "favorably biased" because of the familiar problem of survivorship. 2Where Are the Customers' Yachts? Or, a Good Hard Look at Wall Street (New York: John Wiley & Sons, 1995):16.

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©Association for Investment Management and Research

Lessons from the Warwick and Chateau Chambord our profession to be asking Dad's kind of questions: Why is our profession so generously rewarded when unable to add value? Why are the results of the efforts of so many hard-working and talented professionals with so much data and such advanced tools so disappointing?

Down Side Up The answer is simple: One great environmental change appears to have up-ended-in just one generation-the central assumption on which investment management is based. The cheerful ratio of 10:90 has been converted to a glum 90:10. Let me explain. To achieve superior or better-than-average results through active management, you depend directly on the mistakes and blunders of others. Others must be acting as though they are "willing to lose" so you can "win." In the 1960s, when institutions did only 10 percent of the public trading on the NYSE and 90 percent was done by individual investors, the amateurs were organized to lose to the professionals. Here are some of the characteristics of individual investors that are worth keeping in mind: Individual investors typically do not do extensive "comparison shopping." Most individual investors are not expert on even a few companies. They rely on retail brokers who are seldom experts either. They buy because they inherit money, get a special bonus, sell a house, or have money as a result of something else equally outside the stock market. They sell because their child is going off to college or they have decided to buy a home-again, for reasons outside the stock market. The activity of most individual investors is not driven by investment information based on market analysis or company research or rigorous valuations. The activity of most individual investors is what academics correctly call "informationless trading." So, it is little wonder that professional investorswho are always in the market, making rigorous comparisons of price to value across hundreds of different stocks on which they can command extensive, up-tothe-minute information-would have thought they were able to "outperform" the individual investors who dominated the stock market and did 90 percent of all the trading done on the NYSE. They could and did-a generation ago. That is the way it was. 3 But not today. Today, after just 30 years, the old 90:10 ratio has been completely reversed. The tables have been 3The way it used to be reminds me of the two Drill Sergeants in the movie, "Full Metal Jacket," observing their recruits double-timing in formation to their graduation exercises at the end of basic training. "One out of ten of these boys is real soldiers. The rest are just ... targets."

©Association for Investment Management and Research

turned all the way around-and the consequences are profound. Now, 90 percent of all NYSE trades are done by the "professional crowd.,,4 And what a crowd of professionals they are. Top of the class at graduate school, they are "the best and the brightest," and they are highly motivated. They do not "play to play"-they play to win. But hard as they try, the grim reality is that the professionals are not beating the market. The simple reason is that these skilled and unrelenting professionals are the market. Sure, the professionals will not always get it right, but they will just as certainly be trying very hard-all the time and with every resource they can muster. Yes, they do and will make errors, but they will make fewer and fewer errorsless and less often-and the errors they do make will be corrected more and more quickly. Their "only" problem is that there are not enough amateur patsies around. So, active investing produces too little reward or costs too much or both, as is now the usual reality.5

Profession versus Business Investment management can be divided into two parts. One part is the profession, and the other part is the business. We all know the business part: Too much of a good thing is, to quote Mae West, "wonnerful." But performance on the professional dimension is not nearly so encouraging. As a profession, investment management can be further divided into two realms: one micro and one macro. On the micro or craft level of analyzing securities and composing portfolios, the profession is clearly well advanced-and continues to progress vigorously. Analysts and fund managers at investing institutions enjoy and know how to use their extraordinary electronic access to extensive data and sophisticated interpretations by industry experts-who are on call virtually all the time with detailed knowledge they organize and explain within a global context. Practitioners of the craft of our profession are well paid and are very, very skilled at what they do. Professionalism also comes on another level. Working efficiently, as Peter Drucker has explained, means knowing how to do things the right way, but working effectively means doing the right things. In investment management, the important service of 4In fact, 75 percent of all the trading is done by the 100 largest and most active institutions, and 50 percent is done by the 50 largest and most active institutions. 5This grim, grinding reality was described in my article "The Loser's Game," Financial Analysts Journal (July / August 1975):1926. Since then, the reality has gotten worse because professional practitioners have gotten better and better.

27

The Future of Investment Management

6Gary Brinson, 1. Randolph Hood, and Gilbert 1. Beebower, "Determinants of Portfolio Performance," Financial Analysts Journal (July I August 1986):39-44. 7Charles D. Ellis, "A New Paradigm: The Evolution of Investment Management," Financial Analysts Journal (Marchi April 1992):16--18.

uct mandates with skill and interested in serving clients in several different markets and developing large, long-term relationships centered on active investment counseling. Every investment management organization recognizes that great business advantages will come to an organization that is successful at cross-selling more and more "products" from different asset classes, managing more funds for and earning more fees from each client relationship. But as important as the cross-selling of investment products is, particularly in the business dimension, it is only part of the New Paradigm manager concept. The overarching umbrella under which cross-selling would take place is proactive advice and counsel on appropriate investment objectives and sound policies through which to achieve those objectives. In other words, the glue that holds it all together is active, "normative," investment counseling. Unfortunately, there is a grim reality that must be overcome. To paraphrase Peter Drucker, who spoke so accurately about management consulting, counseling does not pay! In a classic "insult-forinsult" exchange, institutional clients would be insulted by the high fees managers would need to charge to make investment counseling an attractive business and investment managers would be insulted by the low fees institutional clients would be ready and willing to pay-which is why there is no market for investment counseling (and why there won't be a market in the foreseeable future). So, we are back to our modification of Drucker's admonition: Investment counseling does not pay. At least, investment counseling does not pay directly. Indirectly, however, investment counseling can be very rewarding because it redefines the purpose of the client-manager relationship, creates a climate of shared understanding based on sharing of information, and fosters mutual trust and respect through regular, well-structured communications that produce stronger client-manager relationships. Not only will managers develop a larger volume of business with each client, but also the qualitative strength of these relationships will be stronger and more enduring. And client loyalty is the best way to build a great franchise-both as a business and as a profession. For clients, the reciprocal advantages are also large: fewer, better, closer relationships with managers who have and will develop many investment capabilities with consistently high standards and will provide valuable investment counseling-vigorous, proactive, normative advice on investment objectives and on the investment policies and strategies that can reasonably be expected to achieve them.

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©Association for Investment Management and Research

helping investors do the right things is called "investment counseling." The cumulative genius of the past generation has transformed the challenge--for both investment managers and clients-from finding ways to beat the market to learning to accept the semi-efficient market reality as given and to make the best of this reality by making explicit the important choices about longterm objectives and policies. This challenge means shifting from investment craft to the true investment profession of informed, skillful investment counseling. As Brinson, Hood, and Beebower have shown, more than 90 percent of the long-term difference in performance between institutional portfolios is not attributable to differences in security analysis or portfolio strategy but to differences in setting the asset mix. 6 To advise on asset mix, investment counselors will do well to have skills in managing portfolios in each asset class-so they can help implement what they recommend-and to have open channels of communication with clients. Communication is important because both parties have important work to do in the process of determining appropriate longterm investment objectives and defining the investment policies most able to achieve those long-term objectives. Clients can help most by developing and defining their organizational values, or utility functions, tolerance for interim market price fluctuations, tradeoffs between price fluctuations and long-term returns, needs for liquidity, and so on. The investment counselor will know most about the probable long-term average returns and the likely interim fluctuations in market valuations, dividends, and interest income. And sharing, or "professing," the special knowledge and understanding accumulated over many years of study and practice is what makes investing a true profession.

What Is New? Now let us consider one potentially important development in the profession ofinvestment management. What progress has been made in the real-world acceptance of a concept first presented a few years ago-the "New Paradigm investment manager"? 7 In the hypothetical New Paradigm organization, large institutional clients would find a multiproduct investment manager capable of handling multiprod-

Lessons from the Warwick and Chateau Chambord

Limited Action

Investment Counseling

Observers are naturally interested in the market's early reaction to the New Paradigm proposition. Two observations are clear: Activity is concentrated among very large funds, and the rate of increase is modest-so far. The modest rate of increase in transactions is certainly not for lack of interest among executives of large funds. Table 1 reports a portion (large corporate funds) of recent research in which one-third of executives at 2,000 U.s. funds with assets greater than $100 million stated that they were in, interested in, or open to such a relationship. Given this interest in the concept, why have transactions been so limited? Is the limit on demandor on supply? The limits to growth appear to be on the supply side. The investment managers ready to deliver the New Paradigm array of investment products-let alone provide effective investment counseling-are still very few in number. But the number of managers who are genuinely interested in the concept and are gearing up to offer the service in the future is impressive. If expectations are fulfilled, the number of organizations offering a New Paradigm manager service will more than double in the next 12-18 months. And if, as is historically customary, new investment capabilities are not "bought" but "sold," this increasing supply will stimulate increasing demand-and transactions will be seen increasingly often in the marketplace. If the New Paradigm manager becomes more than just an expectation, it could prove to be a boon not only to the business of investment management but also to the profession. Even better, for our clients, it could be the way out of the dilemma characterized as the loser's game and into the happy realm of a winner's game, in which virtually all clients could be winners because each would be using the forces of the capital markets to achieve its own feasible and appropriate long-term objectives.

The trusted investment counselor's main professional work is to help each client identify, understand, and commit consistently to long-term investment objectives that are both realistic in the capital markets and appropriate to the particular client. The hardest work is not figuring out the optimal investment policy; the hardest work is helping clients stay committed to sound investment policy and maintain what Disraeli called "constancy to purpose." Sustaining a long-term focus at either market highs or market lows is notoriously hard. In either case, emotions are strongest and current market realities are most demanding of change because the facts are most compelling-which is why there is enduring truth to what Pogo so wisely explained: "We have met the enemy and he is us." Holding onto sound policy-through thick and thin-is extraordinarily difficult and extraordinarily important work. The cost of infidelity can be very high. For example, during the past 15 years' very favorable stock market, the average mutual fund gained 15 percent annually but the average mutual fund investor gained only 10 percent. Fully one-third of the available return was lost by mutual fund investors switching from one fund to another fund-all too often selling low and buying high.

The Virtuous Cycle The strong New Paradigm investment organization, with a diversity of strong investment products and strong positions in diversified markets, will be in a very favorable position to innovate and invest in developing vibrant new products and dynamic new markets. Such firms will also provide more secure employment environments for capable investment professionals because the individual investment professionals will not be obliged to risk their professional careers on the business success of the particular product they manage for a particular market. Finally,

Table 1. Position of Large Corporate Funds on New Paradigm Relationships Position Have a strategic relationship or "macro" manager Interested in exploring the concept and its possible benefits Open to the concept but not actively exploring it now Doubt the concept would work for their firm Not interested in or opposed to the concept No answer / uncertain

1995

1996

1997

(104)

(85)

(103)

18% 3

19%

17%

4

4

16

22

20 17 23

17

8

16 29

20 27

18

Note: Numbers in parentheses are the number of funds whose executives responded. Source: What Now? report of Greenwich Associates.

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The Future of Investment Management

when the business organization is strong and independent, individual professionals will experience no pressure to compromise or "be realistic," so they will be able to concentrate on what they truly believe is professionally right. And in a virtuous cycle, what is really right professionally will also prove to be right for business.

•

•

sional dimensions, from passive investing and from the strongest active managers. Dominating the environmental changes for all types and sizes of investment firm will be the powerful forces of information technology. Intellectual capital will be far more important than financial capital in determining organizational success.

What Next? What are the reasonably expectable structural changes in the institutional investment management industry in future years? Despite the perils of forecasting free and competitive markets, here are some estimates: • As competition in the marketplace becomes better and tougher, even as the process of natural selection lifts the average skill of the surviving participants, the realities of shrinking rewards for active investing (shrinking because the frequency, magnitude, and duration of errors by competitors will all be decreasing) will mean, as shown in Figure 3, that the magnitude of superiority in the results achieved by the best performers will be reduced and the average success of the average manager will regress to the mean-and then be reduced by activity costs. • Many investment firms will grow larger in either or both of two ways-adding more and more product capabilities and/or serving more and more markets. • Geographically, the most protean firms will become multinational-then international and even global. • Most international and global firms will be active in both institutional and consumer markets. • The leaders will develop their capabilities in a wide range of products covering numerous asset classes (and all the major categories) at a consistently high global quality standard. • Investment managers who represent the ultimate expression of business and professional excellence will combine product strengths and counseling-based strengths and will fulfill the aspirations for the New Paradigm manager. Their largest and best clients will be the largest and most sophisticated institutional funds. • The strongest firms of all sizes will understandand act consistently and vigorously on the understanding-that our real business is not investment management alone but all aspects of investor services. • In this environment, the investment profession and its skilled practitioners will flourish intellectually and spiritually in firms of all sizes. • Less skillful firms will be under increasing pressure, along both the business and the profes-

To summarize, our profession and our business have a future replete with extraordinary challenges and extraordinary opportunities if we seize the day and make bold commitments to the future-our future and our clients' future. Dad would have challenged the perceptions of investors-and of most investment professionalswith what we kids found a familiar series of inquiries, but with an interesting difference. Instead of asking why the sellers are selling their services, Dad's questions would drill down into why buyers are buying. Here's the way the inquiry might go: "Why do investors pay such handsome fees for investment management?" "Because, Dad, folks want to make money and they expect to make more money when they pay up for the best managers." "Did you know that it actually works the other way around?" "Dad, is this a trick question?" "No, it's not a trick question, but getting the right answer will take some careful thinking." And before long, Dad would have us understanding that there are three levels of decision for the investor to make and that, whereas most investors take investment services as a blended package, services can be unbundled into three separable components or levels: • Level One-the optimal proportion of equities as the "policy normal" for the investor's portfolio.

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Figure 3. Performance of Equity Mutual Funds Relative to the S&P 500 Index, 1960-97 21,--------------------,

14 7

o -7 -14 ' - - - - - - - - - - - - - - - = = = - - - - - ' Bottom 20 Percent Top 20 Percent of Funds of Funds • 1960-81

o

1982-97

Source: Based on data from Lipper Analytical Services and a presentation by Peter L. Bernstein.

Lessons from the Warwick and Chateau Chambord

•

Level Two-equity mix, policy normal proportions in various types of stocks (growth versus value, large capitalization versus small capitalization, domestic versus international). • Level Three-active versus passive management. Dad would then explain that investment counseling on asset mix (a Level One decision) and on equity mix (a Level Two decision) is inexpensive and needed only once every few years. (An individual investor with $1 million can buy this service from an expert for less than $5,000 once every 5 or 10 years. An institution with $10 billion might pay $250,000.) Active management (a Level Three decision) can cost-for the management and the transactionsabout 1 percent of the $1 million investor's assets, or $10,000 each year and $50,000 over five years.

