Dec 2008-Jan 2009

BLANK CANVAS 2009: A test of survival

Senior executives including Martin Gilbert of Aberdeen, talk to Fiona Rintoul about what the post-crisis world holds... The asset management industry has, by and large, been a bystander in the current financial crisis. Nonetheless, the long-term effects of the crisis on asset management firms are likely to be profound, not least because this is a crisis like no other.

“I’ve seen a number of crises and this is fundamentally different,” says Jim Dilworth, head of Morgan Stanley Investment Management.

We already know some of the effects. Fortis Investments would not be joining up with BNP Paribas Asset Management had it not been for the crisis. And there would not be total net outflows from European investment funds of €400bn in 2008 predicted by Lipper Feri.

Others are still to come. More regulation almost certainly. Further consolidation in the long-only business. ‘Slash and burn’ in the hedge fund industry. A drive to get back to basics, perhaps, with simple and transparent products preferred over the clever-clever and the opaque.

But before considering what’s to come in 2009, it is perhaps instructive with the benefit of a little distance to delve into what went wrong. As Dilworth notes, if we can’t agree on the causes of the crisis, there’s little chance of agreeing on the solutions.

No one, it seems, saw the crisis coming. As Simon Ward, chief economist at New Star Asset Management, said in the immediate aftermath: “If you’d told me a year ago that Bear Stearns, Lehman Brothers and Merrill Lynch would no longer be there as independent firms, I’d have laughed in your face.”

Many more firms have taken the bullet since then, of course, and New Star has had its own problems thanks largely to a close encounter with what is rapidly becoming the Achilles heel of Britishers everywhere: over-indebtedness.

And indeed debt in the form of leverage is where Dilworth places the blame for the current crisis. “Cheap money led to overleveraging in the US and other countries,” he says. “Banks were overleveraged, governments were overleveraged and companies were overleveraged.”

“Everyone just became too greedy in the industry,” agrees Martin Gilbert, chief executive of Aberdeen Asset Management. “Everything became too leveraged and what we’re seeing now is a massive global deleveraging.” Liquidity, or the lack of it, is also  key issue. “Normal market conditions and models all assume liquidity is available,” says Mike O’Brien, head of distribution or EMEA at Barclays Global Investors (BGI).When it isn’t, there is a meltdown.

Disaster brewing
Then there was the housing bubble, which had to burst just as sure as leaves fall off the trees in autumn, and reforms such as changes to the accounting rules, which, says Dominique Carrel-Billiard, CEO of Axa Investment Managers, created false sellers and suspicion as to what was on banks’ balance sheets. Then, of course, there were CDOs and CDSs.

Perhaps the market should really have seen the problems with these instruments coming, but by and large it didn’t. One man who claims he did smell a rat is Aberdeen’s Gilbert. But then, of course, as he himself concedes, he’s been through this movie before with the split capital trust debacle back in 2002.

“It was quite obvious to me having been through splits that CDOs were going to be a disaster and that credit default swaps were probably going to be an even bigger disaster,” says Gilbert.

Greed is again the culprit. “I think the investment banks just got too greedy on issues like CDOs,” says Gilbert.

Once the whole thing had started to unravel, a crucial error, says Carrel-Billiard, was letting Lehman Brothers go under. Was it because Henry Paulson, an ex-Goldmans’ man, hated them? Was it because they’d arrogantly turned down funding when it was offered? Nobody knows. What does seem certain is that the repercussions of letting Lehman hang out to dry were not fully foreseen.

So much for being wise after the event. What does the future hold and what do asset managers need to do now? After all, as Carrel-Billiard notes, we’re all in this together.

“You don’t have a major catastrophe unless all control mechanisms don’t function,” he says. “Everyone is responsible for the current situation.”

Found out

There’s going to be some scything away of dead wood, particularly in the hedge fund industry, that much seems certain. “There are some [hedge funds] that don’t deserve to be in the industry, which are basically long-only geared beta funds, and I think they’ve been found out,” says Gilbert, while George Soros predicts as much as 75% of the hedge fund industry will wither away.

In the long-only world things are basically going to get a lot tighter. There will be pressure on fees, believes BGI’s O’Brien, as clients become more sceptical about what exactly asset managers can deliver.

