US ROUNDTABLE: One regulatory regime, almost

Our New York panel discusses difficulties with international distribution, plus we hear a cautionary tale about factor analysis.

Thomas Darnowski (head of product development, Schroders)
Jonathan Doolan (principal, Casey Quirk)
Jan Van Eck (CEO, VanEck)
Richard Garland (managing director, global adviser, Investec Asset Management)
Jeff Klepacki
(head of distribution – Americas, Aberdeen Standard Investments)

Funds Europe – Is global regulation harmonised enough to facilitate product development in a way that one product can be duplicated in numerous jurisdictions, therefore lowering costs and gaining efficiencies for asset management businesses?

Richard Garland, Investec – It is a challenge. We have a range of funds in South Africa, Oeics in the UK, funds domiciled in Luxembourg – and we’re also just launching our first 40 Act fund in the US.

The challenge is trying to fit round pegs in square holes. A Ucits fund sold in Hong Kong will need certain regulatory restrictions added, and for Taiwan there is a limit regarding how much can be invested in high yield. It’s difficult to apply a one-size-fits-all approach that would gain efficiencies and lower costs, but I would say Ucits is the best model the industry has, though that could change over the next ten years.

Jonathan Doolan, Casey Quirk – On the institutional side, the ability to sell a common product varies dramatically around the world because of differences in an institution’s need to immunise or manage liabilities. Fiduciary management is the model that has emerged and within that, customisation is absolutely key.

On the retail side – where the vast majority of growth is projected to come from over the next five to ten years – the regulatory environment is about customer protection and consequently, the many different structures around what a firm can package. Recenty, alpha has come from less liquid assets and sophisticated products, which are much more difficult to make democratically available to a wide range of clients.

Jeff Klepacki, Aberdeen Standard – There is probably no one vehicle that’s incorporated globally, but regionally there are high levels of acceptance. Here in North America for offshore clients in Latin America, a Sicav registered in Luxembourg is our vehicle of choice. Cayman-domiciled structures for our alternatives platform – which is typically sold through private placements – have generally worked as a holistic approach,

Local manufacturers find it easier when competing with global businesses in their own market. Suppose you are an asset management entity owned by a global bank; the global bank may be domiciled overseas with Basel III capital requirements and so even when trying to fund seed capital, the internal costs of borrowing are a barrier due to how internal charters match with local regulation.

Thomas Darnowski, Schroders – While there is greater consistency now than in the past in the application of different regulations, specific product structures continue to be applicable in only one region, country, or eligible for one type of investor.

Jan van Eck, VanEck – But from an ETF perspective in terms of product development, there is almost one global regulatory regime – the SEC/CBI [Securities and Exchange Commission/Central Bank of Ireland] structure. The vast majority of ETF assets are either in US 40 Act vehicles or in Ucits formats.

However, it is the distribution, customer, and regulatory requirements that are becoming a challenge. Even in the US we have a liquidity rule, which is now a problem. On one extreme, product development is easier; but on the distribution side over the last year, it has become harder.

Garland – Here is a tangible example. In Hong Kong there are ‘D’ funds and ‘non-D funds’ – meaning derivative funds and non-derivative funds. We regard a multi-asset income fund of ours to be non-derivative, but one of our distributors did their own analysis and said it was a D fund because the fund does use derivatives. They disagreed with our view that the derivatives were only for efficient portfolio management. Suddenly you can only sell the fund to sophisticated investors – yet we sell that same fund to retail investors in Taiwan, Singapore, Italy, Spain and the US.

It means we have to consider whether to launch a new fund for the retail market in Hong Kong that doesn’t use derivatives, leading to a loss of size-related efficiencies.

Doolan – Even the asset-servicing costs driven by customisation that are required to compete effectively have yielded difficult and swollen operational models.

A firm has to customise products for large clients, and then consider how regulations will affect or water down that product for the mass market and take on board biases within specific geographies.

For example, a target-date fund built in the US versus a life-cycle fund overseas is going to look quite different. It may aim to achieve the same growth objectives, but how that aim is realised is very different.

Klepacki – Intermediary distributors will have their own set of client bases with different appetites and needs requiring different wrappers. Intermediaries tell us they want to work with fewer manufacturing partners – such as ETF or 40 Act providers – meaning they want a fund in six or seven different wrappers to meet the diversity in their client bases. The product development challenges are vast.

Garland – It’s a crucial point. If you can’t serve a global bank globally with all vehicles, they don’t want to work with you. Certainly this creates challenges for boutiques. This is one of the reasons we are about to launch a 40 Act mutual fund in the US. This is not something to be done lightly.

