Investment Management After the Global Financial Crisis

1. Investment Management After the Global Financial Crisis Presentation of the 2010 CFA Monograph authored by Frank Fabozzi (Yale University), Sergio Focardi (EDHEC Business School, Nice), Caroline Jonas (The Intertek Group, Paris) Zurich, 25 January 2011 Geneva, 26 January 2011 Investment Management After the Global Financial Crisis

2. My Objective Here Today • Present results of the study published by CFA Institute under the title Investment Management after the Global Financial Crisis • Discuss some of the things asset managers might want to do differently going forward Investment Management After the Global Financial Crisis

3. Context Leading to the Monograph • From mid 2007 through Q1 2009, financial markets were shaken by a series of shocks • The summer of 2007 saw liquidity dry up and the beginning of the subprime mortgage crisis • Following the collapse of Lehman Brothers (Sept 2008), the financial markets began a slide which was to see major indexes such as the S&P 500 and the Morgan Stanley Composite Index (MSCI) lose more than half of their value compared to their highs of 2007 • By the end of Q1 2009, most investors had suffered serious losses; asset management firms were in survival mode Investment Management After the Global Financial Crisis

4. 2009, 2010… • Conventional assets under management in the global fund management industry were estimated to be 71trillion USD end 2009, a 14% increase over 2008 due essentially to the recovery in equity markets • The S&P 500 reached a low of about 680 in Q1 2009, down 55% from its peak of about 1500 in 2007 but rebounded to 1150 by end 2010 • And is now at 1280, the level it had reached five years ago Investment Management After the Global Financial Crisis

5. Trends and ConsiderationsStillValid • Though the equity markets have rebounded • The trends and considerations made remain valid • Essentially because the causes of the crisis have not been removed • And many of the trends are long-term trends that could have been identified even prior to the crisis Investment Management After the Global Financial Crisis

6. The Objective The Research Foundation of CFA Institute asked the authors to reveal how the financial crisis would impact investment management decisions and processes and the investment management industry itself “For everyone in asset management – managers, consultants and institutional investors – it is vital to do a ‘lessons learned’ exercise. The industry failed to do so when the Internet bubble burst in 2000: everyone said that it was the investment banks and brushed it off, moved on. This time we need to do a lessons learned exercise at every level, we need to understand the 10 things that we need to do differently.” CIO at a large Northern European institutional investor Investment Management After the Global Financial Crisis

7. The Research Methodology • A review of the literature • Conversations with 68 industry players, industry observers, executive recruiters, and academics: • 17 institutional investors with a total of €570 billion in investable assets • 15 investment consultants and private wealth advisors with €5 trillion in assets under advisory • 15 asset and wealth managers with €4.5 trillion assets under management • 6 industry observers • 6 executive recruiters • 9 academics • The geographical breakdown: Europe (roughly 2/3) and North America • NB: Most interviews were realized in H2 2009. Academics contributed their evaluations in early 2010  Investment Management After the Global Financial Crisis

8. Finding #1: Asset Allocation Is Back • The central role of asset allocation in generating returns and protecting the downside has been clearly re-established • The events of 2007-2009 highlighted the need for a top-down approach in which macroeconomics will play a bigger role “One thing that strikes me is the growing client awareness that asset allocation drives everything.” Investment Consultant Investment Management After the Global Financial Crisis

9. Allocating Assets More Dynamically • Given the high levels of volatility, asset allocation is also becoming more dynamic; timing asset-allocation decisions will play a big role in explaining returns But: • Academics were skeptical as to investment managers’ ability to successfully time asset allocation decisions • Nevertheless, academics pointed to evidence that suggests that it is easier to time parts of the market (for example large cap versus small cap or individual securities) than to time broad asset classes  Investment Management After the Global Financial Crisis

10. Asset Allocation and Diversification • Investors are turning to greater diversification in asset classes to protect assets from market movements and generate higher returns • The investable universe once centered around two asset classes – equities and bonds – has been expanded to include new strategies and asset classes including real estate, hedge funds, private equity, currencies, commodities, natural resources such as forests and agricultural land, infrastructure, and intangibles such as intellectual property rights • The percentage of alternatives in the aggregate asset allocation of the pension funds in the seven countries with the largest pensions markets was estimated to be >16% by year-end 2008 (17% year end 2009) Investment Management After the Global Financial Crisis

11. Asset Allocation and Diversification,ctd But: • Academics we talked to noted that there is not much history on the (risk-adjusted) performance of many of these alternative asset classes • In particular, academics were skeptical that private equity should generate more stable/better (risk-adjusted) returns than public equity: is it simply a question of lack of pricing information? Investment Management After the Global Financial Crisis

