24th November 2003

"Time to invoke the sixth sense"

By AMIN RAJAN

Time to invoke the sixth sense - In the first of a fortnightly series, Amin Rajan examines the efforts fund managers are making to entice buy-and-hold investors.

Markets have rallied butthe bulls are not yet in sight. Few analysts expect tosee them before 2005.With millions losing billions in the bear market, thelong-term buy-and-hold investors remain disillusioned.

The last bull market did not appear to address a simple question: where was the added value for these investors when the indices were defying gravity?

After all, today's contributors to pension funds think no differently from their grandparents who saved a pot of money, tried to protect it via savings accounts, and then used it to meet their family's needs for rainy days.

But, unfortunately, the grandchildren were encouraged to follow the fad of the moment: either buying funds that tracked various indices or delivered relative returns.

As speculation overtook accumulation, they moved away from the primary aim of pension saving: wealth protection and growth. The market collapse marked a crushing end of a dream for a generation of investors who had been enticed to believe that stock markets had the magical power to deliver something that governments could not: decent retirement pensions. Not surprisingly, they are now questioning whether equities as an asset class are the right vehicle for meeting long-term contractual liabilities.

Accordingly, a minority of fund managers on both sides of the Atlantic are seeking to entice these buy-and-hold investors through one or more of four routes as part of a new deal. As one US chief executive put it to me recently: "We're relying on our sixth sense: common sense."

First, these fund managers are seeking to develop liability management products, using the underwriting expertise of insurance companies and investment banks. These products can potentially reshape the contours of the fund management industry. There is clear recognition, though, that migrating towards these safer products will take patience and persistence - investors still remember the losses notched up by another hitherto safe product: endowment-with-profits policies.

Second, they are offering a suite of absolute return products, with varying risk profiles. They range from low-risk money market products at one end to hedge funds at the other. Both HSBC and Gartmore are exploiting this strategy. But it is recognised that the proliferation of hedge funds over the last two years has reduced their attractiveness, as fewer market imperfections remain unexploited. Regulators are also casting their shadow.

Third, and most important, they are entering into an implicit contract with the sponsoring organisation, its pension trustees, their consultants and beneficiaries. Deutsche Asset Management and State Street Global Advisors have been active in this context. Under it, they jointly appraise the risks that can be tolerated, the returns that can be reasonably expected and the flexibility that can be offered to plan holders. All the activities are then aligned to the delivery of the proposition agreed by the parties.

In particular, the main thrust of research is directed at providing fresh insights as well as information that is pertinent to the delivery. Sell-side research has come under scrutiny as never before.

Fourth, they are turning the spotlight on the investment process by addressing an often neglected question: how can any investor take a long-term view when companies in which they invest succumb to their natural cycle of growth, maturity and decline - especially at a time when the cycles are getting even shorter?

For example, T. Rowe Price and UBS are developing a deeper understanding of financial, managerial, innovation, brand and market strengths of targeted companies. This approach also involves detecting in advance the situations that have inflicted huge losses on shareholders: like Enron, Marconi and Ahold.

This list of actions by a select group of fund managers is indicative, not definitive. But it is long enough to make a simple point: the current market recovery needs a backbone of buy-and-hold investors and ways must be designed to bring them back.

In my estimation, around one in three firms on either side of the Atlantic are implementing one or more of these four responses.

Elsewhere, there is a fear that governments may try to entice the buy-and-hold investors with yet more regulation.

In Europe, the raft of forthcoming rules from the European Union and the Financial Services Authority, the UK's financial watchdog, have the potential to turn fund management into a veritable utility, akin to a factory with rigid processes and a controlled environment. They are also a tax on those great firms who are trying to revitalise the industry. The challenge for individual firms is how to run with the grain of client aspirations by turning common sense into common practice.

Amin Rajan is CEO of CREATE, a research consultancy specialising in new business models in financial services: amin.rajan@create-research.co.uk.