Doolan – In the past 18 months, we have been brought in by firms to look at their product development capabilities. What we have found is that historically, product development has been built off of the back of a team of strong administrators and process-oriented professionals who could take a firm’s capabilities and package them in many different ways for diverse sets of clients.

Firms were spending little time thinking about innovation or speaking to representatives from different distribution channels and geographies; talking with different investment professionals about differentiating a product; or having a forum with the CEO to understand where the business is going in terms of its strategic direction.

A lot of our work today is to engage with management to change product management to encapsulate the life-cycle of products from conception through rationalisation. A lot of this will come by elevating the role to focus around integrating business strategy and providing it the necessary accountability and governance rights.

Funds Europe – Does fintech offer any kind of solution to the uneven landscape for building products internationally?

Garland – No. There are different regulatory viewpoints on different instruments and technology can’t solve that. In the US it’s getting more restrictive, in Asia it’s getting more restrictive. Ironically, Ucits is going the other way: you can invest in too many different things, which they do not want in Asia because it is too complex.

Funds Europe – The quest for yield is still a major force in product design and demand. What innovations is the industry seeing?

Doolan – An interesting area of product creation is in direct lending for infrastructure and real estate. Of all the places you’d look for innovation, you wouldn’t expect it here. Insurers have been plucking out teams from the general account teams that have been able to identify enough capacity to sate the appetite of not only the general account holders, but also third-party clients. Many firms are being thoughtful about how to identify and package yield for institutions and procurers.

Garland – But the problem is that there is now not enough issuance. Money is raised with a target yield, but there are not enough bonds to invest in! Also, investors don’t like lock-up periods of five to seven years.

Darnowski – Income continues to be a solution that is heavily sought after in the current market environment. Income portfolios of yesterday are not the same type of income portfolios that are available today, as the interest rate environment is much different now. Therefore, the innovation in product design has been less about finding the ‘silver bullet’ and magical solution that provides the highest yield and provides for the lowest risk, but educating clients and investors on the yield, total return, and risk trade-offs that come with different income solutions. At Schroders, we have a suite of products that are geared towards providing investors a reliable higher income, but come with different expectations of risk in order to achieve that desired result.

Klepacki – We’re seeing investors diversify their sources of income and we’ve had some great success in the last 12-18 months with an Indian bond fund that invests in investment grade credit and, at the time of this conversation, had a yield of 7% for the dollar version. People are using it as a replacement for high yield and as a complement to their existing fixed income portfolio.

Garland – Money is going back into emerging markets and local currency debt. The basic view was that the dollar was, in theory, weaker while emerging economies were growing. But two to three years ago, EM local debt returned around -14%. People viewed it as a fixed income investment and now want alternative sources of income – multiple sources that might include convertibles, preferred shares and Reits. This is partly because people want a bond replacement for the upward trend in rates.

Doolan – Technology platforms have been able to marry individuals with debtors looking for a loan. They can find lenders willing to take on some risk, identify a mutually agreed-to interest rate, and then directly lend. This is true innovation, but it is hard to scale up and effectively manage risk. It’s difficult for an asset manager to take advantage of it.

Garland – Investec started in South Africa, so we have an African private debt fund that lends to African corporations outside of South Africa. We lend in dollars, meaning we take away the currency risk, which is the only reason it works. It yields 9%-10% – but institutions want a premium for lending to an African institution.

Van Eck – I am concerned about innovation in the short-volatility area. We developed an alternative income concept for an ETF which was a ‘put-write’ ETF. It took two years to design, but we decided not to launch it. Our concern was the market environment of very low volatility. The skews are bad, and frankly I had a really big concern that too many investors are writing puts. There is not enough visibility there, and I’m worried if there’s a major spurt in volatility.

Garland – In places like Taiwan and Hong Kong where we are competing against deposits, people want high income funds. They don’t care about the capital return; they want the high yield number. There are funds paying out income of 8%-9%, and a portion of the income comes from capital. So, yes, it’s income, but at what cost?

An investor may be better off having a good capital growth fund and redeeming units every month. But it’s always the headline yield that people look at.

Klepacki – Clients can get lost in the risk they’re taking to get a yield. Consistently, the bigger yield number wins. If one bond fund has a five handle and one has a four, you’re going to get more business, regardless of how it is that you achieve five. I don’t think some investors realise there are unrated securities in some of these funds and they are risking a high level of defaults.

Garland – And there is the liquidity issue. If there were a run on these funds, who would make the market? If there were a slew of redemptions but the banks weren’t making a market any more, spreads would widen dramatically.

