Asset Management: Interviews—
Dr Shanta Acharya interviews Tim Gardener, Global Head of Investment Consulting, William M. Mercer Limited.
SA: The high level of corporate activity in the asset management industry reflects global trends. To what extent have your clients benefited from it – i.e., have they secured improved performance, reduced costs and better service?
TG: Few if any of the mergers have delivered anything of value to the client. Now, you could argue they delivered cost savings internally and thus have prevented fees from going up. But, there is no evidence that the mergers have had any real beneficial effect on the client. For example, it has not yet resulted in higher quality information coming through into the investment process because the focus of the mergers seem to be on issues such as distribution, cost savings etc. So, from the client’s perspective, the mergers in the industry may seem inevitable, but are not seen as the best means of adding value. However, we haven’t had enough time to see the benefits of these mergers come through. The last round of mergers in 1987 did improve the quality over time; it just took a long time to get there.
SA: In his review on institutional investment in the UK, Paul Myners wrote: “We place a heavy burden on the investment consultants who advise trustees. A tiny group of providers, mainly actuarial firms, dominate this small and not particularly profitable market. The result, despite these firms’ best efforts – to which I pay tribute – is a narrow range of expertise and little room for specialisation. Nor is the consulting firms’ performance usually assessed or measured.” Myners has raised many issues here. How would you respond to him?
TG: First of all, Myners talks about a tiny group of providers. If you look at any industry today, it is dominated by a small group of providers. How many super-markets are there? Five: Sainsbury, Tesco, Asda, Safeway, Somerfields. How many consultants are there? Five. In addition, there are some 20 or so firms that say they do it. So, being a tiny group is one of the inevitabilities of doing businesses these days.
The nature of the investment consulting business is that it has high fixed costs, principally the manager research which needs to be global in nature these days. Our database, for example, covers some 1500 managers with 7000 products, globally. If you are going to research even a small number of those, you need a huge resource. On the basis of the fees consultants get paid, which on average is 1.5 basis points to fund managers’ 27, frankly you have three choices:
- You become large, so that you can spread the high fixed cost of manager research over a larger client base.
- You can be smaller and run a fund-of-funds business in which case you are a fund manager offering some consultancy and paying for your research through the fund management business.
- You offer sub-standard research.
So far most of the firms in the UK have chosen to be large, whereas firms in the US have taken the fund-of-funds route. May be, the UK will change.
Myners says that the result is a narrow range of expertise with little room for specialisation. I take a different view. These are subjective statements. There are about 300 investment consultants in the UK, but then the industry itself is not very wide. The range of expertise may be narrow, but that’s because the business itself is relatively narrow. He is right to the extent that if you want a consultant, who knows the entire hedge fund industry its difficult to find one. Ultimately it boils down to what people are prepared to pay for.
When Myners says that our performance is not usually assessed or measured, how do you measure the performance of other professionals such as accountants or lawyers? And, when you do start, for example, measuring teachers, there is constantly a debate whether it is being done fairly or not. We would love to be measured, because we would love to demonstrate objectively the value we are undoubtedly adding. One of the reasons our fees are so low is because we find it difficult to measure and hence demonstrate objectively the value we add. Much of our work has to do, in the asset allocation area, with the risk/ return advice. You can measure return, but after the event it is very difficult to measure the risk advice. How do you measure advice that has to be given on a probabilistic basis? We can measure whether we rate managers correctly, but that’s only part of our business. When you get into the practice instead of the theory, I reckon that, for what it pays, the industry has received a very good service.
SA: Could you elaborate a bit more as to how consultants add value to the industry? Also, should they be regulated?
TG: We add value to the industry in a number of ways:
- We can be a useful time saver for clients. Suppose a client wants to know how much money under management a particular manager has or what the index return is on a certain asset class, instead of calling various sources for that information, they can access it from the consultant. So, we are a clearing-house for information. Although valuable, this is perhaps the least value-added of tasks we perform.
- · We add the most value in long-term asset allocation advice. Someone has to decide the long-term neutral allocation to various asset classes for the pension fund. All the studies suggest that asset allocation contributes in excess of 80 percent of the total return of investments. That is a risk/ return advice. We add value there. One way of demonstrating that is by comparing the performance of our clients to that of the average balanced pension fund. Over a ten-year period, we have outperformed.
- We also add value by giving advice on investment managers. Instead of funds having to pick and monitor managers on the basis of past performance, we provide qualitative and quantitative inputs. Just as stockbrokers research companies, we research investment management companies. We add considerable value in that area not only at the selection stage but, in ongoing monitoring.
- Helping pension funds with other issues such as custody, educating trustees etc also adds value.