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The irony, Dad would point out, is that the most value-adding service available to investors-that is, investment counseling-although demonstrably valuable and cheap, is in very little demand. Active management, although usually not successful at adding value, comes at a high cost. Dad would want us, as investors and as investment professionals, to at least consider thinking independently enough to realize that the three levels of service can be obtained separately and that we can limit what we pay to the added value of the results we can reasonably expect. Dad would want us to think carefully about the real challenges we face. As Warren Buffett has said about poker: If after 20 minutes you don't know who the patsy is, you are the patsy! Let us not fool ourselves.

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The Evolution of Client-Manager Relationships Alice W. Handy Treasurer University of Virginia

Client-manager relationships have evolved from the traditional relationship limited to basic equity and fixed-income services to strategic alliances in which information is transparent and shared, financial interests are aligned, and clients and managers work toward common goals. In the future, industry trends, such as the growth in passive management and in-house management, will continue to shape this relationship.

he investment management industry has changed a great deal over the past 20 years for clients and managers alike. This presentation looks at the history of the client-manager relationship in the context of a university endowment, discusses the advantages of using flexible managers, and identifies how changes in the client-manager relationship have been influenced by trends in the investment management industry.

In the 1960s, the University of Virginia (UVA) was actually a manager. The board of visitors made stock selections based on advice from a trust officer at a local bank. The board then executed the purchases or sales. The members would meet quarterly and discuss portfolio decisions. In the 1970s, we switched to the multimanager approach and gave advisors portions of our equity fund. The fixed-income position consisted only of a faculty mortgage program. During this period, we gave managers very broad latitude. They continued to be evaluated against the S&P 500 Index but typically would hold some bonds and cash in the portfolio because they knew that their positions represented the endowment's entire portfolio, with the exception of the small position in faculty mortgages. At that time, the endowment had a market value of $50 million. During the early 1980s, we maintained multiple relationships but also made some half-hearted attempts at manipulating asset allocation on a shortterm basis and opportunistically moved in and out of

the international stock and bond markets. In 1987, we learned that timing the market can be very difficult. We raised cash because of concerns about the stock market but held it until 1990, long after the advantage of being out of the market had passed. In the late 1980s, recognizing the difficulties of tactical asset allocation, we decided to expand the mandate of one of our managers to include the asset allocation decision. Because we were firing a growth manager, we asked one of our value managers if the firm would invest in its growth fund opportunistically. We found this strategy to be successful with this particular manager, who now has other portions of the endowment, including all our international equity positions and a forestry commitment. In the past few years, I have seen that clients increasingly want managers to become involved in asset allocation decisions, but the managers often are not prepared to handle such a task. For instance, we encouraged another portfolio manager with a small actively managed portfolio and a large mutual fund business to expand his role. Despite possessing the capability to go into international markets, this domestic equity manager was reluctant to make asset allocation decisions. Similarly, our fixed-income bond manager has the authority to invest internationally, with performance measured against a domestic index, but has been very reluctant to take a major position in international bonds. This manager's international allocation has never gone above 30 percent and typically is less than 15 percent. For the 10 years that we have been giving our managers the flexibility to deal in multiple asset classes, our experience has been mixed. At first, the

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T

Evolution of the Relationship

The Evolution of Client-Manager Relationships results were very good. Adding growth stocks in the late 1980s worked well, and the manager got out of the market at the right time. The international position during the 1990s was less successful. The most significant hurdle, however, is managers' own reluctance to stray very far from their benchmarks. The reluctance to deviate from the benchmarks has been imposed on managers by clients. Either the client or the client's board typically needs the comfort of being able to look at returns and measure those returns against some type of yardstick. Our managers have a self-imposed limitation of 15 percent deviation from their benchmarks. Managers and clients must work together to overcome this limitation as they try to think about the best portfolio strategy for the future. An approach we have found helpful is to nudge managers to make asset allocation decisions by adjusting their individual benchmarks. In the 1990s, UVA also started to venture into other areas. Real estate seemed to be a terrific area at that time. We had resisted going into it throughout the 1980s, but when the market tanked, it looked like a good opportunity. Lawyers and bankers on our governing board knew from their own experience that properties were being sold at ridiculous levels. After beginning with a few opportunistic investments, in addition to real estate, we now have a very broad portfolio that includes distressed securities, arbitrage funds, hedge funds, oil and gas limited partnerships, private equity, and venture capital. Some alternative asset managers are capable of handling more than one area, and this flexibility is very encouraging to us. Such flexibility may be more appropriate than in the traditional asset classes.

Advantages of Complex Relationships Multifaceted relationships with a small number of investment managers offer distinct advantages in terms of added flexibility, simplicity, dealing with familiar managers, and the ability to react quickly. Since the early 1970s, our endowment has grown from $50 million around the collapse of the market in 1974 to more than $1 billion as of March 1998. Growing with and taking advantage of manager relationships is part of the reason we have come so far. Selecting managers is a tedious process for clients and for managers. Managers have to deal with the requests for proposals and other administrative tasks. Clients have to read the proposals, narrow the field, then bring the final proposal before their boards. The timing of board meetings might preclude investment in specific types of structures, such as partnerships. The client's staff must be knowledgeable about the many managers that are available, ©Association for Investment Management and Research

which can be an overwhelming task. Also, firing a manager is very hard when the manager has performed well but the strategy is out of favor or out of line with one's allocations. Because of this particular problem, we prefer to have managers who can move from one area to another. For instance, it is not uncommon to find a manager who does distressed debt and event arbitrage, and this dual capacity is attractive to us because we do not have to close down an entire relationship in order to open another door. Monitoring a few complex relationships with a small number of managers is easier than dealing with numerous limited relationships with a large number of managers. My first boss at the University of Virginia prided himself on the fact that we only had a handful of managers. At first, he could count them on one hand, and then, on two hands. By the time he retired, we gave him the"four-hand award" for managing so many different managers. His preference for having fewer managers grew from his experience on the Virginia Retirement System Board. The VRS had so many managers that determining what the total portfolio actually looked like was difficult. Most of our managers are in the alternative areas. We only had three equity managers in 1974, and today, we still have only three core equity managers. When entering a new arena, such as international equity, clients take comfort in dealing with someone they know and in whom they have confidence. They are familiar with the manager's due diligence and know that they do good work and that their strategies make sense. Often, one style of investing can be transferred to another part of the world. The obvious downside is not working with an expert in the field, and clients may question whether or not they could have gotten better performance from someone with specific experience. Managers with multiple capabilities afford clients the ability to act quickly when opportunity arises. One of our managers developed a product on a month's notice to go into Southeast Asia equities after the sell-off in early 1998. In summary, although giving managers additional flexibility has not worked as well for us in the traditional asset classes because of manager reluctance to deviate from benchmarks, it has added value in the alternative assets and has limited the number of relationships that we need to monitor.

Changes in Relationships We are becoming increasingly involved with our managers. Historically, clients dealt with equity and fixed-income managers and got to know them well. Clients and managers talked on the phone about what was happening in the market, and the managers 33

The Future of Investment Management

would visit the clients once a year. In those days, most clients understood the statements they got. With items such as beta and standard deviation to help us along, we could at least act as if we understood what the manager was doing. With alternative asset classes, however, clients have to deal with all kinds of issues. Managers no longer send the clients a list of assets, but even if the clients had a list of assets, they might not understand them. For example many hedge funds have securities that do not look anything like the stocks one can look up in the Wall Street Journal. Partnerships and Strategic Alliances. The challenge for clients and managers is how to achieve a sense of comfort in a complex relationship. The industry is moving toward relationships that resemble partnerships or strategic alliances. An integral part of such a strategic alliance is information transparency. For example, managers that short their portfolios are very reluctant to provide detailed information in any written fashion. We have worked very hard to get information with as much detail as possible. We certainly get summary information, so we know what the managers' positions are by industry and geographical region, but we still have difficulty getting a listing of stocks. Managers have continued to show resistance in this area even though our expressed interest is simply to aggregate all of our holdings so we can examine our risk profile. Without information transparency, we need to know more about manager operations. We try to understand what kinds of systems the firms have, the quality of their back office, and what kinds of reporting they offer. In general, we want to know what to expect from them and how comfortable we are with what they do. We initially spend a lot of time with these managers trying to settle such issues, which is one of the reasons we have to limit the number of relationships. Alignment of Interests. Another major concern is the alignment of interest between the clients and managers. A very important issue for us, particularly when we go into alternative investment strategies, is that managers make investments in their own firms. Knowing that the managers have invested significant personal capital into a partnership helps provide a greater sense of comfort. Similarly, we want everyone to share in the profits at the same time. We examine terms of the partnership to be sure that the managers do not get paid until we have received a return on our investments. For instance, in the oil and gas industry in the 1980s, the developers took all the money up front in fees, and the pre-1990 real estate industry was the same way. The more we know and 34

understand and the more comfortable we feel about the manager and the investments, the better the relationship is for both of us. Quantitative Analysis. We try very hard to make investment analysis as quantitative as we can, but measuring performance presents challenges. Although we use mean-variance analysis, which works well for traditional portfolios, we know that the variables for most nontraditional or alternative portfolios are very subjective. We try hard, however, to make the performance numbers as solid as possible. Two good quotes apply to this problem. In his book Against the Gods: The Remarkable Story of Risk, Peter Bernstein sums up the problems of quantitative analysis with a quote from G.K. Chesterton, "The real trouble with this world of ours is not that it is an unreasonable world, nor even that is a reasonable one.... It just looks a little more mathematical and regular than it is." In addition, Ted Aronson identifies the real challenge for investment managers. He says that investment management is both art and science. Half of it is voodoo, half of it is artistic, and half is science. 1 The idea conveyed by both statements is that we, as clients, cannot get our arms completely around quantitative analysis, but we want to get them around as much of it as we can. The only way to accomplish this objective is by trying to align the interests of clients and managers to create a win/win relationship. Clients put up the money, and managers develop the ideas. GrOWing Demands on Managers. As clients become more sophisticated, they demand more from managers. In addition to traditional monthly reports and audited financial statements, clients increasingly ask managers for ad hoc reports that can be very detailed in format and thus very time consuming. Clients are also bending the ears of managers for new ideas or support of existing investments. For instance, in our office, our internal bond managers are continually in discussion with other bond managers of all types, exchanging ideas with them about what opportunities they see in different market segments. The more open the dialog, the happier we are and the more adventuresome we are going to be in any new areas that we enter. ltems such as open dialogue and additional reports, however, take time and resources away from the core product. This demand may put additional strain on the client-manager relationship, so a balance must be struck. We try not to be invasive but when we are asked to produce a certain report or lSlraight Talk (September /October 1997).

©Association for Investment Management and Research

The Evolution of Client-Manager Relationships

explore a specific idea, we often have no choice but to use the managers' resources. In-House Investment Management. An important change in the client-manager relationship is that clients increasingly are beginning to resemble managers. We internally manage our own fixedincome portfolio because doing so keeps the staff motivated and saves on fees. Also, we do not have much faith that traditional fixed-income managers can outperform the market. The growth in the size of pension funds is even more threatening to the investment management industry. At the VRS, where I serve as chair of the Investment Advisory Committee, we manage several in-house equity portfolios. Right now, the portfolios are simply enhanced index funds, but they are growing. Furthermore, the VRS is very interested in doing more in-house management for the same reasons I mentioned previously-as a way to keep the staff motivated and to save on fees. Next, they are exploring a move into internally managed international funds. Passive Management. Clients have taken a good deal of assets out of the hands of active managers and shifted these assets into passive investments. I do not share all of William Quinn's skepticism about passive investing. 2 Currently, the VRS invests 59 percent of its domestic portfolio and 44 percent of its international portfolio in index funds. These large positions are handled by two managers. Such passive allocations are made for two reasons. First, the sheer size of the fund makes investing large amounts of money difficult. A correlation seems to exist between the ability to outperform and the size of the fund. When a fund, with minimal staff to monitor the positions, reaches $30 billion, finding places to invest is 2Please see Mr. Quinn's presentation in this proceedings.

©Association for Investment Management and Research

hard. Second, the VRS has been able to maintain almost the same fee structure that it had four years ago-even though assets have doubled. Growth in Defined-Contribution Plans. One great threat to the investment management industry comes from the pension side. That is, when pension funds do move to become defined-contribution funds, they will become mutual funds. Some adjustments will occur. Obviously, they will need services and will have the same performance and reporting challenges as managers. At UVA, we face a much smaller version of this challenge. We created a series of mutual funds with our endowment: an equity fund, a bond fund, a real estate fund, and all of our alternative investments grouped into one fund. We did so for two reasons. First, UVA has 22 foundations, each of which has its own assets and different needs and objectives and each of which wants varying investment strategies. We found appeal in being able to tell our donors that they could invest their trust assets for the university side by side with the university's endowment. So many restrictions exist for trust assets that they cannot invest in limited partnerships, in real estate, and other areas that are not valued on a monthly basis, which explains why we created the bond and stock funds. We compete directly with trust departments for that business, although we are not a huge competitor. The lines between investment managers and clients are starting to blur, and this trend will continue.

Conclusion Money management has been one of the truly great growth stories of the past two decades. Clients have become increasingly sophisticated. Clients and managers now need each other to move forward, and they have a perfect opportunity to forge relationships that will be mutually beneficial and exciting.