Doolan – With so much ‘dry powder’ out there, there is a lot of cash to put to work – and there is a promise offered to clients that you’re going to hit the stated bogey. Given these conditions, it is uncertain how investment teams will be able to maintain their return target discipline and actually deploy the capital raised. It’s remarkable, actually, and indicative of how many illiquid funds are now closed and not taking on new capital, which they could very easily do.

Van Eck – Going back to the question of innovation, we came up with a ‘fallen angel’, high yield ETF strategy that simply buys bonds when they’ve been downgraded from investment grade. It beat the index last year by 10% because it was buying energy bonds without constraint in the first quarter of 2016; it went from 4% energy to 25% energy.

My point is that there are extremely few raw strategies in fixed income relative to equities.

Funds Europe – The vacuum of bank lending in recent years has prompted the development of non-bank lending vehicles. How is the asset management industry in your region responding?

Darnowski – The private debt market, specifically as it relates to loan portfolios, has been a growing area of interest. In the current interest rate environment, building a fixed income portfolio for investors has become ever-more challenging. That is why some less liquid structures, for some private debt strategies, have been in demand.

Doolan – It’s growing as fast as it can but the reality is that lending is not nearly as scalable as the rest of asset management. It takes a lot to build the infrastructure and identify the kind of debt you want to build your business around. This is where, as mentioned, insurers have hit the ground running relative to their peers.

Other firms have picked up small niches in the market where they look to become specialists and scale up to the extent they can.

The appetite from the client perspective is there, no doubt; it’s a question of how asset managers effectively react.

Klepacki – Although investment opportunities are starting to dry up, we’re seeing partnerships in areas like infrastructure and private/public market partnerships. As a firm, we are doing some things in the Andean region of Latin America related to hospitals and different levels of infrastructure building. There is money going to work there and there is so much cash on the sidelines.

Yes, the banks have been more strict on their lending policies, but it seems to have really hit the real estate market more than any other area. To be a commercial developer, it has been extremely tough to get a loan due to the regulations the banks now have to contend with.

Private equity/private capital has stepped in to close that vacuum for the time being.

Funds Europe – How fierce is the battle between active and passive in North America?

Klepacki – The criticism is debatable. The industry is coming out with new types of measurements for active management, such as ‘active share’ and the ‘R2 factor’, which shows how different a portfolio is from a benchmark and whether stock selection is adding value.

However, there are certain holdings that if you don’t own them, they are such a significant part of a benchmark that you can really miss out big if a particular stock takes off. If Google is 5% of an index but half a percent of your portfolio, when it beats earnings you’re going to underperform.

Active share is like getting one side of a Rubik’s Cube white and thinking you’ve solved the whole thing! Investors need multiple data points to measure a manager.

Darnowski – Gone should be the battle between active and passive, as many investors have embraced portfolios that use both types of strategies. As passive strategies have gained share in large core areas of investors’ portfolios, actively managed strategies continue to gather investors’ assets in areas that have proven skill from actively managed strategies. There are some asset management firms that have embraced this dynamic and continue to grow during this ‘battle’, while others philosophically oppose the other side.

Doolan – Active and passive will always coexist, but the industry has seen managers charging significant fees for either the benchmark or some form of closet beta. This practice has now been called out. Investors do need those betas, but they’re now being much more thoughtful in how they construct portfolios and where they put their risk and budget. They are also being more careful about the fees they pay, given the difficult return environment.

ETFs have been linked to the growth of passive, yet passive has existed in institutional sophisticated portfolios for 34 years. In the past few years, we’ve actually seen outflows from institutional passive portfolios as they move towards more liability-oriented portfolio structures.

The retail mindset is now moving in that direction and ultimately, we’re finding the right balance in the retail universe between active and passive.

Garland – I tell our salespeople not to fight against passive investing as it is a pointless discussion. As active managers we need to survive by providing excess returns against a benchmark.

We manage a number of equity funds with active share in excess of 90%, which means that they complement passive funds.

Doolan – One of the real challenges has been short-termism – that is, evaluating the value of an active manager over a one and three-year period.

When I started at Casey Quirk 11 years ago, our benchmarking of different active product portfolios covered five-year, seven-year and ten-year timeframes. This is because the active value proposition is to outperform through market cycles, which are seven to 12 years. However, this has gotten shorter and shorter. Even a one-year number is asked for now. One year should not matter to most managers unless it is an absolute return product.

Klepacki – What would the average investor define today as a long-term investment horizon? It could be a year-and-a-half now whereas years ago it was ten, then seven, then five. In Asia, it could be just one month.

