New York roundtable: The better side of Wall Street

Our New York panel of experts discusses risk, upside, trust in the global industry and the outlook for the years ahead.

Richard Garland (managing director, global adviser, Investec Asset Management)
Dave Lafferty (CFA, SVP chief market strategist, Natixis)
Greg Ehret (chief executive officer, PineBridge Investments)
Marc Brookman (deputy chief executive, North America, Schroders)
Jan van Eck (chief executive, VanEck)

Funds Europe – Looking at markets at present, what do you feel are the risks we are facing and where do you see upside?

Jan van Eck, VanEck – I would say the things that concern me actually are the ECB [European Central Bank], bond markets and negative interest rate policy, and the struggle that the ECB has with trying to stimulate its economy and where that all ends. I would combine with that, which is something that’s not discussed at all, the US fiscal deficit, which is really tremendous. People talk about late-stage recovery, but what’s crazy about where we’re at is how much money the US government is spending, given where we are in the economic cycle.

Greg Ehret, PineBridge Investments – The obvious thing that’s out there from a risk perspective is the wide range of global geopolitical issues that have been at the forefront recently. We believe these issues and also the US-China trade issues have caused a temporary stall, but longer term, we think there’s going to be a tremendous amount of Western capital moving towards Asia. In the past 18 months or so, we’ve been talking to a lot of US investors about allocating capital to China. I would say that is probably the greatest opportunity at present on the upside. There will be tremendous selective opportunities for investors as capital flows towards Asia, in particular China, both on the debt side as well as on the equity side.

Richard Garland, Investec Asset Management – The biggest risk is the trade war between the US and China and it is not clear how and when it gets resolved. The other risk linked to that is what Mr Trump does, whether he wants to resolve the trade war before the election or whether he wants to do it afterwards, assuming he wins. Notwithstanding this uncertainty, we have had significant inflows into our China equity strategies, particularly from pension funds in South America, as well as from adviser clients in the Americas, Asia and Europe.

Marc Brookman, Schroders – Opportunities clearly exist in Asia, but there remains a lot of fear surrounding Europe, and especially the UK. Obviously international equities and emerging markets have both underperformed for a long time now, and I think that fear has created some significant upside potential. For the first time in a long time, institutional investors are starting to think about reallocations here again.

Dave Lafferty, Natixis – The main risks are US-China trade relations and the potential for a messy Brexit. I think the market has an ability to get its arms around that. The one that concerns me long term is the ECB and how it will all end.
One of my biggest worries is that it doesn’t end, that zero and negative interest rate policy and unlimited quantitative easing (QE) eventually has a gravitational pull that just continues to bring inflation expectations and bond yields lower and lower.

In the near term, and we’ve already seen it, that’s great for stocks but in the long run, I don’t think that’s great for stocks. I think the market eventually begins to discount if interest rates are that low and central banks are that worried, then maybe the stock market shouldn’t be rallying. So that’s my big worry.

I guess my hope is the inverse of that, that at some point, central banks begin to wean markets off of accommodative policy. I don’t think they can do it yet but maybe if they hold a little bit more firm, fiscal policy and structural reform can begin to rise up and create productivity gains. I don’t think we’re anywhere near that happening yet, but that’s kind of the long-run upside to get us out of this stagnation environment we’ve been living in.

Funds Europe – In the last year, what investment areas and types of product have seen the most momentum?

Garland – Investors are generally nervous and we have seen so much money flowing into short-term duration bonds. These funds are being used as a safe haven, as almost cash-plus funds. The challenge for owners of these funds is that with interest rates coming down, the yield on these funds is down to 1%-2%. This is a potential bubble waiting to burst.

Van Eck – I think, again from my more US perspective, it was really the risk-off mentality was dominating; it came after a tough fourth quarter in 2018, so it is a little bit understandable at the beginning of the year.

Then in the summer, the absolute collapse in yields I think frightened ‘informed investors’. Whatever it is, you could be justifiably conservative, but it’s the same issue that I’ve seen in portfolio construction since the financial crisis. So much money was left on the table because people were saying, ‘Lets go into short-term municipal bonds or short-term instruments,’ because it makes you comfortable and at my quarterly reviews I’m not going to have to apologise for anything, and I think it really led to a lot of money being left on the table.