“Although there have been no accusations by the regulator of ill behaviour by asset managers, and I don’t think asset managers have done anything to undermine totally the trust clients have, there’s a question mark over their ability to generate alpha,” says O’Brien. “There will be less willingness o pay the fees that have been demanded.”

This and other factors mean asset management will no longer be about revenue generation, but about cost management and expense containment. “All asset managers are experiencing a decline in their AUM,” says Dilworth. “Most asset managers have a large fixed cost base. It’s leveragable on the upside, but not on the downside. They need to have less fixed cost and more variable cost.”

Thus, there will be more outsourcing, but, in the case of Dilworth’s own firm at least, it will be of operational not investment functions. “We have debated that [outsourcing investment advice] in-house, but we believe people will want to go to the end provider,” he says.

Then there’s the tightening that will come from the regulatory side. “There will be a clampdown,” says O’Brien. “We’ve come to the end of deregulation.”

Who will survive in this environment? Overall, the picture that emerges is a familiar one. Large organisations will be reasonably well placed as strong ownership becomes more important in a risk-averse world. There will always be a role for players that are very niche and very skillful. However, the middle ground may become a little soggy, although the proficient will still survive.

Sceptical of alpha
“The big losers will be single-strategy hedge funds,” says O’Brien. “People are very sceptical of alpha.”

Meanwhile, Carrel-Billiard predicts that the fate of “really specialist boutiques will depend on asset class. There will be consolidation and people going out of business, but also creations”.

O’Brien also anticipates more disposal of asset management companies by bank owners in Europe. “They will either sell or sub-advise more,” he says, noting that the asset management industry has always been less attractive in terms of banks – and that the industry, recently described by one headhunter as “a pool of mediocrity”, needs to become more professional.

“Open architecture was growing anyway in Europe,” adds Dilworth, who also sees shutdowns or sell-offs ahead, “and many banks were cannibalising their mutual fund business to put client money back into deposits.”

So what kind of products will companies be emphasising in the slimmed-down, post-financial crisis world? The first thing to note, says Carrel-Billiard, is that the current craziness in the markets will one day end. “The deleveraging of banks and hedge funds is creating a lot of technical noise on the markets at the moment,” he says. “Prices reflect technical factors rather than the intrinsic value of assets. That short-term issue will work through.”

When it does, clients will want products that are “simpler and more transparent, that avoid the ‘black box’ scenario, and avoid liquidity risk and counterparty risk”, he says.

This will create problems for hedge funds, structured notes, guaranteed funds that are not transparent and exchange-traded funds (ETFs). The latter had, of course, been doing extremely well before the crisis hit, and some see a bright future for them as low-cost providers of beta, but Carrel-Billiard is sceptical because many ETFs are swaps.

“People may be wary of that,” he says. “In any case, indices and index management are good in a bull market, but in a bear market you see the return of the stock picker.”

On the institutional side, almost everyone agrees that clients are going to be looking for that familiar but elusive beast: ‘solutions’. Those solutions will ideally be simple and transparent and will deliver ‘outcomes’. How those outcomes will be achieved is another matter. As Dilworth notes, “We collectively failed in our arguments for investment in a diversified portfolio of equity and fixed income. Frankly, that hasn’t created value.”

Thus, while Dilworth is still hopeful that we’re not in a 1930s-Depression scenario, he sees fairly radical new territory ahead. “We won’t go back to business as we knew it,” he says. “It will be business as usual, but different. Risk has been permanently repriced. This will have a pivotal effect on people’s investments.”

In particular, the way pensions are handled is going to change, he says. At some point further down the line, when banks and industrials have been bailed out by government, the realisation will dawn that there are big holes in pensions and there will be calls for government to step in there too.

“There will be a renationalisation of the pensions industry,” says Dilworth. “Governments will take more responsibility for pensions. But they won’t just be able to do it with taxes. They’ll have to invest.”

Government could be the biggest client in the future, then, as the argument for the privatisation of pensions is effectively lost. In the meantime, the best policy may be to follow the advice of a man who’s already faced down a crisis.

“It may sound like a cliché, but my advice for anyone with difficulties at the moment is just to come in every day and survive,” says Gilbert. ©2008 funds europe

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