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The Evolution of Client-Manager Relationships; Client Views of the Future

Question and Answer Session Alice W. Handy William F. Quinn Question: Have the returns from alternative investments been worth the time, effort, expense, and risk? Handy: No, but a lot of the performance has to do with the time frame. In the current market, any deviation from or any diversification out of the domestic equity market has not paid off. So, we have to look at alternatives on a long-term basis. A lot of private equity and venture capital funds have begun to perform. On the other hand, if the question is whether alternative assets have performed as expected, the answer is absolutely. Question: Do you compare alternative asset returns with S&P 500 Index returns? Handy: No, we compare them with our initial expectations, so the standard is absolute return. We toyed with the idea of using a spread to u.s. Treasuries, a riskfree rate of return of 5 percent, but in the current market, such an approach seemed a little ludicrous. We actually look for opportunities other than private equity and venture capital, opportunities at the more speculative end of the range, and prefer investments offering returns of 12-15 percent. Question: How do you judge the performance of alternative investments? Handy: We receive audited statements on an annual basis from the partnerships and know what the returns are. We carefully analyze these statements. For instance, on our real estate funds, we

apply a discount to the market value; the appreciation is discounted 25 percent because the property values are based on appraisals and there could be problems with interim valuations. Again, we hold such investments for the long term and don't buy and sell them along the way. Quinn: The same goes for AMR. We do a lot of private equity and alternative investments. Our goal is to achieve 20 percent absolute returns but also to outperform the S&P 500 over the long term by 500600 bps. To date, we have reached our goal of 20 percent but have not outperformed the S&P 500. The key is the realized return you get at the end of the investment horizon-only then can you determine the true return. Question: How do you deal with managers on soft dollars? Quinn: We prohibit soft dollars because we think they are absolutely wrong. We and the managers have agreed on a fee structure. We have an ongoing monitoring process to make sure the managers do not use soft dollars. We also look at execution and average trading costs. Weare not monitoring all the factors that involve soft dollars, although the managers report to us on a quarterly basis to confirm that they did not use soft dollars, or if they did use them, they must show that the cost was bundled in another trade because we want to know exactly what they paid for the research. Handy: Mr. Quinn makes an interesting observation that if we had the risk controls on a macro

©Association for Investment Management and Research

level, maybe we wouldn't have to do all the rest of the monitoring at the fund level, which is very time consuming and political for us. Quinn: Such monitoring clearly is time consuming. The problem is that when you are dealing with big pension plans, very small differences mean a lot of money. You could lose $1 million very easily by losing a small percentage of your trades in soft dollars. The amount of money involved is what makes you spend the time. Question: Do you think you are sacrificing returns by limiting the number of managers? Quinn: I do not believe we are sacrificing returns by hiring fewer managers for a number of product lines. I also am not saying that the same money manager running our domestic equity will be running our international equity or longterm bond fund. The manager must bring in people with the necessary skill sets and disciplines to add value. We do hire specialists when necessary. For example, we found one manager that offered value in emerging markets, so we added that manager to the group. The economies of scale we achieve through multiple product offerings significantly reduce costs. In the long term, using broader product lines is going to benefit us on a return and a cost basis. Handy: Making a few key decisions is better than making a lot of little ones, which plays right into the argument of having fewer relationships. In other words, you can think about the things that are 39

The Future of Investment Management truly significant instead of spending your time trying to chase various ideas in multiple relationships. Question: Although the situation is difficult for clients, can the clients call the shots and, for example, increase the allocation to cash?

and we give them a long-term horizon. Our average equity manager has been with us 15 years, so they know they've got time to let the cycle work out. We only change managers in the short term (i.e., four or five years) if they change styles or if their principal people change.

For example, real estate is not a permanent part of our portfolio, but we went intoitin a rather major way with 10 percent of our portfolio in 1992 and 1993. Our staff make such determinations, and we make the recommendations to the board.

Do you make TAA decisions, and if not, who does? Who does the strategic asset allocation?

Question: Do you find yourself moving toward non-US. equities now that the US. market has had a good, long run, and if so, do you feel confident about such a move?

Question:

Handy: We can call the shots, but we still have to report to a board and still have to be accountable. Not all board members are financially sophisticated. Often they sit on the board of another fund that does not have the same concerns as an endowment and that is all in stocks and, therefore, has performed better. So, our position is not very different from that of managers. Quinn: We share the same concern about benchmark-driven managers, and we try to solve the problem by making sure that we do not use managers that are closet indexers. We look for managers that will vary the fund's exposure,

40

Handy: The board clearly makes the strategic asset allocations, but in our case, we have a board that is appointed by the governor of Virginia. The members don't necessarily have any investment expertise, and their appointments are only for four years. My staff and I serve as a corporate memory and make all the recommendations to them. In terms of TAA, we were fairly successful in the 1980s at getting in and out of the international markets. In the 1990s, the decisions have been more strategic, but we time our entry into markets.

Quinn: We have had a large international commitment, probably 25 percent of our equity portfolios, in the past year or two, but at 25 percent, we're probably as committed to international equities as we're going to be for a while. Handy: We are a little underweighted relative to our target in international equity. In our case, our manager made a tactical decision to stay lower, and I don't see the manager increasing the position significantly.

©Association for Investment Management and Research

Client Views of the Future William F. Quinn President AMR Investment Services, Incorporated

Doing more with less is a noticeable trend in the investment management industry that is helping to forge better relationships between plan sponsors and managers. Other trends in the 1990s, such as the growth in defined-contribution plan assets and industry consolidation, are pushing managers to offer multiple products to their clients and prompting plan sponsors to expand the use of existing managers. The changes offer advantages and disadvantages for plan sponsors and for managers.

Industry Trends

ne of the dominant trends in the industry is to reduce the total number of relationships in order to focus on creating better partnerships, and AMR Investment Services is an excellent example of this trend. The primary role of AMR is managing almost $12 billion of American Airlines' defined-benefit, defined-contribution, and 401(k) plan assets. We also manage a short-term fixed-income fund for American Airlines and for outside clients on a separateaccount basis. AMR has become a competitor of sorts for investment management firms and mutual funds by creating the American AAdvantage funds. In effect, the equity-oriented funds simply replicate what we do for American Airlines-provide our clients with a large, diversified multimanager product that takes advantage of our economies of scale. We build partnerships with managers who have done well for us and hire them as subadvisors to our mutual fund. We then effectively act as the marketing and distribution arm for our managers and sell the funds to both the wholesale and retail markets. For investing in the American AAdvantage funds, retail investors receive "AAdvantage Miles," which can be used as frequent flyer miles on American Airlines. A few key relationships can lead to meaningful account sizes for individual managers in the range of $1 billion, and in AMR's case, such relationships have contributed to the growth of assets we oversee, which are currently around $20 billion. This presentation discusses how trends in the investment management industry-especially the trend of doing more with less-influence the clientmanager relationship and offer opportunities for plan sponsors and managers alike.

Expanding Relationships with Existing Managers. At American Airlines, doing more with less and consolidating our managers has meant expanding the relationships with our existing managers. During the past 10 years, we have reduced the number of domestic equity managers from 14 to 8. We did not undertake this change overnight and simply decide to cut the number almost in half. Instead, when managers' performance deteriorated, when their

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©Association for Investment Management and Research

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Changes in the investment management industry not only continue to alter the client-manager relationship but also provide interesting opportunities for all parties involved. Six key trends that we see are the pressure for plan sponsors to do more with less, the drive among clients to have fewer relationships with investment managers, the rising complexity of the investment decision-making process, the growth of defined-contribution plans, the increased industry consolidation of investment management firms, and expanding relationships with existing managers. Doing More with Less. The dominant overall trend for plan sponsors is "doing more with less." The restructuring or downsizing of "Corporate America" has forced everybody to try to find out how to accomplish more activities with fewer people. Although the assets of the major pension plans have grown substantially, the plans generally have fewer people handling the increased responsibilities. Every plan sponsor is focused on producing the pension benefits at the lowest cost. With reduced staffs, in order to become more efficient, plan sponsors must have fewer manager relationships.

Client Views of the Future styles changed, or when we were no longer getting the desired product, we pruned them back one at a time. Of the eight remaining managers, five firms either offer multiple products or offer multiple accounts to us and three are single-product managers. On the international equity side, a similar consolidation has occurred. We have gone from having seven international managers to five, but we probably will not reduce the number much further. The biggest change, however, has occurred in our handling of new asset classes. When we decide to enter a new asset class, we first look at our existing managers to see if they have the capabilities we want. If they do, we hire them rather than do a full-blown search. The greatest difficulty in finding new managers is getting to know the people, so hiring managers you already know makes sense. For example, when we added emerging markets about two years ago, two of the three managers came from our existing stable. When we decided to use currency overlays, both managers came from our existing stable of managers. Three examples-Goldman Sachs, Hotchkis & Wiley, and J.P. Morgan-illustrate how we have worked with firms to expand partnerships. Only seven or eight years ago, each of these firms handled only one product for us. Goldman Sachs. Initially, Goldman Sachs managed a long-duration bond portfolio for us, but we have since hired it to manage a currency overlay program and private equity. Being able to invest in their private equity funds has really enhanced our returns. In addition, we use Goldman Sachs for program trading. We also did some of our international security lending through Boston Global, a subsidiary of Goldman Sachs, from time to time. This relationship is growing, and more importantly, we are both able to benefit from the changes. Hotchkis & Wiley. Originally, Hotchkis & Wiley was used only for domestic equities. Later, it developed an international equity product for which it planned to use the same value disciplines and methodologies that it already used for domestic equities. We could have searched for a new international manager, but because we already knew the people and disciplines of Hotchkis & Wiley, we hired it and effectively funded its move into international equities. Since its acquisition by Merrill Lynch in 1996, we have started to do some security lending processing with it, and it also advises us on our mutual funds. J.P. Morgan. J.P. Morgan initially handled only U.s. bonds for us. When we sought to start a currency overlay program and invest in emerging markets, we looked at our existing group of managers and chose J.P. Morgan because it had the products we wanted and an excellent track record. ©Association for Investment Management and Research

Investment Decision-Making Process. The decision-making process for plan sponsors has become more complex than ever. In the 1970s, the only major decision was making the choice between U.s. stocks and bonds. In many cases, plan sponsors did not have to worry even about that decision because they had a single manager, such as a large trust company, that ran a balanced portfolio. So, the plan sponsor's main responsibility was simply to oversee the process. In the 1990s, however, the role of plan sponsors has become a lot more complex. Most sponsors oversee seven or eight different asset classes; evaluate the benefits of tactical versus strategic asset allocation among permissible asset classes and instruments; and analyze currency overlays, securities lending, asset/ liability management, and soft dollar issues. They are also taking an increasing role in corporate governance issues at portfolio companies. In addition, they have the time-consuming process of evaluating managers in each of the different asset classes. For example, private equity is an extremely time-consuming aspect of the plan sponsor's job. Most sponsors believe they can get aboveaverage returns in the long term, but they spend most of their time looking at contracts and placement memorandums and trying to structure the alignment of interests to get the desired returns. They also spend a lot more time on asset/liability issues because more and more corporations are looking at how to integrate the pension fund's obligation with the company as a matter of corporate finance. Such integration forces plan sponsors to recognize the cyclicality of their underlying businesses and hedge the surplus accordingly. For example, with a defined-benefit plan, American Airlines is concerned about the interest rate exposure of its liabilities. A long-duration bond fund can be used to hedge the changes in value of these liabilities. As interest rates decline, the increased value of the liabilities is offset somewhat by the increased value of the bonds. Another way we address the asset/liability management issue is to hire only value equity managers, because we believe we will do well in the long term and because, by taking a value approach, we protect ourselves on the downside, which is when the airline will have the most difficult time trying to fund the pension plan. Growth in Defined-Contribution Plans. Defined-contribution plans have grown substantially in the past 15 years. American Airlines started its plan in 1986, and as of March 1998, it has an estimated market value of almost $3 billion. It is almost the size of the company's defined-benefit plan, and managing the cost structure of 401(k) plans is a big challenge. 37

The Future of Investment Management One of the biggest challenges for money managers is trying to figure out how to provide value in the 401(k) market to clients that already use the managers on the defined-benefit side. In the cost structure of defined-benefit plans, management fees are running at 25-35 basis points, but for defined-contribution plans, the management fees are running at 120-130 bps because they are using traditional retail mutual funds. The large pension plans are all looking at how to bring together defined-benefit and defined-contribution plans. Plan sponsors are fiduciaries for both plans and cannot justify paying much larger fees on defined-contribution assets. More and more people will follow AMR's example: Create a mutual fund using the existing defined-benefit managers and spread the cost savings between the plans. Another way of doing this is unitizing defined-benefit plans. So, managers that have a meaningful relationship with and provide good service to a defined-benefit plan should be trying to help the plan sponsor reduce the cost structure in the 401(k) plan and get away from retail mutual funds. Plan sponsors may also want to address commissions, execution costs, and other costs incurred by their mutual funds. Industry Consolidation. In the 1970s, large, single-manager trust departments were handling almost all the money for pension plans, but the enactment of the Employee Retirement Income Security Act of 1974 led to the rise of specialty boutique managers. ERISA allows sponsors to consider their entire portfolio instead of only each individual investment in determining standards under the Prudent Man Rule. As a result, many boutiques came into existence, some of which are now quite large, but the trend in the 1990s is toward consolidation, as exemplified by United Asset Management. 1 Several large holding companies are being formed. Examples include Merrill Lynch acquiring Mercury Asset Management and UBS acquiring Brinson Partners. These firms are trying to consolidate different asset management firms in an effort to bring multiple products to their clients. To date, this approach has not been done well, but the opportunity still exists for using firms such as those mentioned here to provide clients with better products and to simplify manager relationships.

mutual relationship becomes more valuable. When a sponsor uses a manager for additional services, the sponsor becomes a more important client for that manager. Sponsors get access to more research, more resources, and maybe even investment opportunities they would not otherwise have, such as private equity. The managers benefit because they become an important resource to the clients and build relationships that will be difficult for sponsors to end. In addition, sponsors can deal more efficiently with fewer manager relationships. Managers have a chance to diversify their businesses and start to develop certain products because sponsors involved in a complex partnership are more likely to serve as an initial investor. Sponsors also benefit from developing resources to come up with a very cost-effective 401(k) product. Management fees, which are on a declining scale, can be spread among all the plans. For example, the cost for our 401(k) participants (about 25 bps) is about the same as for our definedbenefit plan. In turn, this development allows the managers to have access to the 401(k) market. Overall, sponsors get economies of scale and a lower cost structure, and managers earn more revenues from these clients. This paradigm is not perfect. Not every manager is the best in the area for which we may need them. For example, when we considered doing global tactical asset allocation (TAA), we had to wrestle with the problem of whether the manager could deliver the desired performance in all the asset classes that we would need. We have not yet found anybody with the capability we seek, which has held back our progress on TAA. We have also found that negotiating the fees is harder. We thought that being a $1 billion client instead of a $100 million client would make getting cost reductions or volume discounts a lot easier, but because of "favored nation" clauses with other clients (a promise not to offer lower fees to any similar client without passing on the lower fees to all existing clients) and limited capacity in certain areas, reductions and discounts have been hard to get. We are making progress, however.

Conclusion

IPlease see Mr. Reamer's presentation in this proceedings.

More and more plan sponsors are looking to consolidate managers. Managers should look at how to provide multiple products and decide whether they can develop them internally or whether they must develop them through acquisition. Managers should try to understand their clients' needs and try to serve as many of those needs as possible while adding value.