In 40 Act funds, Morningstar five-star ratings are indicative of a strongly performing fund and about 80% of all gross flow will go to them. Funds with three, two or one stars experience net negative outflows.

But how many five-star funds are trending downwards towards four or three stars? And shouldn’t we, as contrary investors, be looking at funds that are moving upwards from three stars towards four and five stars? Who is thinking about the allocation in terms of where a manager is in the cycle? This is a point that is lost on the average investor.

Van Eck – As an ETF provider, unfortunately I agree with everyone! It’s not just about active versus passive because even in passive there is a fee war and it’s really brutal. For broad exposures, there will be a move to zero fees.

Within various ETF categories people have used fee cuts to try and gain market share – but they don’t always succeed and I think the failure rate is increasing, particularly for small firms that larger distributors don’t really want to deal with. Investors are comfortable with the liquidity of some of the bigger existing funds and, possibly, higher-fee but established providers.

To the larger point of active versus passive, if we have a significant market correction, the heat may not be on active but instead on passive. Many commentators say that investors will be mad at their results from passive core funds like S&P 500 index funds. I would take the other side of that bet. Most actively managed asset allocation vehicles are not designed to go significantly to cash in a bear market, which means active funds may not have a significantly different drawdown compared to passive funds. People would have thought that if you were a ‘solutions’ provider, you would have switched funds and limited drawdown.

I would also point out that the market in 2017 is extremely odd. The low level of equity volatility is insane and there is just too much debt in the world for markets to continue to behave like this. At some point, and it could take years, I believe there is going to be a massive dislocation if US fiscal policies don’t improve.

Garland – Unlike what some active managers believe, a correction will not be the end of the story for passive investing. Investors are also using passive funds because they are cheap.

Funds Europe – Will smart beta form a part of all portfolio analysis or design in ten years’ time?

Darnowski – Similar to the assumed ‘battle’ between active and passive, multi-factor strategies do have a long-term role in an investor’s portfolio. Being able to add value in areas that are most akin to value being created versus passive is at the heart of an active manager’s philosophy, and multi-factor investing can be an efficient way to gain access to some trends and biases away from traditional benchmark-related passive strategies.

Klepacki – For a contrarian or a value investor, smart beta has a fundamental sensibility about it. Putting capital to work in a rising market, into a capitalisation-weighted index, you’re paying more money for a higher-priced overweight security versus a factor model, where you could be getting a bigger bang for your buck in terms of how you enter the market. It makes sense to a lot of people, so I believe in it to that extent.

I don’t know if it will be in every portfolio a decade from now – though I don’t know that I’d use it to construct a portfolio from scratch. When starting with all cash, I’d want to begin with inflation protection. I’m going to unwind my position into fixed income; I’m taking more risk with equities and I’m building out my portfolio based on a stated benchmark or result I’m trying to achieve. This becomes a different way to get there.

Van Eck – There is an overwhelming tsunami of launches in the ETF world of single and multi-factor ETFs, but let me give you a cautionary tale about factor analysis.

We have a quality-oriented ‘wide moat’ ETF strategy that’s outperformed the S&P over time and when we did a factor analysis without quality as a factor in the analysis, we found that all the outperformance was stock-specific risk, or alpha.

Then we used another analysis that included quality as a factor and sure enough, quality was the most important factor, though stock-specific risk was still a bit more important.

But over a five-year period, quality actually underperformed and the mathematical, factor analysis didn’t tell us why. So if you had bought a quality factor ETF instead of our wide moat ETF, you would have been very disappointed.

The industry will not be at a point in ten years’ time where it will study statistics if those statistics become disconnected from performance.

Doolan – My biggest concern with smart beta is it’s this amorphous term, just like ‘solutions’ or ‘outcomes’, and it’s difficult for me to really understand what it is. If it’s just some sort of factor you’re trying to replicate, if there is some sort of activity happening, then there is a question about how often investors should rebalance.

What I do believe is passive exposures that people want at the lowest fee will be used as building blocks in portfolios to sit adjacent to active, and active will come in all sorts of different forms built either by computers or individuals across the liquidity spectrum.

Garland – I’m a big sceptic of smart beta. If everyone is doing it, what’s so smart? All they are doing is taking an index, restructuring it and then charging active fees for passive management.

A lot of people we speak to are fascinated by factor investing, but I think it is another way of cutting and slicing a benchmark and will eventually be proved not to work.
I need to be very clear. I think smart beta is a fashion that will die.

©2017 funds europe



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