12. Consequence of the Return of Asset Allocation With asset allocation re-established as the most important factor explaining returns: • Asset-allocation products are expected to have strong growth • In particular, investment products with an element of active asset allocation are being engineered for defined-contribution plan members and retail investors • Example: lifestyle funds  Investment Management After the Global Financial Crisis

13. Finding #2: Focus on Risk Management • During the 2007-2009 market turmoil, investor’s attention shifted from returns to risk • Sources identified risk management as the area that has changed/will change the most following recent market turmoil Investment Management After the Global Financial Crisis

14. What Is Changing in Risk Management? • In general, return expectations will have to be better aligned with the overall ability of markets and the economy to generate returns • In addition to market risk, we can no longer ignore other risks such as liquidity risk, counterparty risk, systemic risk, and the effects of leverage • Innovative products, such as the complex structured products introduced by investment banks, have added a new element of risk, calling not only for special methodologies for measuring their risk, but also a greater understanding of the products one is investing in and how they work in different economic contexts Investment Management After the Global Financial Crisis

15. New Tools for Analyzing Risk • To gain a better appreciation of risk, methodologies such as Monte Carlo simulations, stress testing are being more widely adopted • Conditional VaR is being used to measure risk in the presence of fat tails (i.e., large events such as large market movements) • In the area of systemic risk, aggregation phenomena are being studied (for the moment by academia and central banks) using methodologies such as the theories of percolation and random networks Investment Management After the Global Financial Crisis

16. Not All Risks Can Be Easily Estimated and Hedged • Academics we talked to underlined the difficulty in hedging liquidity risk given the lack of data and the likely non-linear impact of liquidity shocks • As for new risks due to complex structured products – a risk underlined by industry players – academics cautioned on their use given the asymmetry of experience and lack of competition in the market Investment Management After the Global Financial Crisis

17. Finding #3: Growing Pressure on Costs Investors who saw their assets shrink as major indexes lost around half of their value in the crash of 2008-2009 are taking a hard look at management fees and other costs “If returns are low, the cost of producing them becomes more and more important” Institutional Investor Investment Management After the Global Financial Crisis

18. Institutional Investors’ Strategies to Reduce Management Costs • Renegotiating fees especially, but not only, in the alternatives arena • Investing more assets in index funds • Bringing management (increasingly) in-house • Including, for the larger funds, setting up in-house teams to manage alternative investments, and pooling assets to wring out layers of intermediaries Investment Management After the Global Financial Crisis

19. Individuals’ Strategies to Reduce Management Costs • High-net-worth individuals are: moving towards simpler, more transparent products such as ETFs, and towards banks that offer more competitive fees, more competitive products • Retail investors are: reducing management fees by putting their investable assets into low-cost funds, a trend already underway for a number of years in some markets (93% of all new net purchases of S&P500 Index mutual funds concentrated in least costly funds 2000-2009) • Trend towards equity index funds continued despite recovery of the market (13.7% of all US equity mutual fund assets year end 2009 up from 13% year end 2008) Investment Management After the Global Financial Crisis

20. Finding # 4: Towards a Redistribution of Roles • Redistribution of roles among investors, consultants, and asset and wealth managers has accelerated • Large institutional investors are increasingly bringing asset allocation and asset management in-house and the largest are building platforms to service smaller funds • Consultants are moving into “implemented” or fiduciary management in an attempt to boost revenues that slumped as the value of assets under management fell and firms sought to control costs Investment Management After the Global Financial Crisis

21. Finding # 4: Towards a Redistribution of Roles, ctd… • Asset managers are offering asset allocation advice, both in response to investor demand and to provide value over and above that added within the manager’s asset-class mandate • Asset managers are also making inroads in asset allocation in the defined-contribution (DC) pension arena, offering “all-weather” portfolios for DC plan members as plan sponsors seek to give some sort of downside protection to plan members Investment Management After the Global Financial Crisis

22. Other Players : Investment Banks, Insurers • Investment banks will continue to play an important role in assisting corporate pension plans, providing hedging of liabilities with interest rate derivatives and perhaps also, more generally, as a provider of swap-based exchange-traded funds (ETFs) • Insurers will play a bigger role as small pension funds outsource the management of their assets, governments try to push down the cost of management, and retiring baby boomers demand principal-protection and risk-mitigation products Investment Management After the Global Financial Crisis