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Using Existing Managers Using managers with whom clients already have a relationship has a number of advantages and disadvantages, for both sponsors and managers. The

The Evolution of Client-Manager Relationships; Client Views of the Future

Question and Answer Session Alice W. Handy William F. Quinn Question: Have the returns from alternative investments been worth the time, effort, expense, and risk? Handy: No, but a lot of the performance has to do with the time frame. In the current market, any deviation from or any diversification out of the domestic equity market has not paid off. So, we have to look at alternatives on a long-term basis. A lot of private equity and venture capital funds have begun to perform. On the other hand, if the question is whether alternative assets have performed as expected, the answer is absolutely. Question: Do you compare alternative asset returns with S&P 500 Index returns? Handy: No, we compare them with our initial expectations, so the standard is absolute return. We toyed with the idea of using a spread to u.s. Treasuries, a riskfree rate of return of 5 percent, but in the current market, such an approach seemed a little ludicrous. We actually look for opportunities other than private equity and venture capital, opportunities at the more speculative end of the range, and prefer investments offering returns of 12-15 percent. Question: How do you judge the performance of alternative investments? Handy: We receive audited statements on an annual basis from the partnerships and know what the returns are. We carefully analyze these statements. For instance, on our real estate funds, we

apply a discount to the market value; the appreciation is discounted 25 percent because the property values are based on appraisals and there could be problems with interim valuations. Again, we hold such investments for the long term and don't buy and sell them along the way. Quinn: The same goes for AMR. We do a lot of private equity and alternative investments. Our goal is to achieve 20 percent absolute returns but also to outperform the S&P 500 over the long term by 500600 bps. To date, we have reached our goal of 20 percent but have not outperformed the S&P 500. The key is the realized return you get at the end of the investment horizon-only then can you determine the true return. Question: How do you deal with managers on soft dollars? Quinn: We prohibit soft dollars because we think they are absolutely wrong. We and the managers have agreed on a fee structure. We have an ongoing monitoring process to make sure the managers do not use soft dollars. We also look at execution and average trading costs. Weare not monitoring all the factors that involve soft dollars, although the managers report to us on a quarterly basis to confirm that they did not use soft dollars, or if they did use them, they must show that the cost was bundled in another trade because we want to know exactly what they paid for the research. Handy: Mr. Quinn makes an interesting observation that if we had the risk controls on a macro

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level, maybe we wouldn't have to do all the rest of the monitoring at the fund level, which is very time consuming and political for us. Quinn: Such monitoring clearly is time consuming. The problem is that when you are dealing with big pension plans, very small differences mean a lot of money. You could lose $1 million very easily by losing a small percentage of your trades in soft dollars. The amount of money involved is what makes you spend the time. Question: Do you think you are sacrificing returns by limiting the number of managers? Quinn: I do not believe we are sacrificing returns by hiring fewer managers for a number of product lines. I also am not saying that the same money manager running our domestic equity will be running our international equity or longterm bond fund. The manager must bring in people with the necessary skill sets and disciplines to add value. We do hire specialists when necessary. For example, we found one manager that offered value in emerging markets, so we added that manager to the group. The economies of scale we achieve through multiple product offerings significantly reduce costs. In the long term, using broader product lines is going to benefit us on a return and a cost basis. Handy: Making a few key decisions is better than making a lot of little ones, which plays right into the argument of having fewer relationships. In other words, you can think about the things that are 39

The Future of Investment Management truly significant instead of spending your time trying to chase various ideas in multiple relationships. Question: Although the situation is difficult for clients, can the clients call the shots and, for example, increase the allocation to cash?

and we give them a long-term horizon. Our average equity manager has been with us 15 years, so they know they've got time to let the cycle work out. We only change managers in the short term (i.e., four or five years) if they change styles or if their principal people change.

For example, real estate is not a permanent part of our portfolio, but we went intoitin a rather major way with 10 percent of our portfolio in 1992 and 1993. Our staff make such determinations, and we make the recommendations to the board.

Do you make TAA decisions, and if not, who does? Who does the strategic asset allocation?

Question: Do you find yourself moving toward non-US. equities now that the US. market has had a good, long run, and if so, do you feel confident about such a move?

Question:

Handy: We can call the shots, but we still have to report to a board and still have to be accountable. Not all board members are financially sophisticated. Often they sit on the board of another fund that does not have the same concerns as an endowment and that is all in stocks and, therefore, has performed better. So, our position is not very different from that of managers. Quinn: We share the same concern about benchmark-driven managers, and we try to solve the problem by making sure that we do not use managers that are closet indexers. We look for managers that will vary the fund's exposure,

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Handy: The board clearly makes the strategic asset allocations, but in our case, we have a board that is appointed by the governor of Virginia. The members don't necessarily have any investment expertise, and their appointments are only for four years. My staff and I serve as a corporate memory and make all the recommendations to them. In terms of TAA, we were fairly successful in the 1980s at getting in and out of the international markets. In the 1990s, the decisions have been more strategic, but we time our entry into markets.

Quinn: We have had a large international commitment, probably 25 percent of our equity portfolios, in the past year or two, but at 25 percent, we're probably as committed to international equities as we're going to be for a while. Handy: We are a little underweighted relative to our target in international equity. In our case, our manager made a tactical decision to stay lower, and I don't see the manager increasing the position significantly.

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Management Strategies for Large Organizations Norton H. Reamer, CFA

Chair of the Board and CEO United Asset Management Corporation

The key for large investment management firms is basic: to combine good investment performance with a high level of client service. Neither result by itself is adequate because the lack of either can drive away investors. To achieve both goals, however, firms must adopt strategies that simultaneously address a variety of factors, which range from how firms organize their investment functions and manage investment professionals to confronting the effects of globalization and rapidly advancing technology.

s the investment management business grows increasingly competitive, large (as well as small) firms face complex challenges in the way they operate. Thus, the topic of management strategies is very timely. Participants in this industry must regularly evaluate their management strategies to assure that they are achieving the best results for clients, employees, and shareholders Critical appraisal of strategies for large organizations is also timely in light of the recent sizable acquisitions of investment management firms-such as the acquisition of U.K.-based Mercury Asset Management by Merrill Lynch & Company, the merger between Swiss Bank Corporation and Union Bank of Switzerland, and the acquisition of LGT Asset Management by Amvescap. These transactions underscore both the attractiveness of the asset management business to other financial service companies and the interest of large firms in becoming still larger. As a holding company that owns 53 investment management affiliates with nearly $200 billion in assets under management, United Asset Management Corporation (UAM) is a large company, but it is a large company composed of many medium-sized and small companies. At UAM, we believe that success in investment management is best achieved through the activities of small groups. We prefer management solutions that promote decentralization, and we discourage the organizational hierarchy found in many large firms. In reality, many of the challenges faced by large firms today are the same as those faced by small firms. For example, the chal-

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lenge of motivating and compensating employees exists at firms of all sizes. The key factors for the success of large firms (and small firms) are understanding the forces of change affecting the industry, effectively managing investment professionals, organizing the team, asset allocation, product development, technology, and focusing on the customer. Just as there is no one right way to manage money, so there is no one right way to run a money management firm. Although some strategies are more effective than others, no specific model will work for all firms in all markets all the time. Constant change and the diversity of local markets around the world ensure that no single model will fit all situations.

Forces of Change The investment management business in the United States is, of course, a dynamic scene. Markets around the world are changing. The three most important changes affecting management finns' strategies are consolidation, globalization, and what might be called "retailization." Consolidation. The concentration of the industry is not occurring as rapidly as some have predicted, but it is occurring-primarily through acquisitions. The most recent data on the total assets managed by the top 300 investment management firms in the United States show that, from 1990 through 1996, the market share of the 25 largest firms increased about 1 percent annually to approximately 41

The Future of Investment Management

47.7 percent of the total. Mergers and acquisitions are occurring between independent money management firms and between independent firms and large "financial services" firms, such as banks and insurance companies.

performance. Furthermore, because individuals and groups, not machines, deliver the product, attracting talented individuals to a firm and systematically developing, motivating, and retaining them should be a fundamental, key management strategy.

Globalization. In this case, "globalization" means two things. First, the trend of U.S. investors investing larger percentages of their assets in nonU.s. securities has affected individuals and institutions alike. In 1996, more than 20 percent of the money invested by individuals in equity mutual funds went into global or international portfolios. Since 1991, the amount of nondomestic securities held by U.S. institutional investors has grown by about 30 percent a year. Second, globalization also involves the trend toward mergers and acquisitions between firms of different countries. This form of globalization is occurring at an increasing rate. An important management strategy for investment management firms of the future is to develop global knowledge. The money management business has always been based on knowledge, but the boundaries of knowledge are changing as the world's financial markets grow more unified and the amount of data available for investment decisions expands. In addition, as clients increasingly seek diversification through cross-border investments, the need for global data has increased. Finally, as the speed of the information flow increases, firms find they must have the capability to make faster decisions. The challenge is to manage firms in such a way that the staff can gather global knowledge and act on it more efficiently than in the past.

Career Focus. Investment management should be viewed as a career-something between an art and a science-that an individual may spend a lifetime perfecting. Some investment professionals even spend most of their careers analyzing only largecapitalization domestic stocks or investing solely in short-term government bonds; others find a niche as experts in emerging markets or precious metals. For large firms, circulating young professionals throughout a large and diverse financial organization for the first year or two after they join the organization is a worthwhile activity, but making early specialization in investment management a standard industry practice will most definitely improve investment performance for clients. In addition, when young professionals know they can specialize in investment management, most will show an aptitude, or certainly a preference, for one aspect of the business or another. Investment management firms realize that time is required for young professionals to understand and be comfortable with key concepts in investing. For this reason, firms should give their employees the time necessary to develop knowledge and expertise by specializing. Such an approach will payoff for the employees, the firms, and client portfolios. As a general practice, rotating talented investment people through non-investment-related parts of an organization may not only diffuse the talent but may also cost the firm when it comes to performance and client satisfaction. Rotation is comparable to expecting talented young surgeons to take their turn in hospital administration or, even more unfortunate for the "client," having hospital administrators take their turn as surgeons in the operating room.

Retailization. Retailization is the increasing tendency of individual investors and families to take an active role in directing their own assets, including retirement assets. During the past 20 years, many people in the United States have shifted from saving through bank accounts and certificates of deposit to investing through mutual funds. This process has both contributed to and benefited from the bull market that began in 1982. Recently, the growth in the U.s. economy of defined-contribution plans, in which employees generally direct their own investments, has exceeded the growth of defined-benefit plans, in which plan sponsors select the investments.

Investment management is not a commodity business because the "product" is not standardized. That is, although common styles and generally accepted principles exist in investing, each portfolio manager or team has a particular way of pursuing strong

Culture. One cannot address the role people play in an organization without mentioning the purpose of a firm's culture, which is closely related to ethics, performance, and client service. A common culture that forces a single way of doing things in a large, complex firm-especially one that has been assembled through mergers and acquisitions-can be counterproductive. The creativity and entrepreneurial spirit that attract people to the investment management business can easily be extinguished if firms force individuals to work in only one certain way. The individuals within a diversified financial services firm who manage money, especially the ones who are really good at it, are often very different from the other professionals within the organization. In

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Managing Investment Professionals

Management Strategies for Large Organizations fact, the strong egos and entrepreneurial spirit that make money managers good at their craft can be inherently at odds with the cultures of the banks or insurance companies that own the money management firms. Diversity, not conformity, strengthens an investment management organization. Compensation. Determining the appropriate form and level of compensation for employees is one of the most challenging management issues. In a large firm, issues of compensation are difficult because the desire for standardized compensation policies can be at odds with the reality of a large, complex organization made up of individuals and groups with different goals and requirements who face different business conditions. Compensation issues are particularly acute in diversified firms that have lines of business other than investment management. In the United States, money management professionals are generally recognized to be talented and creative individuals who are under an enormous amount of pressure from their companies, their clients, and themselves to generate superior returns. Investment management in the United States is also a high-margin business, and successful money management professionals expect and receive relatively high compensation. Large firms that wish to remain competitive in asset management must be prepared to pay their professionals well. They must also make keeping abreast of how competitors reward employees a priority. By seeking out and recognizing trends in compensation, firms can reduce the risk of losing valuable employees to competitors who are willing to pay them more generously. Several other considerations related to compensation should be kept in mind. First, firms should tie part of an individual's compensation to individual effort and achievement, but at the same time, they will benefit by linking some of that compensation to other factors, such as small-group performance and/ or the success of the entire organization. In addition, tying some of an employee'S compensation to long-term performance or future employment at the firm is appropriate. The revenue-sharing agreement that UAM establishes with its asset management affiliates gives each firm the responsibility to determine its own expenses, including the compensation of its employees. It also rewards the firm for growth in revenues. Sharing the benefits of growth adds to our firms' incentive to continue to provide superior performance for clients and increase their businesses. UAM has an additional incentive that we refer to as "incentive units." This type of financial instrument is sometimes called "phantom stock" because it functions as stock in the individual UAM firms. Its purpose ©Association for Investment Management and Research

is to stimulate growth by rewarding the managers of an affiliate for the increased revenues resulting from net new business. It works according to a formula that pays out to an affiliate over a seven-year period. Most of the payout is in cash, but part of it is in the form of options on UAM common stock. More than 40 percent of UAM is owned by employees. Many respected money management firms in the United States agree that equity ownership is helpful in attracting, motivating, and retaining professionals. For example, Fidelity Investments, which is both enormous and privately owned, readjusted its ownership structure in 1995 to provide ownership opportunities to employees. Edward Johnson, the majority owner and CEO, reduced his family's stake in the firm and distributed a limited amount of voting equity among the firm's top 50 executives. In addition, Fidelity established many layers of equity that pay dividends to key employees besides top executives and money management professionals. Rewarding performance and creative thinking is as important as rewarding people for their place in the firm's hierarchy or for years of service. Because of the UAM compensation system, although I am the highest paid executive in UAM's holding company, I am not the highest paid executive in the corporation. In 1997, 35 individuals, all of whom work at the affiliates, earned more money than I did. This fact does not bother me at all. Our system is a positive influence on our employees, affiliates, and shareholders because it reinforces the idea that exceptional professionals will be rewarded for their talents and encourages the decentralization that is key to the success of UAM. Understanding that their compensation is not entirely limited by seniority or how many layers of management stand between them and the head of a firm can serve as a powerful incentive for employees. Management Development. Managementdevelopment and succession planning are critical management challenges in US. asset management firms because (1) so many investment management firms are competing for talent in the United States and (2) many of those firms are managed by "firstgeneration" executives now in their 50s and 60s. Although these executives are not yet ready to retire, they should be planning for their eventual retirement by training the next generation of leaders. Because UAM is highly decentralized-in terms of geography and management-we have found a helpful part of management development to be companywide seminars, conferences, and other types of meetings that improve the skills of our employees and help make them feel that they are part of a larger organization. For the most senior of our executives, 43

The Future of Investment Management we periodically hold a "leadership forum" at Harvard Business School. Executives work in small and large discussion groups to analyze case studies involving marketing, management development, incentives, and other strategic business issues. Succession planning is important because, among other things, it provides continuity for clients. Managers want to avoid letting transitions in leadership, such as the retirement of a key executive, become an opportunity for clients to question the quality or infrastructure of the firm, rethink the relationship, and seek a new asset manager. DAM invests a great deal of time and effort in issues of leadership and succession. The only restriction DAM puts on the payout of the incentive units described previously is that at least half of the award must go to the "second generation"-that is, the younger executives. This requirement is grounded in our belief in management development and succession planning. No time is ever too early for a firm to start thinking about who will take charge once the current leader or leaders assume a less active role. DAM seeks individuals with vision, decisiveness, and strong interpersonal and communications skills. A history of consensus building and strategic planning is helpful. Firms will also want to focus on executives who have developed a keen understanding of their clients and their industry. Firms should formally and informally train the individuals they have identified as future leaders. When firms perform this task well, the leadership transition need not be a traumatic event for clients. Moreover, it can strengthen the total firm. DAM initiates discussions with current leaders to identify time horizons for their leadership and to discuss their retirement plans. Having a clear time horizon is helpful not only to the senior managers but also to the ambitious younger managers who want to be considered for the top jobs some day.

