21 July 2006
Global Investor

Tidal changes ahead

By Prof Amin Rajan

The person who moved a mountain started by taking away the small stones, goes an ancient Chinese saying. With billions lost in the last bear market, the industry had to start moving a lot of stones. Such losses could no longer be shrugged off as part of the deal.

Serialised in Global Investor in 2004 and 2005, the last three Create-KPMG reports* have highlighted a number of positive changes that have been implemented to create a business model that works in bull and bear markets alike. These changes range from having a better understanding of client needs to fragmentation of the value chain to focus on core capability.

In the meantime, the bulls are back. Mergers and acquisitions are racing up the corporate agenda. Changing demographics, pensions reforms in mature economies and accelerating prosperity in Asia are creating strong tail-winds. But the ride will be a turbulent one, all the same. This is because a number of factors are conspiring to frustrate the business-as-usual scenario. Indeed, many of the challenges that the industry faces are the unintended consequences of its past success.

i) Mounting regulation

Following the excesses of the 1990s, only the most naive expected regulators to sit on their hands. As chairman of a large global house put it then: "In the retail market, what we do is akin to selling a bottle of milk, expecting the customer to drink it and leave him alone. It is as if investment is a consumable product."

Not surprisingly, therefore, regulators have struck back with a vengeance: MiFID is the latest in a long line of measures that seek to regulate business conduct in the wake of mutual fund scandals in the US. To the masses in America, Eliot Spitzer may be a new Robin Hood. But to global fund management, his investigations have, as a knock-on effect, resulted in a regime in which it is well nigh impossible to be fully compliant.

"We go beyond compliance to observe the spirit of the laws. Our reputation means everything to us. But what do you do when laws in different regions are conflicting?" asks Tim McCarthy, chairman and CEO of Nikko Asset Management in Tokyo.

On the upside, regulation seeks to provide investor protection, particularly as governments are promoting private pension plans. On the downside, it stifles creativity and innovation just at a time when it is most needed in today's low return environment. At the outset of the EU's Financial Services Action Plan, the worst case scenario was that it would reduce fund managers to no more than glorified utilities. Now, that no longer seems inconceivable.

ii) Emergence of China, India and Japan

As in manufacturing, so in services, the ascendancy of the three Asian tigers is a fact of life. Much has been written about the new market opportunities they provide to Western fund managers. However, there is far less awareness about how they are developing their technology and skills to use as

a spring-board into mature fund management markets in the West.

"What happened in the car industry may well happen in fund management," says Jervis Smith, managing director, Citigroup Global Transaction Services. "Each of these countries has a large middle class, providing a critical mass of savings. Each is also a fast follower of Western ideas and technologies. At the commoditised end of fund management, they can potentially mount a major challenge within 10 years."

This does not sound like wishful thinking, if the history of the past 20 years is any guide. For example, as recently as five years ago, no analyst was expecting Toyota to have a market cap today that exceeds the combined valuation of General Motors, Ford, Daimler Chryler and Peugeot Renault.

iii) Market contagion

Globalisation is a knife that cuts both ways. It has undoubtedly opened up investment opportunities on an undreamt of scale. The boom in emerging market funds is but one of its manifestations. As an asset class, global equities has grown exponentially. The downside, however, is clear. "Owing to the growth in cross-border investment, there is an ever-growing risk that adverse conditions in one market will spread quickly to markets across the world. We have to continuously watch the world markets," says Rikio Nagahama, CEO of DIAM, in Japan.

This has a dual implication. First, research analysts and portfolio managers need to develop much sharper antennae about all the key markets, not just their own. This adds an extra – and potentially intractable – dimension to asset allocation and stock selection. Second, best-conceived ideas may come to grief for reasons completely unconnected with the underlying fundamentals. No matter how well crafted, there is a limit to how many unforeseen events can be built into any investment thesis without over-dilution.

iv) Ascendancy of investment banks

The last wave of pension regulation has lured investment banks into a range of asset management activities and products such as professional advice, asset-liability modelling, structured products and hedge funds. Some fund managers see them as barbarians at the gate, others as partners in progress.

"Investment banks are coming into the institutional space not just as intermediaries but also as principals," says Angelien Kemna, European CEO of ING Investment Management. "Their impact will depend on how smart they are at playing the long-term story. Yes, they have spear-headed the innovations in hedge funds and structured products. Yes, they are not over-regulated as we are. But they will need to work with fund managers. Pension funds remain suspicious of investment banks."

The last sentiment is well taken. For all the talk about liability-driven investment, the amount of funds invested remains small. Worldwide, less than 10% of pension funds have dipped their toes in the LDI pool. Most of them prefer to invest in instruments that have transparent valuations, realistic charges and a significant track record.

For their part, investment banks are ever mindful of these imperatives. Most of them work closely with in-house fund managers and are positioning themselves for a major role in providing products that hedge out non-investment risks from any portfolios. At the very least, they have a significant toe-hold in the value chain of fund management on a scale not evident five years ago.

Where their 'hunter-killer' instincts will take them remains to be seen. As the CEO of one fund house put it: "Expecting investment banks to be good partners is like expecting tigers to be well-mannered."

v) Failure of DC plans

As a chairman of a large US pension fund put it: "Governments failed to deliver decent pensions. So, it invented DB plans, but we've fared no better, either. All hopes are now pinned on fund managers to make private pensions work. Why would they succeed where others have failed?"

This is a daunting question. The reputational risk for fund managers will rise exponentially with DC plans: they will provide huge business opportunities in the years to come but they will also create expectations that may prove hard to match. If and when funding crises arise in future, individual investors will not have the same clout as governments or employers.

"But there is room for optimism," says Suzanne Donohoe, head of the North American client businesses, Goldman Sachs Asset Management. "All the necessary skills may not be there yet, but with innovation and flexibility, we'll get there. Capital flows will attract new talent. A new generation of fund managers and distributors is also emerging to promote client interests."

Each of the above factors will have far-reaching effects on fund management. However, at the level of individual fund managers, the story will be different. Capitalising on new opportunities will not be about playing the old game better. Instead, it will be about navigating through fog to invent a new game far removed from old connections and causality.

The new game starts with the holy trinity of innovation, strategy and leadership:

-Innovation that shifts emphasis from 'product sale' to 'life style portfolio management';

-Strategy that seeks continuous improvements in all aspects of business and holds people accountable for their actions;

-Leadership that ups the ante, thinks ahead, builds teams, motivates staff and delivers results.

These are the critical success factors in the emerging environment. For individual fund managers, they amount to moving giant rocks, not little stones.

* Copies of the reports available free from amin.rajan@create-research.co.uk.

Prof Amin Rajan is the CEO of Create, a research consultancy.