23. Finding # 5: A Greater Attention to Ethical Behavior • Consultants and investors are stepping up due diligence, especially in alternative investments • Larger consultancies are building up their research teams, esp. in the area of operational risk • Institutional investors – burned by hot money in hedge funds – are taking a closer look not only at who is managing the money and how, but also who the co-investors are Investment Management After the Global Financial Crisis

24. Finding # 5: A Greater Attention to Ethical Behavior,ctd… • In addition, continental European funds are taking a closer look at what activities are behind the profits of the firms in their portfolios • While investors in English-speaking countries are focusing more closely on governance and other ethical issues that bear on the value of the firm Investment Management After the Global Financial Crisis

25. Finding # 6: Biggest Challenge for All in the Industry: Regain Investor Trust Will require: • More transparency • More communication with investors, especially on risk • Better management of expectations • Some help from financial markets “Bubbles come and bubbles go and leave a lot of people angry. Asset managers need a trust proposition” CIO, Europeanasset management firm Investment Management After the Global Financial Crisis

26. The Challenge for Pension Funds • The challenge: pay the pension promise in what many investors expect to be a highly uncertain, low-interest-rate, low-return environment Among the strategies: • Get costs down • Move more assets into in-house management wherever possible • Try to increase returns with greater diversification and more opportunistic, active asset allocation, • While paying more attention to the macro environment Investment Management After the Global Financial Crisis

27. The Challenge for Consultants • The challenge: add value as investment strategies pursued by institutional investors become more complex Will require: • A bolstering of competencies in risk budgeting, asset allocation, and new asset classes • Might include enlarging the service offerings to include, for example, fiduciary management • Or merging (ex Towers Perrin/Watson Wyatt) or considering alliances with asset managers or institutional investors Investment Management After the Global Financial Crisis

28. The Challenge for Investment Managers • The challenge: redefine the offering, aligning the promise with the ability to deliver Strategies: • Play a bigger role in asset allocation – advising institutional investors and engineering products for retail investors – and in risk and liquidity management • Restructure: As investors move their assets increasingly into index funds on the one side and alternatives on the other, the industry is expected to restructure, with a few large firms with a comprehensive product offering including alternatives and advice, and a large number of specialized boutiques • Separation of production and distribution: As the industry consolidates and the pensions market undergoes “retailization,” the industry is moving towards a separation of production and distribution in which revenue-sharing will be a major issue Investment Management After the Global Financial Crisis

29. Employment Trends • Mid 2009: 20-55% drop in overall recruitment mandates due to downsizing at large asset management firms as they tried to control costs in the face of falling assets under management and investors’ preference for lower-margin products • By end 2010 recruitment firms reported that dramatic cost cutting was over and recruiting was up again though still not up to 2007 levels Investment Management After the Global Financial Crisis

30. Compensation Trends • Compensation in the industry was down 20-40% in 2009 compared to 2008, due essentially to a reduction of bonuses • Compensation bounced back 10-15% in 2010 but it is still below 2007 levels • Compensation structures are also being reviewed, with a larger percentage of compensation being deferred, performance evaluated over several years, and incentives aligned with the long-term performance of the firm Investment Management After the Global Financial Crisis

31. Recruited Most / Least in 2009 Demand up for: • Asset-allocation specialists and persons with multi-asset experience and quantitative skills • Risk managers, including counterparty and operational risk managers • Global and emerging markets specialists • Credit specialists Demand down for: • Stock pickers, as investors moved assets into index funds • Equity portfolio managers for developed countries • Retail wholesaling staff, with the decline of the open-architecture model Investment Management After the Global Financial Crisis

32. What We Might Do Differently “For everyone in asset management – managers, consultants and institutional investors – it is vital to do a ‘lessons learned’ exercise. The industry failed to do so when the Internet bubble burst in 2000: everyone said that it was the investment banks and brushed it off, moved on. This time we need to do a lessons learned exercise at every level, we need to understand the 10 things that we need to do differently.” CIO at a large Northern European institutional investor Investment Management After the Global Financial Crisis

33. #1 : More Effective Diversification • Consider correlations at the relevant time horizons • Instantaneous correlation between the returns of different assets and asset classes does not fully reflect the behavior of the returns of assets or asset classes in times of crisis • Diversification based on correlationsat short time horizon does not protectagainst crises • One needs to understand trends atintermediate times and diversify trends • Or equivalentlydiversifyat the relevant time horizons and • Understandcointegrationthatis the clustering of priceprocessesaround a smallnumber of key trends Investment Management After the Global Financial Crisis