Organizing the Team

neurial environment. Although scale in distribution can bring critical mass and economies, it can also bring problems in the investment management process. Making investment professionals feel they are part of a small group when they are actually part of a large organization is, therefore, one of the most important challenges large organizations face. Consider the successes of small groups within larger organizations in other industries. A small group within Microsoft came up with Windows, the operating system that runs more than 90 percent of the world's personal computers. A small group within Chrysler was given the freedom, autonomy, and financial backing to invent the immensely popular minivan. Organizing the Research Function. As a general principle, the research function should be organized to fit the needs of portfolio managers. To the extent that a firm offers a uniform set of investment products-based, say, on one style of investingstressing a consistent research approach is not only appropriate but is what clients expect. If the firm offers a broad line of products, however, and offers them through various distribution channels, dividing research into different groups is appropriate. Organizing research analysts in small teams, even informally, within larger groupings is a useful approach. Teaming young analysts with senior analysts and with portfolio managers can be extremely helpful for training, managing, and judging the effectiveness and the potential of the younger members. Teaming analysts with portfolio managers is also beneficial because working as a research analyst is excellent experience for becoming a portfolio manager and because the challenges and insights provided by the portfolio manager will improve the analyst. As international borders become less important to global companies, they will also become less important to global investors. For the future, the research function, at least for top-down investing, will need to be organized less around geography and more around industries worldwide.

As the design and management of DAM reflect, I believe that investing is an activity best conducted by individuals and small groups and that success over a long period is more likely to be achieved in a setting that fosters creativity and innovation. Money management is more likely to be successful when firms are small and flexible. Investment performance can suffer when growth is too rapid or when organizations become too large and bureaucratic. Moreover, many talented investment professionals prefer working in organizations where they feel they have decision-making authority and a direct impact on performance. They thrive in an entrepre-

Because investment management is not a commodity business but a highly differentiated process that often depends on talented individuals interacting together, small groups can be very useful in portfolio management. Small groups not only allow for the efficient exchange of information but also provide a "human scale" work environment in which individuals can make a difference and be recognized for their accomplishments.

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Organizing the Portfolio Management Function.

Management Strategies for Large Organizations Diversity of talent within groups is particularly important in an increasingly global market. To know where the "next good investment idea" is going to come from, not to mention what the next 10 good ideas will be, is hard, but maintaining a diverse organization and encouraging diverse teams improves the likelihood of generating superior investment ideas and performance. A commitment to diversity also means recognizing the unique talents of "loners"-people who do not fit well in groups but who provide valuable contributions and insights as analysts and sometimes provide exceptional performance as portfolio managers. Intelligence comes in many forms, and firms would do well to make use of all of those forms.

Asset Allocation The importance of asset allocation in generating superior investment performance has been increasingly recognized in the past 10 years. Evidence shows that asset allocation, which accounts for as much as 90 percent of portfolio return, is by far the most important determinant of investment performance. Because of asset allocation's importance, many clients want more than simply good investment selections within a specified asset class or style; they also want assistance with allocating assets. In the United States, this phenomenon is true for both individual and institutional investors. The globalization of the industry increases the complexity of asset allocation because the universe of choices is the world. For their most sophisticated customers, asset managers must be able to allocate assets among foreign equities and bonds as well as domestic equities and bonds. In short, investment managers must be prepared to use a much more sophisticated set of skills and knowledge to practice their craft than in the past.

Product Development Broadening the product line to generate growth is a time-honored strategy, but although multiproduct firms are growing in importance, merely offering a broad array of products will not guarantee success, especially in the institutional market. In today's competitive environment, firms should offer only as many products as they can efficiently provide without diluting their standard of performance. Broad product capability is needed, but each asset category within an organization must achieve excellence. The reason is simple: Clients, particularly institutional clients, recognize when a firm is overextended, and eventually, they will refuse to accept mediocre products. In the United States, institutional ©Association for Investment Management and Research

clients and consultants are skeptical that a single firm can effectively manage all aspects of a very broad product line. They prefer to use a number of specialist firms. Even when a successful firm broadens its product line, most clients view the manager as good or very good at only a couple of types of investing. Individual investors may be somewhat more forgiving. In the short term, they may choose to place a diversified pool of assets with a firm even if they perceive the firm to be performing better with some asset classes than others. They too will seek to move assets, however, if they experience prolonged underperformance of a particular asset class. The fact that even the best firms do not provide superior performance in all products consistently is, of course, another reason to broaden a product line. Because investment performance of asset classes tends to run in cycles, a broad product line insulates the firm against temporary problems in one or more areas. Globalization offers both challenges and opportunities for the investment management industry with respect to product development. Developing the new products and services made possible by globalization is expensive and, what is perhaps more difficult for some organizations, requires an openness to change, new habits, and new ways of thinking. On the other hand, globalization provides an extraordinary opportunity for a firm to generate new revenues and profits. In addition, establishing a reputation for product innovation can significantly improve a firm's image as a leader in the market. Because clients increasingly want to diversify their portfolios, firms that wish to grow through product innovation must have global expertise and relationships. Only global knowledge will enable them to offer their clients new asset classes, broader geographical reach, and advanced investment styles. A growing alternative to internally broadening a firm's product offerings is the use of strategic alliances and subadvisory relationships to fill productline gaps. This strategy is particularly appropriate for firms that have strong relationships with clients but lack the ability to quickly develop certain types of high-quality investment products that they know their clients would like. To make strategic relationships work, the firm must select reputable, high-quality partners with the resources and commitment to deliver what has been promised and to commit for the very long term. For example, one ofUAM's firms, acting as a subadvisor, has achieved a 12-year record of excellent performance by consistently adhering to its investment style and philosophy during the period. 45

The Future of Investment Management

Both sides of an alliance should be as explicit as possible about the desired characteristics of the product, the costs, and the reporting requirements. Once a joint relationship has begun in earnest, however, the firms must be patient about meeting the agreedupon goals, especially during the development phase when operating details are being worked out.

Focusing on the Customer

Little of today' s opportunity for developing global knowledge and introducing new products would be possible without the dramatic development and growth of technology. Technology is transforming the investment management business much as it is transforming other fields. A curious aspect of the effect of technology on investment management is the opportunity it confers for the relative competitiveness of small asset management firms. To be sure, firms are using more data than in the past, but the cost of obtaining the data has fallen significantly. Because of technology, fewer people are needed to gather the same amount of information. The large firm, therefore, must improve its technological capabilities just to remain even with its small competitors. Also, even though the cost of acquiring a given amount of data has declined significantly, the overall cost of technology to an organization is rising because it has more data to sift through and firms have found new uses for technology. Large firms do have an advantage in one important use of technology: customer service, particularly for retail customers. Firms are using technology to make the process of getting information or making account changes as simple as possible for employees and customers. Some firms have designed sophisticated databases containing extensive product and customer information and linked them to personal workstations that customer service representatives can use to answer questions and execute customer transactions. If customers wish, they can bypass the representatives and use touchtone telephones and computers to transact business or gain access to account information directly. Even speech-recognition telephone answering is beginning to be used for customer service. Large firms have a natural advantage when incorporating this level of technology because they can spread the high fixed costs of developing and maintaining the systems over a larger revenue base. Technology, particularly technology based on the Internet, will play a key strategic role in the investment management industry in the future. It will not replace talented people in organizations, but it will playa central role in enabling firms to meet client needs.

Some in the industry argue that the essence of the investment management business is now scale and distribution capability. Although the industry is consolidating and large firms do have certain distribution and service advantages, no one should lose sight of the most basic fact: Customers are looking for superior performance. If managers cannot organize their firms to deliver good performance, then clients will eventually look for other firms to deliver it. Superior investment performance, goal setting, and risk evaluation are the most crucial elements for client satisfaction in the long term. As firms grow and age, they may unintentionally lose their client focus for various reasons. Some firms lose it because of complacency; others lose touch because their clients' objectives have shifted or because the market has changed. Other firms make the mistake of putting more energy into maintaining and building their organization than in meeting their clients' needs. To avoid this problem, firms must take three steps. First, they must identify customer focus as an explicit internal goal that appears in their mission statement, their business plans, and any other tools they use for monitoring business activity. This commitment to the customer must be set by the head of the organization and carried out at all levels. If the most senior executives of a firm lack a commitment to serving customers, then chances are the rest of the firm will lack it as well. Second, firms should rigorously and consistently practice the techniques of identifying customer needs and tracking customer satisfaction. Regular contact with customers to gather feedback and act on it is essential, but this practice can be supplemented with market research consisting of independent surveys and focus groups. Periodic surveys enable a firm to establish a base of information and then track it over time. Client advisory boards can also be a helpful way to strengthen relationships with customers. Finally, firms must always keep in mind that marketing, sales, and client service are interconnected in the customer's eye and, therefore, should be closely connected in the firm. Problems in one area will probably cause problems in the others-especially in large organizations, where the functions are more likely to be separate from each other and communication problems can arise. For instance, if a firm markets products and services to clients by raising unrealistic expectations about investment performance, no level of client service can repair the damage. If service is poor, clients may leave the firm-even if performance is good-for a firm that can provide both good performance and service.

46

©Association for Investment Management and Research

Technology

Management Strategies for Large Organizations

Two Types of Clients. Although all clients desire good investment performance, institutional and retail customers differ significantly and the firm's service strategies must reflect such differences. Institutional clients. Institutional clients today expect to receive a high level of service. They expect asset managers to adhere rigorously to the investment style and asset categories for which they were hired. Institutional clients and their consultants have sophisticated performance measurement tools for quantifying risk factors and analyzing investment returns. These tools allow them to evaluate the contribution of each investment manager and asset class to the overall portfolio and guide them in rebalancing the portfolio. Institutional clients require more data than in the past and expect to receive it more quickly and, increasingly, online. Relationship management for institutional clients is more quantitative and sophisticated than for retail investors, but it is less costly because it is more focused: Investment managers are dealing with far fewer people and with less record keeping per dollar managed. Of course, the institutional segment of the market has multiple distribution channels and each requires a somewhat different level of service, but managers should assume that the sophistication of all institutional clients is going to rise in the future. Managing the business under this assumption will allow the firm to successfully anticipate clients' needs before they make them known. In this sense, managers would do well to emulate the famous Canadian hockey player Wayne Gretzky, who when asked the secret of his success, replied, "Other players skate to where the hockey puck is, but I skate to where it is going to be." Retail clients. One of the most significant trends under way is retailization-the increasing tendency of individuals to assume responsibility for their own investments, particularly their retirement assets. Retailization in the United States is closely identified with the growth of defined-contribution plans and the growth of mutual funds. US. definedbenefit pension plans hold approximately $5.4 trillion in assets for employees; defined-contribution plans hold around $1.8 trillion. Defined-contribution plan assets are growing more rapidly than definedbenefit plan assets, however, and should exceed them by the year 2030. Mutual funds total nearly $4.5 trillion and are also growing rapidly. Research shows that approximately 85 percent of mutual fund shareholders have retirement as a primary investment objective. To serve these retail investors directly, investment managers must be prepared to invest in tech©Association for Investment Management and Research

nology. They must make shareholder literature reader friendly and educational, and they must make customer contact as easy as possible through toll-free telephone numbers and around-the-clock customer service. Rather than simply stressing the superior investment performance of their funds, they should structure their funds so that they are perceived by retail clients as solutions to various investing needs rather than simply products. For example, some investment management firms are offering retail customers "lifestyle" funds that are structured to meet the risk and return requirements of specific age groups. Some firms are offering portfolios that minimize taxes by controlling turnover for customers who want good investment returns without the negative tax consequences of heavy turnover. To capture and hold retail clients, firms must understand the importance of having well-recognized brands. A strong brand that consumers can understand and identify with allows an investment management firm to differentiate itself from its competitors. Because more than 8,500 mutual fund portfolios compete for investors' attention in the United States alone, brand identity is particularly important in the mutual fund business. Firms have many brand attributes to choose from when establishing or modifying a brand. A firm can link its identity to its leading portfolio managers, or it can emphasize its investment process and, perhaps, group approach to asset management. Investment performance, superior research, breadth of product, educational materials, and low fees-all are brand attributes that investment management firms have used to differentiate themselves in the U.s. retail market. Branding can be expensive because of the high cost of retail advertising, but branding is a proven way to compete successfully for retail business. The so-called "fund supermarkets" are services set up by large financial services firms through which they offer the funds of other money managers to their own retail clients. In exchange for offering these funds to their own customers, the supermarkets charge the money managers a small fee. Fidelity Investments and Charles Schwab & Company are two large-firm examples of this type of service, but many other firms also provide it. Fund supermarkets have become popular because many retail investors like owning a variety of mutual funds but prefer to purchase them from a single source because of convenience and the simplicity of receiving a single account statement. The investment management firms whose funds are sold through fund supermarkets benefit from the extra revenues that are generated, but the potential disadvantage is that they are vulnerable to losing 47

The Future of Investment Management

business if they should suffer even temporary underperformance-unless they have a brand name behind them. Without the confidence instilled by a brand, the retail investor may not have the faith required to remain with the fund as a long-term investor or may switch to another fund managed by the firm. Even the popularity of the fund supermarkets, therefore, does not negate the importance of branding. Although firms might like to "own" the client, such a relationship is not always possible and some firms can operate quite successfully without it. Many mutual fund firms do not have strong, mass-market brand identities. Some sell their products directly to the retail investors; others sell through intermediaries, such as financial advisors. Still others participate in the mutual fund business indirectly by managing assets as subadvisors for firms that have better marketing and client-service capabilities. All these business strategies can be successful. A number of DAM's affiliates have successfully established longterm subadvisory partnerships with other firms by providing investment management services for the clients of those firms.

48

Conclusion Given that the investment management industry is currently going through a period of global consolidation, some might conclude that only the largest firms will emerge successfully. Nothing could be farther from the truth. Large firms do have a number of advantages over small firms, but size should not be confused with success. Because investment performance is central to clients and because superior investment performance can be generated by relatively small groups of people, the investmen~ management industry will always have a range of flrmssmall, medium, and large. Indeed, the fate of the dinosaurs should remind us that Darwin spoke of survival of the fittest, not the largest. Size is not a solution for mediocrity or complacency and, in fact, is all too often a cause of both conditions. Size is not the goal itself but the means to an end, which is to have the resources to do a better job for clients, employees, and shareholders.

