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Costs, Cost/Benefits and Value Destruction
Have we lost our way?Anne Cabot-Alletzhauser
June 2016
Let’s use today to really get to the heart of the matter
How did we get into this
mess?
What’s wrong with the
model?
How do we get out of this
pickle?
If regulators decreed that all-in fees were capped at 75 bps
We would survive as an industry (Most of us)
How did we get into this mess?
The origins of modern day
asset management
Understanding the
concept of fiduciary
“No man can serve two
masters”
How we got to fees based
on AUM.
“Don’t worry your pretty little head young lady….we’ll take care of
you”
And they did….establish cash flow first, invest surplus in “special interest shares”
How did we get into this mess? – financial planning 1970’s
Impact of democratization of investing
Traditional wealth management
model
Stronger regulatory protections
make mutual funds accessibleShift from DB to DC
Discretionary:
Advisers focused on cash
flow matching first, then
invested the surplus into
individual shares
DB schemes
Source: Investment Solutions
Exponential growth in mutual fund
(unit trust) industry
DC schemes to provide top-ups
Equities being touted as the
antidote to inflation
Performance objectives –
benchmarks, competitors &
performance tables
Emergence of multimanager fuels growth in specialist
mandates
Academic insights into performance drivers expands
exponentially
Bull markets of 2000’s drives all asset classes – making
balanced managers appear as kings
Performance outcomes
become primary driver of
fund flows
Intense debate about
“ethical reporting”
Harsh reality was technology
limited any other option to
past performance criteria
First passive funds are
introduced
As the world turns…for Asset Managers – what changed
over the last 30 years
How business models changed
Fees on AUM
Asset Mgt as profession morphs into Asset Mgt as business
Managers rewarded on benchmark outperformance
“Codes of Ethics” relax
Financial service companies as listed companies
Asset managers absorbed by financial service companies
Asset gatherers vs. alpha hunters
The rise of performance fees
Industry pushed back call for “fiduciary” designation
How we learned about what
drives performance outcomes
1974 William Sharpe – Adjusting for Risk in Portfolio Performance
1975 – Charles Ellis and The Loser’s Game
1987 – Barr Rosenberg: Multi-factor Risk
1989 – Grinold: Fundamental Law of Active Management
1992 - Contribution of style –William Sharpe
2001 – Generalised fundamental law of active management – transfer co-efficient
What drives performance
What drives performance
2.3%0.315.0%Multiple Constraints
3.7%0.495.0%Turnover limit 25%
3.5%0.475.0%Market-Cap Neutral
4.3%0.585.0%Long only
7.3%0.985.0%Unconstrained
Expected Active
Return
Transfer Co-
efficient
Active RiskPortfolio
Constraint
A
- 70%
reduction
in
performan
ce
The more concentrated the market,
the lower the transfer co-efficient =Less performance from
manager skill
Source: Clarke, da Silva, Thorley 2002
How well do we understand…
Source: Michael Mauboussin 2010
What factors determine whether activity driven more by skill or luck?
• Can you intentionally lose? If so…indicates skill required
• Does practice improve outcomes?
• Do outcomes revert to the mean? If so….luck element high
• Is there evidence of transitivity? If “A” beats “B” and “B” beats “C” then “A” should beat “C”
• How many factors involved in path to success?
Is our world changing?
The rise of the
professional
asset manager
and it’s impact
on performance
The need to
reinvent “active”
management
Is our world changing?
Story grafting
Shrouded
attributes
How bad can the impact of costs be?
3%
15 %
34%
Assuming manager has
50/50 skill, if costs are
1.5% only 15%
probability of investor
success
This is not an argument for passive,
There is no such thing as a purely passive
investment
You still have a target to hit – how will you get
there?
Someone has to determine the asset mix, the
indices to use, the allocations over time
The key to unlocking the true value of a
professional manager is to find the solution that
has the highest probability of meeting your
funding goal
Costs matter – understand them
This not an argument for passive
It’s not about highest return
It’s about matching the strategy to the time
frame and the certainty you require that you will
get there
Income, protection from loss, growth, liability
matching all demand different investment
strategies
The “new active manager” who wins this game
will be the one who can put it all together
Who is responsible for member outcomes?
