The asset management industry in Asia has undergone some pretty big changes since AsianInvestor got its start in 2000. Having served as the title's founding editor and, more recently, as editorial director at Haymarket Financial Media, I’ve enjoyed a front-row seat. Yet I feel I have more questions than answers about where the industry is headed.
As my final contribution to AsianInvestor, I have come up with a list of what I consider the top five issues.
1. Can asset managers be ‘too big to fail’?
Last year, the industry won a reprieve when the International Organization of Securities Commissions decided to avoid tagging the biggest players as ‘systematically important’. The question has been deferred, but it hasn’t gone away.
Big asset managers such as BlackRock argue they cannot be compared to ‘systematically important’ banks because they don’t take risk on their balance sheets to the same degree, and because they are not as endangered by the sudden withdrawal of liquidity. Fidelity, among others, argued that efforts to regulate asset managers would only harm investors and markets.
Size alone does not make a bank or other institution ‘systemically important’. To be ‘too big to fail’ requires several conditions.
First, the institution must treat risk as a commodity rather than as something to be methodically mitigated. Are risks being insured against, or are fund houses relying on mathematical equations, such as those underpinning discredited notions such as value-at-risk, to either assume too much risk or to shift risk to unsuspecting counterparties?
Second, the institution must be involved in many complex counterparty relationships. The greater the number of players involved in trading, settlement, cash management and so on, particularly when hedging and derivatives come into play, the more likely a problem with one entity puts others in danger.
Third, is the asset manager taking additional risk in the belief that it is likely to receive government support in the face of a looming collapse? Long-Term Capital Management, a hedge fund, enjoyed such backing in 1998, so it’s not only banks that are guilty of exploiting conditions of moral hazard.
Fourth, how dependent is the asset manager’s trading operations upon liquidity? Liquidity is ample until it isn’t; it is a service available on demand but only if most customers don’t take advantage of it. Lehman Brothers and Bear Stearns failed when they faced relatively modest, short-term breakdowns of liquidity, suggesting these were badly managed businesses rather than victims of temporary cash shortages.
‘Flash crashes’ in both stock and bond markets have revealed how quickly liquidity can disappear. An abundance of liquidity does not reflect anything other than an abundance of trading, but if counterparties stop trading with an asset manager, even for a short period, the pain may be acute. And if such an event happens, would the fallout damage its counterparties?
Finally, temporary shortages are likely to be magnified if the asset manager is using leverage. Leverage is more than borrowing: it is a multiplier, of both returns and of losses. It is often the factor that makes the difference between a crisis of liquidity versus one of solvency.
If these five conditions describe the business of BlackRock and its brethren, then there is a strong case to suggest they are too big to fail, and should be subject to stricter regulation.
In that case, however, the onus would remain on regulators to come up with measures that are appropriate. Asset managers face far fewer conflicts of interest than banks; banks, with their unsavoury blend of broker-dealers and depositor money, have a reliable track record of menacing society. So even if an asset manager is ‘systematically important’, it is important in different ways than banks.
2. Can pension funds and insurance companies survive zero or negative interest rates?
These institutions, the most important set of clients to the buy side, face the growing prospect of ‘legacy spreads’ and insolvency. Whatever the merits of monetary easing or excessive credit creation, the biggest institutional victim has been the liability-driven investor. If central banks succeed in reigniting inflation, all may turn out well enough. But there is no sign as yet of inflation returning.
Japanese society has managed to engineer a decline in expectations by policyholders and pensioners; over the past two decades, terms have been renegotiated. But Japanese institutions also had the ability to invest overseas, into US Treasuries for example, in order to achieve a better return.
That is no longer a luxury available to institutions in Japan, or anywhere else. Nor are retail concoctions invented in Japan – such as income-dividend funds that piggyback currency plays on top of global bond products – likely to work as well.
The almost universal answer these days is to extend the search for yield into alternative assets. Private funds, be they aimed at companies, real estate or infrastructure projects, broadly come in two types: about 25% of them deliver excellent returns, and the other 75% lose money net of fees. The ratio is even worse for venture funds. It’s hard to see how alternatives alone can save liability-driven investors.
Japan’s institutions now face the reality of negative interest rates, but will they figure out a new response? And what are they willing to pay if asset managers can’t help them meet their objectives?
3. Are active managers worth their fees?
It is customary when the active-versus-passive debate comes up for advocates on either side to politely conclude that, of course, investors should use both types of strategy.
Well, maybe, but the academic studies seem pretty clear: passive is almost always better, on average, net of fees. There are dissenting voices from traditional active players such as Capital Group. Look at us, they say. Yet even giving Capital the benefit of the doubt doesn’t really help: the handful of companies that might credibly claim consistent outperformance can’t manage all the world’s mandates. Nor would they want to.