Ehret – A lot of institutions clearly sat out the first quarter of 2019 and volumes were low. What was really interesting is that we had a great fourth quarter the previous year from a flow perspective because institutions had already decided they were going to allocate, and they kept on allocating even when retail fled. Retail investors came back in in the first quarter, but institutional investors took a pause during that retail rally. But then we had the best summer we’d ever had, and we usually don’t see this level of allocations in the summer. We had fundings from clients in the Middle East, from the United States, from Asia. The search for yield and returns in a highly uncertain market environment meant investors gravitated to strategies that are flexible and provide differentiated sources of alpha – we saw momentum in loans, emerging markets, high yield as well as Asian equities strategies like China A-shares and Asian small-cap.

Brookman – We’ve raised most of our assets from the offshore market, which has typically favoured short duration. But we’ve attracted onshore flows too, which has gravitated towards emerging market debt and other things.

Looking ahead, I do think that there are some good new corporate cash opportunities in the US. There are record amounts of cash sitting in lots of companies, especially tech companies. The question is, are they willing to do a little bit more to get a slightly higher yield, to take on a little bit more risk? That’s going to be the key question, and we’re going to find out the answer in the fourth quarter.

Lafferty – Our international team has more short duration than we have in the US, and it hasn’t been a huge boon for us. In the US market, that trade looks like it’s fading, so the growth, you still see positive flows in the short and ultra-short product, but the rate has slowed dramatically, not surprising as central banks begin to retrench.

We do as much if not more on the retail side than the institutional side; the retail investors are really focused on taxes, they’ve had a ten-year bull market in stocks and bonds and they’re sitting on massive capital gains, so we have no problem getting meetings talking to people about how to mitigate tax liability, whether it’s loss harvesting on the equity side or whether it’s municipal bonds in spite of low yields.

Funds Europe – Fund distribution is changing across the board, how do you anticipate this will change and what role do you think technology will play in this?

Garland – In the US, we are witnessing the slow death of the mutual fund. The future of the US retail industry will be ETFs [exchange-traded funds] and SMAs [separately managed accounts], because mutual funds are not tax-efficient and are too expensive compared to ETFs and SMAs. Furthermore, globally we will see more distributors setting up their own mutual funds and hiring sub-advisers. We have seen this trend accelerate in the UK and Europe as a result of RDR [the Retail Distribution Review] and MIFID II [the second Markets in Financial Instruments Directive].

Ehret – When I was at SSGA [State Street Global Advisors], I spent a lot of time thinking about the future of indexing and ETFs, and I think technology is going to disintermediate ETFs. I think we’re headed towards more of a mass customisation of index products that will have tilts, similar to the tax loss harvesting SMAs that you see today. We’ll see very tax-efficient portfolios that will reflect clients’ biases and will also reflect clients’ concentrations in where they work and live and other important details. That technology is right around the corner and as soon as it’s available at a very cost-efficient rate, investors will benefit from that instead of ETFs.

I think that there’s an opportunity for technology to really have a big impact on that business. Technology is changing the way we all do business, even beyond distribution. For active managers like us, we use AI in our equity research, algorithmic and quantitative analysis to enhance fixed income trading and technology platforms to interface with our clients efficiently, as a few examples.

Lafferty – Yes, if you like ETFs for the tax benefit, the idea is it doesn’t throw off a lot of taxes. When you begin loss harvesting, if you can give somebody the same index broad market return and kick off 3% or 4% in tax losses; some of our portfolios, the tax alpha fades over time but you can get six, seven, eight years of 2%-3% tax alpha, it pretty much dominates a straight ETF portfolio or straight index mutual fund. It’s tough to make it scalable until the technology kicks in, but every year that goes by, it becomes more and more efficient to run more and more of these portfolios.

Brookman – Yes, during my 12 years at Morgan Stanley, on the wealth management side, we drove a lot of the move to separate accounts. The mutual fund is an antiquated vehicle. It’s convenient for broker-dealers, because of the revenue sharing that you can get out of it, but slowly but surely everyone’s moving to institutional shares.

We talked about this at our conference the other day, the actively managed ETF is not what everyone thinks it is; it’s not a regular passive index. And if you’re going to manage it, you’re not going to get the transparency, you’re not going to get a lot of things that people want. The irony is separate accounts are exactly what everyone is looking for. They want transparency, they want to be able to take distributions in kind easily, and they want tax efficiency. There are these unified managed account platforms that exist out there that do tax overlay. They can be done at the broker-dealer side.

Van Eck – International shares are a problem in separately managed accounts, so you’ve got to use American Depositary Receipts (ADRs) and separate accounts, unless you get creative and create no-fee mutual funds.