©Association for Investment Management and Research

The Value of Added Value: The Smaller Active Manager's Approach to the Future Langdon B. Wheeler, CFA

President Numeric Investors L.P.

Small investment management firms can compete with large managers through active management but must find a niche, most likely by designing novel products that add value. The average active manager, however, provides no intrinsic value because the positive value of the manager's intermediary function (converting client assets into the desired asset-class exposure) is negated by poor added value. A crucial piece of the puzzle is transaction costs. Transaction costs increase with assets under management and eventually reach a point at which added value becomes impossible. So, managers should focus on net excess returns, not growth of assets under management.

ecause Numeric's strategies are somewhat

unique, this presentation opens with an overB view of our investment strategies, investment process, and business strategy. The discussion then turns to the two general ways in which investment managers provide intrinsic value for their clients. The third section addresses the findings of Numeric Investors' analysis of transaction costs. This analysis reveals that such costs are higher than people might think and go up rapidly as assets under management increase. The fourth section suggests how to use the insights of transaction cost measurement to build more effective stock selection strategies and to gauge how large an investment strategy can grow. The conclusion expresses concern that fiduciary responsibilities are being compromised in the headlong pursuit of growth.

Numeric Investors Numeric Investors is an active, quantitative manager of U.s. equity portfolios offering a family of investment strategies with aggressive investment objectives. Founded in 1989, Numeric has about $4 billion under management. In addition to separately managed accounts, we manage limited partnerships and the n/i Numeric Investors family of mutual funds for individual investors. We currently invest exclusively in the United States but are working on extending our approach to non-U.s. markets. Numeric has an unusual business strategy: to be ©Association for Investment Management and Research

good, not big. Numeric measures success by the dollars of excess return generated for clients rather than dollars of assets under management. We focus on returns, not marketing, and we specialize in longshort investing. To maintain returns, Numeric limits asset growth. Three-quarters of the assets we manage are in strategies that are closed and cannot take more money. Portfolio Strategies and Investment Process. Exhibit 1 contains a list of strategies and their benchmarks. As the exhibit shows, our strategies have aggressive return objectives. Our least aggressive strategy is a large-capitalization/value strategy (Value Aggressive) that endeavors to beat the Russell 1000 Value Index by 3 percent a year after fees (that is, annualized average excess return). In the most aggressive long-short strategies, we have lofty excess return objectives. We generally meet or better the objectives shown in Exhibit 1, but there is no guarantee that we will in the future, nor have we done so every year. Our strategy is to search for market inefficiencies that arise from investor over- and underreaction. We base our strategies on finding some return in the market that would not be there if the market were truly efficient. The purest way to harvest such returns is in a long-short portfolio, but it also can be done successfully with a long-only portfolio if the client specifies a benchmark and the manager has a model that works well in that particular domain of the market. 49

The Future of Investment Management Exhibit 1. Numeric Investors Strategies and Targets Strategy

Targeta

Value Aggressive Core Aggressive MidCap Aggressive Small Cap Growth MicroCap Fair Value Long/Short Original Long/Short Levered Long/Short

Russell 1000 Value Index + 3% S&P 500 Index + 4% S&P MidCap 400 Index + 5% Russell 2500 Growth Index + 6% Russell 2000 Growth Index + 6% 5-8% excess return 8-10% excess return 10-12% excess return

Note: From top to bottom = least to most aggressive. aAnnualized excess return after fees.

Our investment process is based on two quantitative models. One is grounded in the theory that investors are slow to react to new earnings information. Earnings revisions and earnings surprises, therefore, are not immediately and fully reflected in prices. This situation creates an opportunity to invest with the trend of the estimates in our Estrend (earnings estimate revisions) model. The second model, our Fair Value model, is a complicated valuation model that tries to identify mispricing. Stock prices are more volatile than the underlying information about stocks, which changes slowly. So, we beton the tendency for prices to come back to an equilibrium level, and we use the Fair Value model to identify the mispricing before the reversion. Both models are based on fundamental concepts. The approach is not "black box" arbitrage but stock picking with the help of a computer. Our stock selection process is bottom up. We do not time the market, we do not time styles, and we do not allow ourselves to make sector bets. The strategies work via stock selection, or they do not work at all. Our process runs live; we rank stocks every minute. As a result, our portfolios have high turnover, so we keep a keen eye on what transaction costs can do to our strategy.

have people and time to develop them. We sell a strategy to its capacity, and then we close it. Because we are constrained by the capacity that any strategy can successfully handle, we look for new markets, which is why we are looking into nonU.s. markets or new asset classes for which our techniques will work. For example, we might be able to apply our techniques in convertible bonds or options, although those markets may not be liquid enough to afford us significant growth. Finally, we would love to uncover some new inefficiencies, but that event only happens every decade or so. One challenge we face as a business is to build a sustainable organization that will deliver sustained added value in light of increasing market efficiency. Another challenge is to establish a management structure to monitor the investment process and be able to parse the production process to identify the specific causes of investment returns: How well did we trade? How well did the portfolio manager respond to the signals from the computer? How fast did the computer model capture the data?

Intrinsic Value of Investment Management The intrinsic value of investment management arises from two components: an intermediary function and a value-added function. In the intermediary function, management firms take the customer's assetstypically, cash-and convert them to the desired asset-class exposure. The value-added function is the generation of returns in excess of the return of the asset class.

Business Strategy. Numeric has made a serious commitment to processing information quickly. Our firm employs 30 people, 125 computers, and almost 18 miles of computer cable connecting the computers in 10,000 square feet of office space. We closely monitor performance, particularly the efficiency of implementation. We have a research program that constantly seeks to overcome increasing market efficiency. Occasionally, some new idea bubbles up from our research program that begets a whole new strategy, but the main focus of our research program is to keep ahead of increasing market efficiency in existing strategies. One frustration is that we have more ideas for new strategies than we

Intermediary Function. The intrinsic value of the intermediary function relates to market sophistication and the difficulty of achieving and maintaining asset class exposure. Difficulty is partly a question of whether the asset class is deal specific-that is, the manager must study each deal, as in real estate or venture capital-or whether it involves a public market, in which managers can be sure that they are buying what they think they are buying, such as U.s. Treasuries. Difficulty is also partly a question of how much maintenance the exposure requires, such as whether the manager must stay focused on the deal to make sure that the entrepreneur or the tenants in the office building are meeting the venture capital or real estate manager's expectations. The intrinsic value of the intermediary function increases to the extent that the product is unique, that it provides some diversification value, and that it is expected to provide higher returns. The intrinsic value of the intermediary function decreases when either competition is substantial or alternative solu-

50

©Association for Investment Management and Research

The Value of Added Value

tions exist. For example, in the case of US. equities, investors can get equity exposure by buying an index fund from myriad sellers or by taking an alternative route-entering into a swap contract or buying index futures. US. equities are a primary asset class for most investors. Plenty of money managers can serve as intermediaries, and with today's technology, an investor can make the purchase from any locality. These circumstances reduce the value of the intermediary function provided by US. equity managers. Contrast this scenario with investing in venture capital or private equity in emerging markets. Such an investment places unusual demands on the intermediary and thus gives the intermediary function very high intrinsic value. In a developing country, the intermediary must get to know the people, do some relationship building, find an introduction to the deal, and hope that the parties to the deal have integrity and the deal is carried through. Probably no alternative or synthetic way exists to create exposure to emerging market venture capital. In addition, the investor probably expects high returns; otherwise, he or she would not be interested in the asset class in the first place. Emerging market venture capital is a tertiary asset class (as opposed to U.S. equity, which is a principal asset class, and emerging market equity, which is a secondary asset class), so it affords good diversification. The manager that has emerging market expertise and can provide the intermediary function for such assets provides a high level of intrinsic value for the investor. A comparison of the intrinsic values for different intermediary functions is instructive. Table 1 compares rough estimates of intrinsic values for intermeTable 1. Comparison of Intrinsic Values of Intermediary Functions for U.S. and Russian Equity Markets Strategy

United States

Russia

Large-cap equity Small-cap equity Long-short equity Real estate Venture capital

10 bps 20 50 50-100 100-200

75 bps 150 200-250 200-300

diating various asset classes in two extremely different environments-the United States and Russia. The intrinsic value of providing large-cap U.S. equity exposure to investors is worth, say, about 10 basis points (bps) a year. Small-cap equity is a little harder to trade and takes more attention, so it is worth somewhat more. Because long-short equity investing involves a long portfolio and a short portfolio and ©Association for Investment Management and Research

because not as much competition exists for managing long-short as exists for long-only portfolios, the intrinsic value for managing a long-short portfolio is higher. Real estate and venture capital are both deal-specific, maintenance-intensive asset classes that have much higher intrinsic values for providing the intermediary function than public equity markets and bonds. Real estate and venture capital both demand the same amount of manager work, but real estate has not been a high-return asset class for the past decade, so the market does not perceive a high intrinsic value for that exposure currently. Venture capital has been hot recently, so its intrinsic value appears higher. Now consider the situation of providing the same intermediary functions in Russia. A manager that can give investors exposure to that market has provided substantially higher intrinsic value to investors than a manager functioning in the US. market because of the inherent difficulty in doing so. Long-short equity investing in Russia merits a blank because I do not know if it can be done there. Real estate and venture capital exposure are more valuable because of the legal difficulties and the geographical distance. As Table 1 suggests, the intermediary function has less intrinsic value in efficient, well-developed markets, such as the US., and much higher intrinsic value in less-efficient markets. Added Value. The intrinsic value of providing alpha-excess return or added value-is the second reason for an investment manager to be in business. One measure of the intrinsic value of added value is the standard 20 percent performance fee that is widely used in performance fee contracts. If 20 percent is the value of the manager's added value, then the manager should be able to claim 20 percent of the excess return above the benchmark return as the intrinsic value of his added value (after deducting the intrinsic value of the intermediary function as a "base fee"). The total intrinsic value of the investment manager's services is the sum of the intrinsic value of the added value plus the intrinsic value of the intermediary function. As an example of how added value can be calculated, Table 2 shows the intrinsic value of Numeric's intermediary function during 1997. On average, Numeric had $3.3 billion in assets under management during the year. Of the three asset classes shown, Numeric had the most money under managementin long-short equity, and that asset class's intermediary function has the highest intrinsic value. The intrinsic value of Numeric's intermediary function is $11.9 million. During 1997, Numeric generated excess returns before fees of $116.8 million. If the intermediary func51

The Future of Investment Management Table 2. Intrinsic Value of Numeric's Intermediary Function, 1997 Annual Basis Points

Asset Class

Assets under Management (billions)

10 20 50

Large-cap equity Small-cap equity Long-short equity Total

Annual Value (millions)

$0.7 0.6 bQ $3.3

tion of $11.9 million is subtracted, the net excess return is about $104.9 million. Credit the firm with 20 percent of that excess return, or $21 million, as added value. With intrinsic values of the intermediary function at about $12 million plus added value at $21 million, Numeric's investment management services in 1997 had an intrinsic value of about $33 million. Now apply this framework to calculate the intrinsic value of the "average" active manager of u.s. equity portfolios. Unfortunately, this average active manager does not generate any intrinsic value. To illustrate, the average active long-only U.S. equity manager can be given between 10 bps and 20 bps credit for performing the intermediary function. For added value, however, the average active manager has underperformed the benchmark by about 1 percent a year or worse. Because 20 percent of -1 percent is -20 bps, the average manager does not generate any intrinsic value. For the average active manager, the poor added value more than negates the positive intrinsic value provided by performing the intermediary function. Note that the previous discussion of intrinsic value did not consider fees. Given that the average active manager also charges higher fees than passive managers and fails to generate added value, it is unclear how such a firm can remain in business. In the future, investment management firms will need a business plan that defines the intrinsic value of the services provided and, if the firm provides active management, must focus on added value.

Transaction Costs Transaction costs are particularly important for Numeric because our stock selection processes produce high turnover of 200-300 percent a year. During 1997, we entered 28,000 orders for roughly one billion shares. About 90 percent of those shares, or $30 billion worth of stock, traded. So, we traded roughly $8 for

$ 0.7 1.2 1Q..Q

$11.9

every $1 under management. We estimate that Numeric single-handedly represents about 0.4 percent of all trading in the United States. Because of our high turnover, we must be more conscious of transaction costs than firms that buy and hold stocks for longer periods of time. Therefore, we have built an elaborate system to measure the costs of everyone of our trades. Transaction costs contain four componentscommission, bid-ask spread, market impact, and opporhmity cost. The first three components are well known, but the importance of opportunity cost to a manager may not be as well understood. Opportunity cost is the cost of what the manager wanted to trade but could not because the price moved too far away before the manager's full order was completed, prompting the manager to cancel the unfilled balance of the order. Said differently, your model may have identified a great trade, but you could not get all of the money to work at the price the model used when it identified the trade. Managers ignore opportunity costs at their peril, because if they cannot get the trade done, they cannot get the profit to the shareholders. Opportunity cost converts to market impact as trades are executed. Transaction costs vary widely. Table 3 illustrates average one-way transaction costs for four of our strategies. In the larger-cap Value Aggressive strategy, we buy on the basis of value signals and trade in very liquid stocks. As Table 3 shows, this strategy involves a fair amount of opporhmity cost plus some market impact, bid-ask spread, and commission costs, which together total 53 basis points for the average one-way trade. Contrast this example with the transaction costs for our Small Cap Growth strategy, in which we trade primarily on the basis of earnings revisions and earnings surprises. In this strategy, a lot of people are on the same side of the trade as we are, so the average trade costs 176 bps and

Table 3. Average One-Way Transaction Costs by Strategy Strategy Value Aggressive Small Cap Growth Original Long/Short Fair Value Long/Short