While this debate is hardly new, it is taking on urgency as too much money chases too few assets – of all types, in all strategies, including private situations, multi-asset funds, and absolute-return products. The world is awash with debt, much of it in securitised form, and much of it public but with private origins. Those assets are failing to perform in an environment of ultra-loose money supply and zero-ish interest rates. In Asia, many institutions continue to amass assets, and private wealth management remains a growth industry – all adding more money to the chase for yield. This must ultimately have an impact on fee structures.
Consolidation is likely to result, which in turn raises the prospects of huge asset managers being subjected to greater regulatory scrutiny (see question one, above).
Passive players will face their own problems, though. How much of the market can they absorb before they develop problems? It’s one thing to track the market, but another to be the market, from trading, operational and regulatory perspectives.
The rise of exchange-traded funds are also at risk of being overdone to excess. ETFs exist on the promise of liquidity, and liquidity is an illusion – it's not there when you need it most. ETFs in the US junk bond space have already experienced problems when they faced short-term redemptions. As ETFs get bigger, extend into inappropriate asset classes and morph into complex, synthetic structures, the odds of a failure, including a failure that has systemic implications, will rise.
4. Will technology render many asset management activities obsolete?
The robo-adviser is no longer the stuff of science fiction, and the initial results suggest it works. The financial industry has done a good job over the years of making itself more complex, jargon-filled and obscure than it needs to be to serve households. Investment is no exception.
Yet it turns out that an algorithm can come up with a reasonable portfolio of low-cost index funds that resembles the advice of an expensive human being. Anything that returns financial services to simple, clear, low-cost offerings that ordinary people can grasp is to be welcomed.
It is possible to conceive of a world in which advice becomes automated for the mass affluent, but increasingly human for people who pay for it. Some creative ideas will remain exclusively the purview of human beings, reserved exclusively for the rich and well-connected. This is not so different from the reality today, but it does suggest many of the well-groomed salespeople who work at banks, masquerading as investment advisers, must either climb the value chain or lose their jobs.
This outcome may not be immediate, however. Simple calculations offered by the likes of Wealthfront are one thing. Relying up on machine learning to offer more complex suggestions is another. DBS, for example, is using IBM’s Watson (the computer that beat humans at chess), to experiment with more advanced solutions.
The feedback is: promising but not yet ready. Machines are learning quickly, but they are only useful to the extent that humans learn along with them. Even AlphaGo’s recent triumph over human Go players tells us that machines are getting creative. But until financial markets resemble rules-based games rather than irrational casinos, it’s possible that humans may yet enjoy careers in financial services.
The place to watch will be the quant funds. The likes of Renaissance Technologies, Citadel Group and Dimensional Fund Advisors have, despite their very different business models, enjoyed steady outperformance based on mathematical strategies.
But if too much money goes into quant strategies – from, say, insurance companies desperate for yield – can quants still outperform? Put another way: how scalable are quantitative investment strategies? If they prove to be quite scalable, it will be a further blow to traditional (human) active fund managers.
5. Will an Asian asset management company achieve global prominence?
This is probably a ‘when’, not an ‘if’. But so long as the ‘when’ takes a very long time to be realised, it feels like an ‘if’.
AsianInvestor’s most recent survey of fund houses accruing assets from clients based in Asia Pacific showed that Western firms have been struggling – admittedly partly because of unrelated fluctuations in exchange rates – while local, notably Chinese, firms have grown at a fast pace.
Chinese and some Korean asset managers harbour globe-spanning ambitions. Tokyo-based Nomura Asset Management has a global business but mostly for managing Japanese equities. Nikko AM, another Japanese firm, has gone the furthest in creating a pan-Asia business, although its strategy of acquisitions and joint ventures makes it more a collection of separate business units than a cohesive whole.
Korea’s Mirae Asset has the beginnings of global reach. Its early expansion was fuelled by its domestic success; when its local equities business tumbled, its global operations seemed to slow down. The firm seems back on a growth path, and is trying to integrate its overseas acquisitions, such as Canadian ETF provider Global Horizons, into a holistic offering.
But Chinese and Korean firms suffer from outdated managements; the patriarch is still expected to call the shots. This doesn’t work in a world of complexity.
Mirae is an exception in Korea; but in China, there are plenty of firms that have set up in Hong Kong with the intention to go further. And many of them have enjoyed a rapid accumulation of assets to help finance their expansion. These companies often think big, even if their capabilities aren’t quite up to scratch.
Accessing Hong Kong gives them a huge advantage that local fund houses in other countries cannot match. China’s market opening – its interbank bond market, the various channels for cross-border flows, the new mutual recognition scheme for funds – will give its asset managers more opportunities to experiment. The risk, of course, is macro: that China itself – engorged on credit, bloated property and dangerously opaque financial linkages – suffers a crisis. In that case, no mainland financial institution would be safe.
Even so, when the ‘when’ is realised, the odds are it will be a Chinese company making the leap. A domestic crisis would simply delay it happening a little longer.