On the subject of the death of ETFs, you just have to put some caveats in there. For some asset classes, ETFs offer greater liquidity than the underlying securities. So, we have this in a local emerging markets local currency ETF. If you’re an institution and you’re trading $30 million, it’s stupid for you to go to a broker and buy the underlying bonds when you can just trade the ETF at a penny wide spread. Then, if you have a taxable investor and an active, high-turnover strategy, ETFs are awesome for that. If you have a high-turnover strategy, you can’t tax loss optimise your way out of that one if you have a separately managed account. So, there are use cases for ETFs. I don’t think they’re going to go away, but I’m not fighting that trend in the conversation, and if you’re a non-taxable client, then it doesn’t matter.

Funds Europe – Looking solely at the North American market, do you anticipate any changes in the dynamics of the market and investor needs?

Lafferty – At some point the pain comes back and people have to have a recognition of risk management. I don’t see how you can do $17 trillion in global QE, take interest rates to zero, take them negative across the yield curve around Europe, and I cannot believe that that hasn’t forced investors into portfolios that are above and beyond their risk tolerance. At some point in the future there’s going to be a shift, there is going to be a bear market, we don’t know when, we’re not quite in the recession camp yet, but there inevitably will be a recession. I have to wonder how many clients have been forced into portfolios that are not appropriate for their risk tolerance because the option was to buy a negative yielding bond, or they were forced to take their private equity allocation from 5% to 15% because the option was to own a 2% ten-year treasury when the discount rate on their liabilities is 7%.

Ehret – Also where I’m starting to see a shift is in investors’ reliance on the whole concept of benchmarking. From institutional North American clients, downstream to all investors, they don’t think of, for example, an EM allocation as an EM allocation any more, they think about where specifically they’re going to invest their EM dollars. They are questioning the whole concept of what is a global benchmark and does it make sense? Maybe it’s been useful for measuring my strategic asset allocation, but they have to somehow figure out how to translate that into a workable investment in maybe Brazil, India and China, or some other combination of the various countries. I do think that if you look back in the 90s and early 2000s, all the global consultants were talking about global benchmarks and saying, ‘Get away from the style box, go global.’ We’re going to see that coming back because the connectivity of all those markets seems to be different.

Brookman – A goals-based approach is gaining momentum, especially in the retail and intermediary channel. Again, the big firms are pushing aggressively to get away from benchmarking; focusing on what the goals are and target them. That’s is what you should be looking at.

The other interesting one is a similar point around risk. I ran a consulting firm for some years, and the hardest thing a client could ask was, ‘Why am I allocated this way? Why am I buying these expensive hedge funds when I could be 65% in the S&P Index and 35% in Lehman Ag and outperform you for 2 basis points?’

The answer is, ‘Well some day that will change.’ When and if that change comes is a difficult question, and the more you plough fees into it or use hedge funds or anything else makes it tougher still. But when it does, it is the best way you could invest. I do think there will be a day where it will be the right strategy to buy gold and some of these other asset classes again.

Garland – We need to accept that clients’ portfolios will end up with 30%-50% in passive investments and that the portion being invested in active funds will shrink. This is a structural shift and as an active manager, we need to focus on offering concentrated high-conviction portfolios with a high active share.

Van Eck – Maybe for big active shops, but in my next life I want to be an active manager, just give me five or ten stocks I can own. There are so many companies that are under-researched right now. The sell-side is just getting weaker by the year. I don’t know when that changes the overall dynamic, but I think that would be really fun.

Funds Europe – Do people trust the funds industry and what needs to be done to improve this?

Garland – No. We need to be more transparent and create clear outcome-based solutions for clients.

Van Eck – I have to give my idiosyncratic answer to this. My biggest concern about the fund industry is the concentration of ownership of corporate America. The top four asset managers – State Street, Vanguard, Fidelity, BlackRock – own 20%-plus of the stock of a lot of public companies and it’s going to be a big issue at some point, period. It’s because their ownership is increasing as their market share increases, and it’s going to be a political issue. It’s on the fringes, but I can tell you that there’s a cottage industry of lawyers, law professors and some economists talking about it. No one, I think, wants those companies running corporate America.

Brookman – But their obligation from a stewardship perspective is in conflict to that, right? So, it’s a huge issue, I see that.

Van Eck – Where the rubber meets the road is that for antitrust purposes, if one owns over 5% of a company’s stock, one has to be ‘passive’, but I don’t always know what that means. The concept of passive has gotten very confused these days because boards are meeting with big shareholders, whether active or passive, talking about ESG [environmental, social and governance] and all kinds of different topics, and it’s not transparent what’s going on there, and it’s potentially conflicted.