Should we be regulated? My own sense is that regulation would result in more conservative advice being given. Until such point as it is demonstrated that self-regulation doesn’t work, I do not see the merit of introducing it as it would deter the industry from doing its job properly and that would be detrimental for the client. One thing that does not exist and where the Financial Services Authority (FSA) hasn’t got its act together, is that anyone can set themselves up as an investment consultant to pension funds. It is reasonable that the FSA should recognise what we do and put in a barrier of competence for those who wish to call themselves investment consultants. If that is the sort of regulation you are referring to, then it would help. But, if you are referring to the FSA actually regulating the activity thereafter, then I think self-regulation is better. An ‘Association of Investment Consultants’, for example, to set some standards would be welcome. Something needs to be done in terms of minimum competence levels for quality control purposes.
SA: There has been a steady shift to what can loosely be referred to as the core-satellite approach to asset allocation among trustees in the UK, at least in terms of their risk allocation. How has your firm positioned itself to benefit from such a shift in terms of developing expertise in the various asset classes?
TG: The way we look at it, at any point in time there is a set of asset classes, which satisfies a set of criteria that is suitable for pension fund investment. So, for example, works of art do not satisfy that criteria. Once we believe an asset class to be suitable, we will research it. If there are new asset classes emerging, and they fit the criteria, then we research them as they emerge. We start from the basis that there is nothing fundamentally wrong with a mix of bonds and equities; we are not in the business of introducing esoteric asset classes to make this year’s model look different to last years. Indeed, we are happy to stick with bonds and equities, if we can’t find alternative asset classes that suit our investment criteria and add something in terms of enhanced return and/or reduced risk.
We position ourselves to give best advice on the asset allocation process. Doing a good job means always being aware of new opportunities but never recommending them just because they are “fashionable”. About three years ago, we concluded that the next ten years were unlikely to be as profitable as the last ten for pension funds. Most pension funds are funded on the basis of achieving future investment returns, which were becoming rather optimistic in our view. We coined a phrase, ‘the search for excess return.’ What we initiated was a study to ask ourselves what asset classes were out there which offered the potential for excess return. Such investments would obviously have risk but the incremental risk should not be great.
So, we went to our clients and said that, going forward, they have a choice – i.e. carry on being conventional and invest in bonds and equities as in the past. Returns will probably be decent but they will probably not generate a high level of surplus. But, if they agreed with us that returns would be hard to come by, then we suggested they come with us on a journey and that many involve investing in corporate bonds, real estate (including property development), private equity, hedge funds, emerging market debt and equity etc. The main criteria for the inclusion of an asset class being: Is it going to deliver excess return over the alternative asset class? Is the risk acceptable? Does it have any characteristics which make the risk more than one-dimensional, the obvious one being a lack of liquidity.
So, that is how we approached it. We never called it core and satellite. Thus, the answer to your question in terms of our developing expertise in the alternative investment sector is: ‘Yes, absolutely.’
SA: What level of exposure do you recommend to the alternative investment sector in a global balanced portfolio? Is exposure to this asset class set to rise?
TG: Well, it depends entirely on the circumstances. My personal view is that if the exposure is lower than 5 percent, it is not worth having. On hedge funds, at the moment, the answer is zero; not because they are a bad thing but due to the amount of money that is going into the sector. One asks oneself, whether it is the next disaster waiting to happen, (except for the long/short or market neutral strategies). As the existing exposure of pension funds to hedge funds and private equity is low, it will rise. Pension funds have a history of being last into new investment areas, as was the case with property in the 1970s and this worries me. Such is the weight of money today that I see a bubble developing in the hedge fund sector.
With private equity, the nature of the beast is such that it usually takes 4-5 years for the manager to draw down the funds annually, by which time the capital returns start coming in. So, for those for whom it is appropriate a commitment of around .75 percent of their portfolio annually to private equity is reasonable and should mean that they will never exceed 5 percent of their total portfolio to the sector.
SA: There is the issue of transparency with hedge funds. How will it be addressed?
TG: If the transparency issue is not dealt with, then hedge funds are not a suitable asset class. I am not convinced that pension funds need to be invested in hedge funds as they need to invest in bonds and equities, for example. They certainly don’t need absolute returns, as pension funds are more long-term in their focus. If hedge funds want to sell to pension funds in a meaningful way (which I doubt), then they must come up with the products and address the concerns of the pension fund trustees.
SA: As a global adviser, is your advice similar to your clients in the US?
TG: The advice we give is consistent with the marketplace – i.e. the culture of the underlying investor, the liabilities involved and the sophistication and knowledge of the investor. In the US, the decision makers can be different. The decision makers or the fiduciaries could be in the treasury department. We would feel more comfortable recommending hedge funds to the chief financial officer (CFO) or assistant to the CFO of a large company than to a group of trustees in the UK with no financial expertise. Another example would be Hong Kong, where investors are far more concerned with capital loss than their British counterparts. So, recommending absolute return strategies to them makes more sense.