52

Opportunity 23 bps

28 25 28

Market Impact

Bid-Ask Spread

Commission

6 bps 99

16 bps

8 bps

43

66 -4

30 16

6 8 9

Total 53 bps 176 129 49

©Association for Investment Management and Research

The Value of Added Value

has a large component of market impact. In the Original Long/Short strategy, we are also trading on both value and momentum signals in both large- and small-cap stocks, so the one-way transaction cost is less than for Small Cap Growth. The one-way transaction costs for Fair Value Long/Short trades are slightly lower than the costs for Value Aggressive because value-based trades are even more dominant than in the Value Aggressive strategy. These one-way transaction costs take on real significance when multiplied by turnover. Table 4 calculates the annual cost of transacting for each strategy. For example, the Value Aggressive strategy pays a one-way 53 bps transaction cost multiplied by an annual turnover rate of 250 percent times two to buy and sell, thus producing a total transaction cost for the strategy of 2.65 percent a year. The investment objective for this strategy is to generate an annual excess return of 4 percent before fees, so transaction costs are 66 percent as large as the investment objective. Recall that in the long-short strategies, roundtrips double because positions in both the long and short halves of the portfolio must be bought and sold. Recall also that in the Small Cap Growth and Original Long/Short strategies, the turnover is higher than for Value Aggressive because earnings revisions change so frequently. Thus, for the Original Long/Short strategy, we expect to spend 15.5 percent a year to generate a target net excess return of 11 percent. The operational efficiency of the U.S. stock market is so high that investors must spend a lot in transaction costs just to make a little added value. Net Alpha Forecasts. We use our extensive transaction cost database for two purposes: (1) to generate net alpha forecasts-the excess return we expect to make in a stock net of the cost of trading it; and (2) to determine the right level of assets under management. Transaction costs are determined by many different variables, with the size of the trade being most important. In addition to size of trade, costs are also determined by trade direction and motivation, share price, and the exchange on which the stock is traded. Trade motivation is important because buying stocks on the basis of new information that everybody sees, such as an earnings surprise, is expensive. Over-thecounter trades appear more expensive than listed,

but when other factors are considered, costs for exchange-traded stocks are not different from overthe-counter costs. The importance of trade size-the number of days' volume needed to build the desired positioncan be seen in Figure 1. To trade less than 1/8 of a day's volume will cost, on average, about 40 bps; to trade more than two days' volume will cost about 2.5 percent on average. We have built models that allow us to forecast trade costs. For example, on February 20, 1998, Abbott Labs looked generally positive in our models. As depicted in Figure 2, we thought buying it would cost more than selling it. (To sell it short, however, would cost even more.) Abbott Labs is a liquid stock that was trading an average of $98 million a day at that time, so $5 million worth of Abbott Labs could be bought quickly and would cost only 19 bps, because a $5 million trade does not have a big impact on a stock trading $100 million a day. General Cigar also looked extremely attractive in our model on that day, as shown in Figure 2. It had an extremely one-sided market at that point, however, because the company had announced good earnings. In contrast to Abbot Labs, to buy $5 million worth of General Cigar stock would have taken twoand-a-half days' worth of trading volume. An investor would incur market impact or opportunity costs to attempt such a trade that would cost 2.5 percent. One thing we have learned from our work on transaction costs is that on a stock-by-stock basis, transaction costs are far more forecastable than alpha. So, building a stock selection process that modifies the forecasted alpha with the more certain cost of trading the stock should improve the net deliverable alpha to the clients. The Right Level of Assets under Management. Perhaps the most interesting outcome of our transaction cost research is that it allows us to forecast how excess returns will change as assets under management vary. Because we know how much we spent on trading last year as well as the net excess returns of each of our strategies, we can calculate each strategy's gross alpha. Gross alpha is the sum of what we spent to trade plus what we were able to bring home in net, before-fee excess returns to our clients and

Table 4. Effect of Annual Trading Costs on Alpha by Strategy Strategy Value Aggressive Small Cap Growth Original Long/Short Fair Value Long/Short aBefore fees.

One-Way Cost (bps)

Turnover

Total Cost

53 176 129 49

250 x 2 300 x 2 300 x 2 x 2 250 x 2 x 2

2.65% 10.56 15.48 4.90

©Association for Investment Management and Research

Expected Net Trade Costs as Alpha Percent of Net 4.0% 7.0 11.0 8.5

66% 151 141 58

Realized Annual Alpha a 5.8% 12.3 11.2 10.7

53

The Future of Investment Management Figure 1. Variation in Costs by Trade Size 300,---------------------------------, '[ 250 ~

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represents the raw information content of our stock selection processes. Assuming that gross alpha is stable and that the sizes of our trades vary with assets under management, we can estimate how net excess

returns will change as assets under management vary. The inspiration for this analysis stems from a paper published by Andre F. Perold and Robert S. Salomon, Jr., entitled "The Right Amount of Assets

54

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The Value of Added Value

under Management.,,1 For example, our Original Long/Short strategy experienced an average one-way cost of 129 bps to trade the $800 million we had under management in 1997; our transaction cost forecasting model predicted similar one-way costs of 123 bps. Figure 3 illustrates the increase in average and marginal trading costs as assets under management in this strategy increase. Obviously, if the average cost rises as assets under management increase, the marginal cost curve goes up even more steeply as assets increase. If we managed only 80 percent of the assets we actually had in 1997, we would have expected average one-

way trading costs of only 112 bps; an additional 20 percent more assets under management would have raised the expected one-way cost to 148 bps. Assuming constant turnover, one-way average and marginal trade costs can be easily converted to annual costs for any level of assets under management. Figure 4 shows the trade costs for our Original Long/Short strategy on the vertical axis. With assets under management of $800 million, the average annual cost to trade is about 15 percent. For the marginal trade, however, the cost is about 20 percent. Figure 4 also shows the gross alpha of the strategy as a straight horizontal line, indicating that gross alpha is independent of assets under management. If we could trade frictionlessly, we could generate sub-

IFinancial Analysts Journal (May jJune 1991):31-39.

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©Association for Investment Management and Research

55

The Future of Investment Management stantial excess returns in this strategy. In the real world of transaction costs, however, the curves show that we could easily spend more transacting than we could hope to get out of the strategy if assets under management grow too large. The challenge is to know the point at which transaction costs consume the alpha. In Figure 4, Point $A is the point where the marginal cost to trade a marginal extra dollar completely consumes the gross alpha produced by the strategy on the marginal dollar. Any incremental money under management beyond Point $A costs more to trade than the gross alpha that the stock selection process can generate. If a manager manages assets beyond Point $A, the manager is robbing returns from prior clients to take on more money from new clients, thus creating a severe fiduciary conflict for the manager. At Point $B, the strategy as a whole cannot generate positive excess returns because the average cost to trade is higher than the gross alpha. Figure 5 shows the relationship between net alpha (in the shaded area) and assets under management. Net alpha declines steeply as the cost of transacting increases with more assets under management. The strategy cannot generate positive excess returns beyond Point $B because transaction costs exceed gross alpha. The dollars (rather than the rate) of excess return generate the parabolic curve shown in Figure 6. With few assets under management, a superb rate of excess return is multiplied by almost nothing, causing the dollars of excess return to be small. From this initial level, the dollars of excess return go up steeply as assets are added-until they peak at the point where

the marginal cost of any extra dollars under management totally consumes gross alpha at Point $A. Then the dollars of excess return roll over and plummet rapidly, because the dollars of assets under management are now quite large. Managers have many motivations to increase the size of their business, but doing so reduces their performance. Managers are encouraged to build their business because the firm owners want to make more money and the managers want to feel more professionally accomplished with larger asset pools under their command. Moreover, active managers sell the idea that they can beat the market, so they must believe their own marketing pitch. What does the manager care if the dollars of excess return decline as assets increase; management fees increase as well, as shown by the straight line in Figure 6. This approach works until clients figure out what the manager is doing. If active managers understood their transaction costs, they would realize the impact of size on returns and concede that they cannot forever increase their business and honestly expect to generate positive added value. Transaction costs are especially ominous for a high-turnover manager like Numeric, but trade costs increase with assets under management in every strategy. Every strategy thus has a point beyond which the dollars of excess return will decline. No investment strategy should grow beyond that point. For a prudent fiduciary to know about this point of maximum excess return is reasonable. Although Perold and Salomon suggested the mathematical framework for this analysis in 1991, few managers have paid attention to it. Perhaps managers do not

Figure 5. Net Alpha versus Assets under Management 30 .------------------------------~ Gross Alpha

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The Value of Added Value

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want to look at the idea, but as fiduciaries they have no excuse for not knowing it. Maximizing dollars of excess return depends on how much information is in the stock selection process-that is, the gross alpha-and on the stationarity of the alpha. Alpha is not stationary because successful strategies attract other managers, causing the stock selection process to generate less alpha. Investing with earnings surprise and estimate revisions like Numeric does is getting harder because more and more managers are using the technique. Plus, any strategy occasionally has a bad year. If transaction costs consume much of the gross alpha in a good year, then the ability to generate dollars of excess return quickly flips negative when gross alpha is low in a bad year. Transaction costs, however, are more predictable than excess returns. Thus managers should be able to incorporate transaction costs into their investment process and business planning. Net excess returns, expressed either as percentages or dollars, should be the real objective of a money management firm, not growth of assets under management. Active managers need to be sure that they are actually adding value for clients, or the intrinsic value of the firm's

©Association for Investment Management and Research

services will be lost and the firm will cease to have an economic reason to exist. Eventually, the clients will recognize this fact and withdraw their assets.

Conclusion We believe that adding value is a more central objective for the investment management firm than adding assets. This view is especially true because adding value becomes more difficult with more assets. To make matters worse, the market is becoming more efficient all the time. So, adding value, even without growth, becomes more difficult through time. Adding value is what all active managers should be working to do. The intrinsic value of the services that Numeric provides to its clients is primarily through its added value and much less through its intermediary function. We believe that growth and size for size's sake impair an active manager's ability to add value. Numeric has chosen a business strategy of remaining small in order to pursue the portfolio strategies it has found to be successful as an active management firm. Other managers must consider how their firms provide clients with intrinsic value.

57

Managing and Motivating Investment Professionals Patrick O'Donnell Managing Director and Chief of Global Equity Research Putnam Investments

To be successful, managers of investment professionals need to understand how to recruit, retain, and motivate creative professional investors. Although compensation is important, successful investment professionals also value independence. Nevertheless, they need to be incorporated into a culture that focuses on specific goals. Effective managers and firms thus provide latitude for investment professionals' individual skills and strengths to operate for the overall goal of investment outperformance.

o many people, the very idea of managing investment professionals is a paradox. Investment professionals exist in the popular imagination as highly individualistic and unmanageable stars. Certainly, their respect for authority would seem, in fact, to be well below the national average, which puts any manager of investment professionals in a challenging and stimulating role. This subject is substantially terra incognita. Investment professionals do not know much about managing themselves in huge, global enterprises. By today's standards, this business was the functional equivalent of a cottage industry only 20 years ago. Daily management and long-range planning did not have to be very sophisticated. For the past 15 years, however, burgeoning equity markets combined with an aging and increasingly sophisticated US. investing public have pushed wave after wave of assets into the hands of investment managers. The industry has long since outgrown the management approaches that were appropriate in the 1980s, but it has, in many instances, held onto them by default. This presentation tries to identify the main problems faced by today's managers of investment professionals and to offer some thoughts on handling them.

The investment management industry is only now beginning to focus on the challenges of managing itself. Morningstar recently updated the employee turnover numbers for the top 20 mutual fund companies. These numbers are startling. A few companies

have no turnover in some years; others have doubledigit employee turnover in a single year or maybe for two years in a row. Any analyst would see such turnover as a danger signal in a company he or she was evaluating as an investment. Surprisingly, a literature search to see whether anybody had studied the reasons for this phenomenon found the cupboard was bare. In the middle of my career, I discovered that I actually enjoyed managing analysts. I was fascinated by the problem of managing creative people who struggle to outperform. The complexity of the challenge is invigorating. Reversion to the mean is as close as we come, as investment professionals, to stating a law of karmic inevitability. The fear of dreaded but virtually unavoidable periods of underperformance is the constant companion of all investment professionals. We have to manage people who are deluged by "information," who must operate in constantly shifting global capital markets, and who are responsible for decisions affecting billions of dollars of other people's money. Although there is virtually no professional literature about managing investment professionals, the Putnam Investments library did provide me with a body of research on managing creative people in other businesses. Managing engineers or programmers in a technology company, for example, requires constant management flexibility and innovation. Published materials in academic and professional journals have been helping to explain the particular challenges of managing such creative

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T

Managing Creative People

Managing and Motivating Investment Professionals people in businesses that must find a competitive advantage amid conditions of constant change and uncertainty. This pursuit is, of course, relevant to the management of investment professionals. As an industry, we have much to learn from other businesses that face challenges somewhat similar to ours.

Motivating Investment Professionals The goal of investment management is outperformance. The goal of managing investment professionals is to create circumstances that favor the creation and maintenance of outperformance. As in virtually every other human activity, the right motivation is the sine qua non in this business. In the absence of any good literature on what motivates investment professionals, I surveyed a wide range of investment professionals, including the best analysts I know and some illustrious veterans, to identify what motivates them. This survey was not scientific, but I doubt that a more proper academic study would come to significantly different conclusions. My results showed that successful investment professionals are consistently motivated by the following factors: • Competition. Investment professionals are very competitive. They want to beat the market and outperform competitors. • Creative independence. Investment professionals enjoy exercising creative independence-that is, coming up with a great original idea and acting on it with real money. • Recognition and affiliation. Investment professionals also like to be part of a group of bright and competitive individuals, to have the opportunity to learn from very smart colleagues, and to gain recognition from respected people. • Compensation. One definition of compensation simply means making lots of money, but investment professionals not only wantto be paid well, they want to be evaluated fairly. • Conscience. Conscience means having a fiduciary sense of trying to do as well as one can for the client. Each of the analysts in the department for which I am responsible has a plaque on his or her desk that quotes Samuel Putnam's definition of the Prudent Man Rule. Judge Putnam ruled in 1830 that "all that can be required of a trustee to invest is, that he shall conduct himself faithfully and exercise a sound discretion. He is to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probably safety of the ©Association for Investment Management and Research

capital to be invested." Virtually everyone I surveyed said that the fiduciary duty is one of the pleasures of being in the business. Most cited examples of specific clients who had thanked the managers because they were better off financially for entrusting their money to them. Out of curiosity, I also asked my interviewees what they believed motivated their competitors. Many-maybe most-answered that some combination of greed or desire for status was the reason for most people to be in the business. This finding makes me think that, in addition to the motivations listed above, there is one more motivation for an investment professional, one they are unlikely to identify spontaneously, which is a sense that he or she is different from other practitioners and in some way uniquely qualified or skilled in the art of managing investments. For the managers of successful investment professionals to understand this sense of being different is important because it certainly requires that the manager provide appropriate latitude for different skills and personal styles, even those that make people "difficult," "volatile," or "stubborn." The manager's challenge is always to balance individual approaches with the overall objectives of the department or the firm. Knowing when to-and when not to-"manage" an individual is, in fact, the key to successful management of the group.

What Makes a Good Manager? A good manager of creative people has a lot of the characteristics of a successful coach. A coach presides over a process with the goal of performing better than the competition. 1 Managers of investment professionals supervise a very complex process that involves trying to understand many variables, such as the way the human mind makes decisions about complex phenomena. These managers are, therefore, always trying to figure out the best relationships among investment process, individual quirks and strengths, and cognitive accuracy. The manager monitors the ways in which people sort through a mass of information, much of it highly distracting, in order to make the maximum number of correct decisions. Managers want to get the process right. They need to manage so that they are at least removing the obstacles and, ideally, improving the circumstances that IThroughout the following discussion, one might substitute a choreographer or a conductor for the coach. I chose the coach only because our business is, at bottom, one of measurable performance, unlike dance or music. On the other hand, choreographers and conductors need to harmonize the creative energies of professionals who are often individualistic and idiosyncratic. In this respect, they perhaps provide a better analogy than the coach.

