The Future Of Asset Management
By: Eric Brandhorst
Modern portfolio theory has spawned a number of investment strategies and instruments that have materially changed the investment landscape. These have set the stage for broader and more significant changes in the way investment portfolios will be structured writes Eric Brandhorst of the Structured Products Group at State Street Global Advisors.
The way that investments are managed will fundamentally change in the coming decades. The changes will unfold as investors and managers seek out portfolio structures that maximize the likelihood of meeting investment objectives. Although the changes will unfold incrementally due to the presence of entrenched institutional practices, the pressure to efficiently capture asset class risk premiums, add value in portfolios, and minimize costs will lead to significantly different portfolio structures. Both investors and managers stand to materially benefit from these structural changes.
In this new structure, the market return elements of a portfolio will be managed entirely apart from skill-based efforts to add value in portfolios. In other words, market-level risk premiums will be captured through passive management, while efforts to add value with skill-based management – in any asset class – will take the form of pure value-added devoid of persistent asset class exposure. Pure value-added strategies would typically take the form of a combination of long and short positions reflecting the relative valuation insights of a manager.
Modern portfolio theory has, in recent decades, spawned a number of investment strategies and instruments that have materially changed the investment landscape. For example, passive investing plays an increasingly important role in many portfolios and derivatives are a commonplace tool in exposure and risk management.
These and other innovations have set the stage for broader and more significant changes in the way investment portfolios will be structured. The important implication of these financial innovations is that they provide investors with the ability to separate efforts to add value from the job of capturing market returns. The historical shifts toward passive management relate primarily to arguments that support use of passive strategies vis-à-vis active strategies.
In contrast, future changes in portfolio structure will come about at the hand of investors who embrace the idea of active management. Ironically, investors most focused on the objective of adding value in portfolios will generate – among other things – a significant increase in the use of passive strategies.
Traditionally, investors have utilized strategies with the combined objective of capturing asset class returns and some attempt to add value. Investors usually provide a chosen active manager with a benchmark that represents a subset of the strategic asset allocation within either the riskless or risky asset portion of a portfolio. From an aggregate investor perspective, it is clear that incorporating positive valueadded into portfolios is the most daunting challenge since the average effort to add value fails to do so.
The challenges investors face in identifying truly skilled managers is the primary motivation for what will be a dramatic shift in the way portfolios are structured. Traditional structures in which investors aim to both capture market returns and generate value-added fall short of this goal because the portfolio structure fails to treat identification of skill as a distinct and separate priority and because the opportunity set of skill-based managers is unnecessarily constrained.
Identification Of Skills
Another significant shortcoming of the traditional investment structure is the fact that the identification of skill typically occurs within narrowly defined subsets of asset classes after strategic asset allocation and assessments of asset class efficiency have taken place. The traditional process significantly handicaps the search for skill by shrinking the opportunity set of skilled-based managers to those who are believed to add value in the context of narrowly defined subsets of an investor’s strategic asset allocation that meet efficiency criteria. Given the fact that over half of all efforts to attempt to add value in portfolios fail, the constraint imposed by attempting to add value within the strategic asset allocation is onerous and unnecessary.
An important benefit of this new structure is that both asset allocation and identification of skill become distinct priorities in the investment process. This realigns the investment process from a linear process to a parallel process where asset allocation and skill identification each independently unfold as a top priority. The effect of the realignment is to allow both strategic asset allocation and the search for manager skill to unfold with as few constraints as possible. As is the case with any analytical problem, removal of constraints allows a better solution to be identified. In this case, opening up the opportunity set of skill-based managers represents a non-trivial improvement in investors’ ability to identify skilled managers and capture market returns.
Identifying skilled managers is not the only part of the investment process that suffers from constraints imposed by the traditional investment process. The benchmarks imposed on skill-based managers often prevent managers from realizing the full value associated with their investment insights. Constraints imposed on managers come in many forms and include capitalization-neutrality, long-only requirements, universe limitations, sector/ industry neutrality, and risk factor neutrality. While the imposition of constraints is an understandable response to the dual goals implied in the traditional investment process (capturing benchmark returns and managing active risk), it comes at a potentially high cost.
In a recent paper,1 Roger Clarke, Harindra de Silva and Steven Thorley illustrate just how costly the imposition of typical constraints can be. A long-only constraint alone can reduce the forecasted excess return by 42 per cent. Hence only 58 per cent of a manager’s insight is reflected in a portfolio simply due to a limitation on portfolio construction. Additional constraints can wipe out nearly 70 per cent of manager insight.
The separation of market returns and value-added represents an entirely new way of employing the building blocks of portfolio return. Its material benefits include:
- The search for skill-based managers becomes a distinct priority on par with the goal of achieving the appropriate strategic asset allocation.
- The opportunity set of skill-based managers increases as all managers who seek to add value are considered for inclusion in the portfolio.
- Constraints on individual managers are removed, ensuring that manager insights are fully reflected and realized in portfolio returns.
- Risk management is simplified as asset class returns are separated from active risk exposures.
- The pricing of manager skill is more straightforward since portfolio manager roles are better defined and de-coupled from the goal of achieving asset class returns.
- Transaction costs are reduced since active risk management does not induce transactions in market exposures and asset class rebalancing takes place in fungible passive strategies.
Despite the potential benefits of a shift towards the new portfolio structure, several challenges may affect the pace at which industry participants make the switch. For example, the universe of skill-based managers who embrace the idea of pure valueadding strategies is limited. Investors may simply be unable to identify traditional institutional money managers who are willing and/or able to translate their investment insights into an unconstrained, pure valueadded space. Most active managers who are currently focused on pure value-added are hedge fund managers. Opening up the playing field to all skill-based managers, including the hedge fund universe, can be daunting.
Investors may not have resources in place to evaluate and monitor such a large opportunity set. Investors have not necessarily developed a comfort level with the variety of tools employed in pure value-adding strategies such as short positions and leverage. Some of these techniques introduce complex risk scenarios which are difficult to evaluate or even detect. Certain risks are, by definition, unique to the specific area of manager expertise and are often invisible until certain unforeseen circumstances bring them to light.
Managing the implementation of the new structure can be made more challenging if skill-based managers selected are not fully market neutral. This simplest way to implement the new structure would be to hire passive managers for asset class exposure and market-neutral skill-based managers to achieve pure value-added.
However, to the extent that skill-based managers are not fully market neutral, investors will need to control for asset class exposures (beta) embedded in active manager portfolios. In addition, investors may wish to use derivative instruments to gain asset class exposure on fund assets allocated to skill-based managers.
Finally, the challenge of finding skillbased managers who can add value over time remains daunting. While the new structure will both allow manager insights to be more fully reflected in portfolio returns and enhance the ability of investors to detect whether a manager has true valueadding capability on an ex post basis, finding skilled managers in advance will still be a challenge.
Nonetheless, these challenges do not outweigh the potential benefits associated with moving to the new structure. In fact, the advantages of the structure are so unambiguously positive that a shift in that direction is inevitable.
Eric Brandhorst is director of research in the Structured Products Group at State Street Global Advisors.
1. Clarke, Roger, Harindra de Silva and Steven Thorley, 2002, “Portfolio Constraints and the Fundamental Law of Active Management,” Financial Analysts Journal (September/ October), pages 48-66.
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