The European market is very diversified. You have very sophisticated investors and others less so. Some of them use hedge funds and others are very concerned about risk and remain invested in bonds. Coming back to your point on transparency, the less sophisticated the client base the more transparent the investment needs to be.
SA: Could you give me some idea of your own firm’s turnover among clients and that of the fund managers you recommend to your clients?
TG: Around 20 percent of our clients provide 80 percent of our revenue. If you take these clients (who use our services extensively), then turnover among them is well below 5 percent annually (i.e. less than 1% of our total clients). In addition, for as long as I can remember client gains have exceeded losses by a factor of around 15:1. That is an indication of our performance. If you take the remaining clients, I really do not have a figure.
Underlying turnover among fund managers is more difficult to quantify as we have just gone through a period when there was a huge shift from balanced managers to specialist ones. When you change a structure, then the turnover is both structural as well as performance related. My guess is that the average tenure of a specialist manager is about 5 years. Were I a manager, I would plan for a 5-year holding period, but it could be a lot longer.
SA: How soon would you be willing to re-appoint a fund manager?
TG: We have reappointed managers within a couple of years of recommending their termination. Sometimes, fund managers need to be sacked by several clients to enforce the necessary internal changes. I can think of one manager at the moment that needs to undergo such a change. Frankly, the period of time could be as short as a year.
SA: I would also like your views on the independence of broker research? Would you recommend trading costs be absorbed into fund management fees?
TG: That’s easy. In my view, Myners was absolutely right. What goes on at the moment is scandalous, and is demonstrably open to a huge amount of abuse. I cannot see how clients are well served in the present system. It will be a tremendous benefit to clients if something can be done to make sure that the current system in which the fund manager uses someone else’s money to buy services for his benefit is abolished or else made for more transparent.
SA: How do you advise your clients on socially responsible investments?
TG: It is my firm view that it is not the role of the adviser to formulate moral or ethical policy on behalf of the client. Also, if you are giving advice on an individual basis, then you may give different advice depending on the circumstances.
I do think the industry should be more pro-active on SRI issues because the underlying issues are serious and affect us all and also because governments increasingly find it harder to govern multinational companies. I do not believe in un-elected and un-governable institutions. The owners of companies can govern and so pension funds can be more active in their governance and should take such a stance at the macro level.
The problems arise at the micro level, where you are not concerned about “saving the world”, but are more concerned about what’s right for a particular company and there are significant dangers to the layman becoming involved. How do you demonstrate that ‘involvement’ with a company has improved your return, and if it does not how can you justify it when the law is quite clear that your primary duty as a trustee is to enhance your return. So, there is a conflict between what is right at the industry level and what the individual scheme can do. I’m afraid the government is going to have to legislate on that if it wants greater action on the part on institutional investors.
Investment managers can adopt a policy of engagement. It is simple. It may not get the headlines, but it is actually a powerful way of going forward. For example, they can make it a requirement that the companies they invest in include a statement on their SRI policy in their annual reports. Then, at least, one small step would have been taken in raising standards. My personal view is that a policy of engagement on SRI issues SRI is good and also for the industry in the long-term.
If you start from the basis that SRI is the right thing to do, then you want a common process to be adopted and not an individual one. The industry needs an approach, which is sufficiently non-confrontational that the majority can adopt it. Engagement by the fund managers fits the bill and if you can get the major fund managers who control the bulk of the wealth (Fidelity, Capital, BGI etc.) singing off the same hymn sheet, positive social change can be achieved.
SA: What is your vision of the future of asset management?
TG: There is no doubt in my mind that the investment industry takes a disproportionate and unhealthy share of the wealth of the nation. There are some outstanding people in the City, but not that outstanding and not that many of them either. There is some economic inefficiency in this area. I think that one of the drivers of the fund management industry going forward will be an attack on their wealth. Hopefully, their response will be to become far more efficient. It is true that such inefficiencies exist across the board – i.e. not just in fund management but even more so within investment banking and perhaps marginally less so among corporates.
Conventional wisdom has is that the US model will take over the world. If you believe this then you can have a vision of what fund management will look like in five years’ time. For myself I am not convinced that the American domination of Europe is a foregone conclusion.
Shanta Acharya started her investment management career with Morgan Stanley Asset Management in London after an academic career at Oxford and Harvard. She was subsequently a fund manager with Swiss Bank Corporation Portfolio Management International and Baring Asset Management. She also served as a Client Servicing Manager at the Bank of Ireland Asset Management. Her most recent publication is Asset Management: Equities Demystified (Wiley, UK; 2002).