So, I just think that politicians will come in one day: that’s one of my concerns. I don’t have a proposal, but I do think the industry has got to figure out what appropriate behaviour is.

Brookman – There is trust in the industry, but I don’t think the general public trust Wall Street. This was a big thing for me personally, in 2008 and 2009 during the financial crisis. As asset management firms or wealth management firms, we did the right thing for our clients.

I get really passionate about how we help our clients – whether they’re retail or institutional – how we help meet their goals, dreams, aspirations, provide for generations, all that corny stuff. But we really do that. When people tout how bad and evil Wall Street is, and our industry is tainted with that brush, I think it’s unfair.

What we aim to do, I think, means people trust our industry, because there have been so few blow-ups. Yes, there are a handful of them, and a couple of the hedge funds and Ponzi schemes and things like that, but I think overall, our industry is pretty well thought of.

Lafferty – We have some data on this. We survey investors and advisers and asked them, ‘Do you trust your financial adviser?’ And it’s a lot like Congress, they don’t trust the industry as a whole, but they love their congressman. So, when our data showed that when you asked them about their adviser, over 90% of them registered some reasonably high level of trust. When you asked them about advisers in general, that number falls to 65% or 70%. So, it’s reasonably high, they don’t have a huge problem with the advisory practice, they like their adviser more than they like the industry as a whole.

Ehret – To address trust, there is also a one-client-at-a-time type of work you have to do. In the last four years, we have probably gained 25 clients who are strategic partners, relying on us for advice on how they run their business as well as investment strategies, and I think that trend is increasing. The desire of our institutional client base, as well as financial advisers getting real advice from their asset managers, has grown, and that can put a strain on a firm’s resources at times. But there’s an opportunity to heal the wounds of the global financial crisis through those partnerships.

The demonstration of how you work and partner with your clients will always overshadow anything that’s as self-serving as us saying, ‘You should trust us.’

Funds Europe – If there’s one thing you’d like to change about our industry, what is it?

Garland – We need to work on explaining the value of active management and not allow passive to be seen as the only investment option.

Brookman – My one wish is to improve perception of our industry. This is a great industry that helps people every single day, and it should be ahead of dentistry in terms of public perception.

Lafferty – If you read the media, the casual reading is ‘passive is cheap and good and active is expensive and bad’, and we need to try to balance those scales. I wish the financial media would write as much about where active is outperforming.

But I get it, we’ve all had media training, if it bleeds it leads, and frankly, saying that you’re overpaying and not getting value is a far more interesting story than you paid and got value for it. That was what was supposed to happen. So, we would like to see a more balanced narrative, and there’s nothing about this argument that is any way designed to downplay or mitigate the good parts of passive. We are huge believers in passive, we just think the narrative has become completely unbalanced.

My back-up choice would be technology. The industry has just been slow. Other industries are really ramping up technology, we are doing it in fits and starts because it’s kind of been a high-margin business and we don’t really want to bring a lot of technology too quickly to what we do. That would be my back-up choice.

Van Eck – Scepticism. I feel like we fall into paradigms of the ways of thinking about the market right now. I’ll give you an example: growth versus value. So, there was a study 20 years ago that said that value always outperforms and those huge asset managers that are biased towards value. Yet growth has beaten value for many years. I don’t think anyone knows why. I don’t know why, and I really don’t believe anyone has sufficiently explained it. Just because one study came out or it worked for 30 years, doesn’t mean it’s going to work for the next 20. The financial markets reflect a changing world, let’s just be a little bit more broadly sceptical about the future.

Ehret – I would say the whole argument that equates scale with success. The whole concept that big is always better in asset management is usually touted by the very large firms themselves and can be a backwards argument, especially in active management. Managing more money in an active portfolio doesn’t necessarily mean you’re going to have better performance.

Scale has to reflect who and what you are and what you’re offering, it doesn’t necessarily have to mean you have to be big. This actually does have a negative impact on investors as well. For example, if you can only be a certain percentage of a fund and let’s say you pick a middle-market private equity fund – how big should a middle-market private equities fund be? Maybe that fund shouldn’t be a big fund by nature of its investments, but maybe it’s still a good investment for you. Maybe it shouldn’t be any bigger than $800 million or so, but now you are constrained by the size. Scale has been forced to be the mantra of our industry and it’s sometimes counterproductive for our clients’ success.

©2019 funds europe



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