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

-------- - - - - - - - - - - - - -

70

60

40

30 20

Active Segment ---

.

_

10

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.

©Association for Investment Management and Research

17

The Future of Investment Management

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

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

1,000

§ P:;

900

'0 '-
.

OJ

c

0 0

2

3

4

5

6

Trade Size ($ millions)

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

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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.

Figure 3. Predicted One-Way Trading Costs for Original Long/Short Strategy: Average and Marginal 350 ". Ul

300

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6...., 250

148