34. # 2 : Review Asset Allocation More Frequently • Today’s markets experience more large swings in valuations and change behavior in fundamental ways that affect the forecasts of entire asset classes and require dynamic asset allocation • But: while dynamic asset allocation holds the promise of higher returns, it is a source of risk given that it shifts assets dynamically from entire asset classes, leaving little margin for mistakes in the difficult task of timing • Therefore the need to understand what asset subclasses can be forecasted most accurately Investment Management After the Global Financial Crisis

35. #3 : Consider Extreme Events • Extreme events do occur more frequently than today’s risk models forecast • Empirically, we know that returns distributions are fat-tailed • In addition, there are hidden sources of extreme risk that have to be accounted for, e.g., 6 May2010 flash crash • The presence of fat tails implies that linear correlations do not reflect co-movement between asset returns • But we still have to separate fat tails of short-term returns from prolonged market slides • And understand when extreme events are triggers of crises Investment Management After the Global Financial Crisis

36. #4 : Consider Liquidity Risk • Consider carefully the magnitude of losses should one need to unwind positions rapidly • Recent events have demonstrated that a sudden withdrawal of liquidity from markets might occur, leading to potentially very large losses on leveraged strategies • But liquidity is difficult to understand • Because it is a non linear phenomenon only partially explained by standard asset pricing theories Investment Management After the Global Financial Crisis

37. #5 : Consider the Complexity of the Web of Relationships Between Agents, Investment Products • The structure of market links has come to the forefront as a source of risk as complex derivative products might propagate losses throughout the economy well beyond what was believed realistic before the 2007-2009 crisis • The Bank of England’sExecutiveDirector of Financial Stability Andy Haldane has proposedmeasures of marketconnectedness Investment Management After the Global Financial Crisis

38. #6 : ConsiderMacroeconomic Quantities • The real economy does matter • Though macroeconomic variables move slowly, they are important insofar as they can signal the building up of situations that might lead to large losses • For example, the progressive building up of excessive mortgage exposure is a fact that could have been revealed by economic analysis  Investment Management After the Global Financial Crisis

39. #6 : Look at Macroeconomic Quantities, ctd… • Financial returns must have an economic basis • One has to understand the sources of returns… • And their sustainability • The economy, markets are finite, • While classical finance theory essentially assumes infinite markets Investment Management After the Global Financial Crisis

40. #6 : Look at Macroeconomic Quantities, ctd… • We know a lot about crises, in particular about the links between crises and the excess of money and credit • Studies have underlined common characteristics of the economy in periods preceding a crisis (e.g., Minsky, Reinhart & Rogoff) • But these forewarnings are often interpreted as signs of a favorablesituation for generating returns Investment Management After the Global Financial Crisis

41. #6 : Look at Macroeconomic Quantities, ctd… • The injection of money in the economy will have to be closely monitored • It might be profitable to split inflation into an inflation vector with many components including asset inflation • In order to understand if the realignment of different sources of returns is likely to happen smoothly or through more frequent boom-bust cycles Investment Management After the Global Financial Crisis

42. #7: Consider the Risk that Hedging Strategies Can Fail • The failure of Lehman Brothers demonstrated that apparently solid counterparties can and do fail • With the crisis that started in 2007, hedging has acquired a new dimension as the possibility of failure of counterparties such as major banks and insurance firms has increased beyond what was considered likely before the crisis • Need to care not only about the reliability of counterparties but also of their environment, interconnectivity Investment Management After the Global Financial Crisis

43. #8 : Build up Multi-asset and Multinational Capability • Exposure to alternative asset classes among the seven largest pension markets has gone from 6% to 17% in the last ten years • Markets are global and investors increasingly expect those who manage their money to have a global view on the investment environment Investment Management After the Global Financial Crisis

44. #9 : Build up the Quantitative Capability • The size and complexity of today’s (equity) market is enormous • By yearend 2010, worldwide regulated exchanges listed over 45,000 firms with a total market capitalization of 55 trillion USD • Optimal execution increasingly calls for automation and quantitative capabilities Investment Management After the Global Financial Crisis

45. # 10 : Align the Promise with What the Investment Management Industry Can Deliver • Investors have been stunned by large swings in market valuations three times in the past 10 years (1997-1998, 2000-2002, 2007-2009) years • The industry needs to regain investors’ confidence • More transparency will be needed • Investor confidence cannot withstand another crisis, markets cannot function correctly in the absence of a minimum level of trust Investment Management After the Global Financial Crisis

46. A Final Word from Academics: “Don’t forget that there really is a risk-return trade-off. If something looks too good to be true, it probably is.” Professor John Finnerty, Professor & Director of the MS in Quantitative Finance Program, Fordham Graduate School of Business Investment Management After the Global Financial Crisis