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The Future of Investment Management

raise the probability of being right. They are also trying to encourage the early recognition and reversal of errors. Good coaches are fair and even handed in their treatment of individuals. They understand that humans have a built-in error rate. They also understand their own role, which is to provide leadership in minimizing the error rate while understanding that errors cannot be eliminated. They focus on a group goal rather than encouraging the attainment of individual records while the team is losing. The history of successful people in management and in coaching suggests that coaches and managers do not have to have been the best individual contributors before moving on to coaching and managing. They do, however, need to be able to identify and recruit talented individuals. Then, they must be able to provide a vision and a structure that allows individual strengths to make maximum contributions to the group's objectives. Confidence. A good coach has and expresses confidence in the individual participants. This trait is extremely important in the investment business because of the inevitability of periods of underperformance. Even the best investment managers have slumps. I once observed a highly successful swimming coach who did very good work with a particular swimmer. After the season, I asked the swimmer what the coach did to get such great performance out of him. He said that, when necessary, the coach had more confidence in him than he had in himself. The coach knew when to tell the young man that he was in a slump, had not lost his competitive ability, and had not become a loser. The coach, in other words, understood how to keep the competitor's view of his skills balanced and realistic. As I explain later in this presentation, the best way to accomplish this goal, in my view, is in the form of fact-based reviews, especially when people are performing poorly.

I favor an exhaustive process of getting to know candidates. In our department, candidates whose resumes look promising are asked to complete a timed written exercise by fax or e-mail. Those whose answers demonstrate resourcefulness, investment savvy, and the ability to work under time pressure may be asked for an interview, which is conducted by 10-15 people. We put them through a series of carefully chosen formal tests or cognitive exercises. When new colleagues join us, they feel we know them well; and they know they are not an "admissions error." This confidence is important because we can then give them wholehearted support early in their careers, pushing them to learn from their inevitable mistakes and to recognize their erroneous decisions and reverse them without panic. FleXibility. In order to be good coaches of investment professionals, managers have to be flexible and remember to be comfortable going beyond numbers when evaluating their people. The numbers are simply a way of measuring all the complex decisions made by the people the managers are trying to help succeed. I keep returning to the idea that everybody underperforms in some periods. Because this problem is so widespread and because it is so sensitive, times of underperformance are precisely when the investment professional needs help in diagnosing the sources of the problem. Such periods are also when the person is most likely to be defensive or discouraged and, therefore, least able to perform an accurate self-assessment. Like a good coach, the manager needs to help the professional analyze the performance numbers skillfully, not punitively.

Good Recruiting. To have confidence in their professionals, managers have to select the right people in the first place. The recruiting process must be thorough and discriminating. Once candidates become colleagues, they should know that people of mature and proven judgment have welcomed them into an elite group. Inevitably, new colleagues feel to some extent that they are still on trial, but managers should not treat them as probationers. It is important that they be encouraged to take appropriate risks, which is the practical and psychological heart of our business. They can handle risk taking more skillfully if they feel they have been thoroughly evaluated before being given any responsibility.

Self-Understanding. Managers need to understand themselves and their own sources of anxiety. For example, this business should be fraught with conflict. Investment professionals must differ about all sorts of things before buying or selling a stockthe company's earnings, cash flows, growth rates, valuations. If they do not disagree, they probably are not doing their jobs with enough attention. In one sense, they come to work every day to make each other smarter. If they were all good enough investors that they could succeed alone, most would not come to an office full of other people every day. Moreover, my informal survey suggests that, for many professional investors, the give and take of making investment decisions-comparing insights, debating probable outcomes, even changing one's mind because of the arguments of a colleague-is part of the fun of the business. In order to manage a process by which people make each other smarter, managers have to be able to sit in the presence of conflict a good bit of the day.

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Managing and Motivating Investment Professionals

The problem with conflict is that it can easily be mistaken for strife. Creative conflict is a facilitator of good decision making, but strife is cognitively distressing, which lowers the odds that thinking will be accurate. Conflict focuses on issues; strife, on personalities, whether overtly or sub rosa. The manager needs to be comfortable with conflict and willing to let it continue without trying to bring it to a premature resolution. Forced resolution, or even thoughtless agreement, is a fairly good definition of"groupthink." The extensive professional literature on the subject of this phenomenon, first identified formally in studies of military decision making in the 1960s, clearly indicates that decisive agreement among participants in important decisions is often the worst thing that can happen. A forceful leader who is unable or unwilling to tolerate creative conflict will eventually jeopardize the process of creative conflict.

Management Tools Three of the principal tools for the management of investment professionals are recognition, professional development and advancement, and compensation. Recognition. A strong theme in the responses to my informal survey was that successful investment practitioners want recognition within their organizations. Recognition comes in various forms, but the ones to focus on do not single somebody out simply for having a noteworthy investment record. For example, a very effective but often ignored form of recognition is simply congratulating a person for doing something well. I have consciously trained myself to visit analysts' offices to praise a terrific comment at the morning meeting or a great insight. I have found that this approach goes a long way. Public praise for jobs well done can also be quite effective. Recognizing individual contributions in front of colleagues can, of course, jeopardize group morale under some circumstances. In order to avoid arousing corrosive jealousy, the key is, over time, to praise as many people as possible so that everybody feels his or her special contributions will be noted at the right time. Another important point is to note what the group can learn from the individual's praiseworthy behavior. Essentially, we should always be looking for ways to add to our inventory of "best practices," in the process of which we can recognize individual contributions in the context of their improvement of the group's approach and, therefore, results. For example, one of our analysts went to Europe to visit 14 companies that we needed to add to our coverage list as quickly as possible. Normally, we would not try to do such an assignment in only three ©Association for Investment Management and Research

weeks from start to finish, but the circumstances were exceptional. The analyst was able to accomplish so much because, before embarking on the trip, he did some extremely thorough preparation, with much help from a junior associate. Months later, when it was clear that the analyst had recommended the right stocks-and more importantly in this case, kept us out of some serious underperformers-I asked him to describe in some detail to his colleagues what he had done to cut through some of the conventional wisdom on these stocks so quickly. My intention was to focus on his methods and his results. He was pleased with the recognition, and the other analysts picked up some valuable tricks of the trade. Sometimes, simply creating new roles, even if they are only temporary, is a good way to provide recognition. For example, our department did a massive project on the potential investment implications of the year 2000 software bugs. We did it to shake up our thinking, which can be too focused on individual companies and industries. We wanted to take a broad look at risks and opportunities for the whole economic spectrum. In this instance, we asked two fairly new analysts to run the project. These analysts had hands-on experience with computer software and systems in previous jobs, so they had unique expertise. They formulated questions for each analyst to pursue in his or her area of coverage. They then assembled and critiqued the responses, helping some of their senior colleagues clarify their understanding of the potential for computer-related snafus at the turn of the millennium. The two analyst/coordinators of the project wrote an action-oriented report to the entire investment division. The project provided nice recognition for the young people who got to do it, and they matured professionally by doing it in the face of the normal resistance to "special requests" that exists in any organization. Professional Development and Advancement.

Professional development and advancement is an excellent motivational tool that requires forethought and follow-through from the manager. Probably the best vehicle for professional development and advancement is the creative use of the performance review. Reviews ought to be frequent and specific. They should use both quantitative and qualitative perspectives. They should also be based on a business plan formulated by the professional and the manager. In our department, we work on specific business plans involving the development of skills that the analyst needs or wants to improve. The most effective approach is to focus on the relationships between specific skills and specific investment decisions. Examples of questions that tend to produce useful insights are: Was your work on Company X 61

The Future of Investment Management

better because you have become more skillful at knowing where and by how much your insights differ from those of Wall Street analysts? Do you need to spend more time working on the off-balance-sheet assets of Company Y to get a competitive advantage? I also ask analysts to evaluate their own skills relative to where they were, for example, a year ago. Another important method is to review decisions to see whether the analyst is developing self-critical abilities. Did he or she learn anything from the decisions that turned out right? Did they learn anything from the ones that underperformed? I do not want to hear that a bad decision was only a big mistake. I do not want to be persuaded that a good decision was merely a spectacular, brilliant intuitive insight. Our hope is to see what we can learn. For example, if we made a decision that strongly opposed market sentiment on a stock, what can we preserve about our thinking process that was differentiating? In other words, reviews should help people to think about questions of method and cognition. They should avoid too narrowly attending to the statistical results and should favor looking at the underlying decisions. A review should have no negative surprises. If someone looks up in a review and says, "I had no idea you thought that," then I have failed. 1 have an obligation to discuss with an individual any problems I see as soon as possible, so we can try to correct them as quickly as possible. I do not want people to come into the review wondering what negative observations 1 have saved up for the past six months. A review should contain no negative surprises at all. Reviews should emphasize trends over one-, three-, and five-year periods. Reviews should also address indirect contributions, such as doing something to help improve a colleague's performance. In large companies, people obsessed only with their own performance are probably not helping their colleagues, and providing such support to others is an important part of the job. One mistake a manager can make in evaluations is implicitly encouraging professionals to take the wrong kinds of risk. For this reason, half-year and one-year reviews should focus on trends. If people have done poorly in the first half of the year and think that 80 percent of their bonus is going to come from their out- or underperformance at year's end, be careful. Managers do not want people to have an incentive to take inappropriate risks in the second half of the year to try make up for that underperformance. On the other hand, if they do well in the first half of the year, managers want them to stay awake for the second half, rather than lapsing into hypercautiousness in order to try to protect their record.

Other constructive, and often unexpected, things come out in the review sessions. For example, a few years ago, 1asked some analysts if they would benefit from taking two days to work with a tutor on learning how to use all the advantages of a modern computer. Some analysts started in the business in the precomputer era and still did not know how to use a spreadsheet program to full advantage. When I started, I used green pieces of accounting paper and pencils to do my models. I was covered with eraser dust all day long. 1 remember how hard it was when the guy from the information technology group in the brokerage house in which I worked came in and said a personal computer could make my life a lot easier. I groaned that it would take too much time to learn how to use the computer. He was persuasive, I am thankful to say, and he was right. Now, as a manager, I offer people help in learning how to use computer tools, even if these analysts are assumed to be fully computer literate. A surprising number of them have accepted-and not only the people who are the longest in tenure. Some people who have not been out of business school more than 5-10 years would like to go off site, get a little quiet tutoring, and come back. For some analysts, the most agonizing part of their job is to present a recommendation to a group of colleagues. When offered the opportunity to train in public speaking and dealing with questions and answers and antagonistic situations, they hit the bid every time. We make the offer only as a suggestion, but it communicates that we are paying attention and that we want them to get better at their jobs, which is the whole point. At Putnam, our colleagues in the human resources department design the presentation course for the analysts. The course gets better as more analysts go through it because the trainers keep learning and refining the material. Human resources also offers a range of other skill-improvement seminars and works with investment professionals to create specialized training as required. Compensation. People like to make money, which generally comes in two forms: cash and stock. Cash is great, especially in the beginning of careers when people have debts. There are a number of ways of delivering cash, but two are notable. The first is the normal payment of cash salaries and bonuses. The problem with this approach is that it does not create wealth as well as some alternative methods. The second is to defer a portion of the bonus payment on an involuntary basis. Doing so means consulting someone who can spell out the laws and tax codes affecting such deferrals. When deferrals are put into the firm's investment products, it makes the investment professionals co-investors with the firm's clients. Dr. Samuel

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Managing and Motivating Investment Professionals

Johnson said that the prospect of imminent hanging marvelously focuses the mind. Similarly, having one's own money in the firm's products focuses attention nicely, aligning employees' financial interests with those of the people who trust them with their money. So, deferring individuals' cash into a firm's own products can be a terrific way not only to intensify people's motivation but also to convert some of their income into more income. Ownership in the firm is probably the best way to give investment professionals a chance to create net worth. It absolutely establishes a feeling of partnership, although using it can be tricky. Complicated vesting issues accompany stock issuance, including potentially inconvenient tax events. Firms should let junior professionals participate in ownership as soon as they are qualified, professionally and legally. This policy broadens the partnership spirit and puts the

©Association for Investment Management and Research

focus on the firm's broad goals rather than merely on individual results, although individual results are still important because their sum is the firm's total.

Conclusion Managing investment professionals is an interesting, challenging task that requires knowing what motivates a competitive and creative group of individuals and having the right tools to manage them. Fair compensation is only one important motivating factor. Opportunities for creative independence, affiliation, recognition, and the exercise of fiduciary responsibility are also important. Recruiting talented professionals is an indispensable skill of a good manager. Providing investment professionals with the right structure and environment within which to outperform is the final objective.

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The Future of Investment Management

Question and Answer Session Patrick O'Donnell If you know you have a good person who is in a slump, how do you deal with it? Question:

O'Donnell: Having poor performance numbers is very scary for investment professionals because they are so identified with the numbers. When people are going through a period of poor performance, the one thing you can be sure of is that they are aware of it. Sometimes the underperformance is simply a matter of their good decisions not having had enough time to work out in the market. At other times, they are making poor decisions. The important thing is to find some way to get a handle on improving performance, which involves looking at the mistakes, reexamining the thinking that went into them, and finding out what we can learn. It is important to understand-and say-that absolutely everybody goes through such periods at some point. So, for a capable, attentive professional to

64

have a bad patch is not surprising. The individual is likely to find it unacceptable, which in some respects is exactly the attitude you like to see because it can lead to a thoughtful examination of causes and solutions. Question: You mentioned the things that motivate professionals. What are some of the things that discourage them? O'Donnell: The fastest way for people to get discouraged is to feel that their efforts do not make any difference, that they are not having an impact. Also, purely administrative and bureaucratic chores tend to frustrate investment professionals. Every company has a certain amount of such procedural frustrations. One of my roles is to try to cutthrough the Gordian knot when I can. More importantly, I spend as much effort as I can paying attention to the first problem, the feeling that an individual's

efforts do not count. As long as people are coming to my door and saying, for example, they are frustrated because they cannot get a colleague to buy a certain stock, we're probably okay because we're hearing about it. When I stop hearing about people being frustrated, I worry, because in a big department, a few people are always frustrated about something. The danger for managers is that we may not listen for what we're not hearing; we assume that the light goes out when we close the refrigerator door. As a manager, I could fall into that trap easily, and to do so could be a big failing. So, I try to manage by walking around, looking for frustrations, seeing what I can do. As long as people know that somebody is curious about their problems and willing to try to solve them, we can avoid the cynicism that marks ineffective organizations.

©Association for Investment Management and Research