This article originally appeared in Investment News and Pension & Investments online editions on 22 and 23 of January 2012.
As we start a new year, many are asking what the events of 2011 mean for investors in the months ahead. The U.S. stock market is within very short striking distance of where it started a full year ago, having traveled multiple round trips. The broad U.S. bond market, as measured by the Barclays Capital U.S. Aggregate Bond Index, delivered a nearly 8% return last year. If you were invested elsewhere, you were likely not so lucky, with European markets in particular having demonstrated fragmentation once deemed unthinkable.
More importantly, 2011 was marked by unprecedented volatility. For instance, the S&P 500 moved more than 2% on 35 trading days, more than twice the average since 1927; the index moved more than 1% on 96 days.
All of this has implications for institutional and individual investors alike, as well as the asset management firms they hire to invest on their behalf. Welcome to the Age of Austerity.
How did we get here? Last year’s events in Europe and the U.S. speak to the enormous buildup of debt over a number of years. The headwinds of the European debt crisis, the fright in the municipal bond market and the downgrade of the U.S. sovereign rating have buffeted many investors. Arguably, what was labeled as a “surplus of savings” in 2007 revealed itself as the mother of all debt bubbles in 2008, for which we will continue to pay the price for some time.
We are in a period of transformation. We are exiting the Age of Entitlement, which was characterized by leverage, lax lending standards and the general belief that trees and home prices grew to the sky. The Age of Austerity that now is unfolding is consequential for investors of all types. Balance sheet strength and fiscal responsibility will be emphasized. As we traverse this secular journey, the process will not be easy. There will be winners and losers and the risk of unintended consequences will be high.
It is worth noting that the extraordinary amount of uncertainty and market volatility in 2011 wasn’t completely new. In fact, we have been experiencing higher volatility since mid-2007. Negative debt dynamics breed their own structural volatility. Any institution – or country, for that matter – that is encumbered by high levels of debt generally is limited in action and may be prone to mishaps that increase risk and expand the range of outcomes, both positive and negative.
Banks are at the center of this vortex. They must adapt to new regulation, higher capital requirements and heightened litigation risk. We are seeing the effects daily as banks and nonbank financial institutions are shrinking their balance sheets, cutting their head count and reining in outsized bonuses.
But it goes deeper than that. The financial industry as a whole must adapt, and do so in ways that are profound and long-lasting.
Here are some highly probable outcomes:
Debt dynamics will constrain investment returns. The markets and investor behavior are sending us a few important signals that reflect a fundamental shift. Whether it is stocks or houses, the pride of ownership is not what it used to be.
Over the past two years, we have witnessed net outflows from the equities markets, and we all know what has happened to housing demand. These are the consequences of the global financial crisis that began with the collapse of Lehman Brothers Holdings Inc. Investors of all stripes have continued to pay down debt and make their portfolios more conservative, and their appetite for borrowing to own has visibly diminished. In this environment, returns from all major asset classes, not just bonds, likely will be modest at best.
Success in the investment management business depends upon delivering returns and managing risks. Industry revenue is derived through two means: fixed fees based upon assets under management and performance, or success fees based on performance above the market. Both of these revenue streams depend upon performance, either through systematic returns from the market (beta) or the idiosyncratic returns generated through active management (alpha). Low growth and constrained balance sheets will trim beta, and highly volatile markets without trends will make generating consistent alpha all that more difficult.
Heightened volatility tends to drive investors to seek perceived safe harbors as wild price fluctuations can lay waste to any well-intentioned investment strategy. Indeed, investor fatigue is setting in, and we have seen capital outflows from the broad risk markets over the past several months.
The sum of these factors describes an investment management industry under stress. The broader financial industry is in a state of contraction, and the primary drivers of investment management revenue have become less reliable.
Donald Sull, a professor at the London Business School, in his book “The Upside of Turbulence” (HarperCollins 2009), spoke to how companies with the abilities to adapt and absorb change can succeed in a world plagued by heightened volatility. To succeed, investment firms need to embrace two business axioms: focus and flexibility.
To absorb the changes that already are upon them, investment management firms must build more resilience into their businesses. Drawing on Mr. Sull’s insights and our own experience as a global investment management firm, we would identify the following five key elements to pursuing success in this changing landscape:
The clients come first. The old adage has never been more important and urgent. Higher volatility and lower returns have fundamentally changed the relationship between investors and the managers to whom they entrust their wealth. We are all being held to a higher standard. At the same time, our clients’ risk tolerances are changing, and how they will deploy their capital likely will be altered similarly.
Meet inconsistency with agility. Markets that behave inconsistently or even erratically also dictate that investment management firms have sufficient organizational flexibility to adjust to more variable revenue streams. Beyond simply managing the assets of their clients, investment managers also will need to better understand how to manage the assets of their own organizations and develop the appropriate tools to do so.
Your costs count. As entitlement turns toward austerity, expense management becomes a priority. Like most companies in a professional service industry, the largest variable expense for most investment management firms is paying the staff. Heightened volatility that creates a broader range of business outcomes likely will require sensitizing employees to accept more variable streams of compensation that further discern and differentiate by performance. Similarly, underperforming firms that fail to adapt to the new environment may be challenged to maintain their current staffing levels.
Economies of scale. In recent years, the investment management industry increasingly has become a winner-take-all marketplace. The economies of scale that were always believed to be negative at the fund level have turned unambiguously positive at the firm level. We believe this turnabout is the result of two forces. As the balance sheets and trading power of the investment banks have shrunk, the influence of the largest investment managers has grown. All investment managers are being hamstrung by the declining market liquidity. But some of the largest managers continue to receive superior market access.
Bigger firms are more resilient. Size can also provide advantages, as larger firms typically can build more-sufficient operating reserves to withstand a rapid decline in assets from a sudden market downturn. Similarly, larger firms can use their financial strength and brand to continue to innovate and invest in human talent in an otherwise consolidating industry. Though there will always be a place for the enterprising niche investment shop or hedge fund, their staying power may be tested.
The years ahead promise more of what we began to see in 2011, with the shift from entitlement to austerity creating waves of volatility. We believe those investment management firms that can adapt and absorb these profound changes will come out ahead and will be best prepared to deliver value to their clients.