The World As We Know It
Employee
Benefit
Consultant
Actuary Asset Consultant Asset
Manager
Administrator
Function Structure of the fund
Benefits Structure and
delivery
Fund administrators
Asset/liability
modelling exercise
Structure the investment
solution to meet member
needs
Identify who the best blend of
managers would be
Manage the assets Member record
management
Output Fund rules, fund policies
Benefit payouts
ALM output with
strategic asset
allocation solution
Monitor performance, monitor
compliance
Alpha
Beta
Benefit statements
Projection statements
Reality of
role
Spend more time doing
administration functions
than showing necessary
value-add.
Only large funds
typically request
ALM’s
Spend more time
selecting/defending/switching
managers than assessing
whether members are
meeting their goals
Great marketing
Time
required
Quarterly
Semi-annual
Annual
Once every three
years
Could be daily valuations but
more likely, financially
insolvent
Daily focus Daily
Charge
structure
Retainer / Fee Set Fee i % of AUM Variable: % of payroll,
per transaction etc.
How costs distribute in a pension fund?
Cost allocation on basic
off-balance-sheet fund
Consulting = 5.6%
Asset mgt = 39%
Cost allocation after 30
years
Consulting = 2%
Asset Mgt = 79%
The Great Pension Fund Conundrum
A problem –
The Value Chain (2002 discussion):
Consultant Investment
Manager
Broker Custodian Performance
Measurer
1 1/2 1/21527 3
Source: Watson Wyatt
Does the fee structure influence how seriously each participants’ role is taken?
Does it make sense that we reward the consultant’s contribution the least?
Who has the best models
and highest R + D expenditure?
Trading Houses ConsultantsAsset Managers.
Time frame
Importance
funding
est. time to
dismissal
day trade yearly 40 years
12
1 day three years ?
Perhaps it’s time we considered a new model
The case for the uber consultant
Until government policy can
fill the gaps funds have a
serious need for “gap
closers”
Will our clients pay for it?
But will regulators allow it?
The uber-Consultant Model
Manage employer policy
and fund policy gaps.
Provide the relevant
analysis of the membership
demographics and
behaviours to establish:
member needs,
suitable targets,
suitable default solutions
and
a suitable asset allocation
and investment solution to
meet member liabilities
Define and manage risk
budget for the fund’s
investment strategy.
Consider appropriate platform
and cost structure to address
member profiles
Monitor member progress to
established goals.
Measure and monitor impact
of trustee decisions on
member outcomes.
Ensure appropriate
communications of all these
points to all relevant
stakeholders.
The uber-Consultant toolkit
Asset liability modelling tools,
Risk budgeting and risk
management tool,
Aggregated reporting and
attributions analysis for funds,
Tools and models for member
projections and for building
asset class return
assumptions.
Member progress monitoring
tool
Strategy stress testing
Here is our real challenge
What if regulators capped fees at 75bps all-in?
How would companies cut back to accommodate?
The solution
Compulsory Investments Mandate “Active” design of solutions that
algorithmically adjust exposure to different building blocks to meet goals Growth
Income
Capital protection
Designed around a risk budget
Selection (or termination) based not on performance but ability to maintain control and meet goals
Why do we gamble with compulsory funds?
Discretionary Investments Mandate Manager can charge whatever
they believe is fair for their value-add
Traditional highest return for specified level of risk
Or..whatever
Go for it!
Combining our uber consultant with our goals based
manager (using compulsory savings mandate)
Manager focuses on outcomes – all the way down to the member outcome
In aggregate we should be able to reduce costs
Asset manager fees would most definitely come down but should also compensate investors with better risk-adjusted returns
On the consulting/actuarial side we’ve streamlined and focused the service to deliver measurable outcomes
This now warrants a more serious compensation consideration
The solution
Where does that leave us? Costs need to come down….!!!
We are paid too much for
doing the wrong job and
too little when we need to
do the job right
As an industry we are
spending money on the
wrong things - costs
balloon to support
elements that add little
value
Where are the regulators
on demanding that our
“vehicles” are
“roadworthy?”
We pay high costs for
compliance – but have
we considered whether
this is the right
compliance
Give us the cap – Get the right message out
then let us get on with it!
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