Twin pressures are likely to exert an influence on fund management over the next decade – the first is the legacy of the debt crisis, the second the impact of the retail distribution review, due to come into effect at the start of 2013. Both are already having an influence on the type of funds offered and are likely to shape the industry for years to come.
The debt crisis has depressed interest rates and lowered growth in developed markets as the debt is unwound. Lower interest rates have had the greatest effect for investors, who now have to move higher up the risk curve to achieve a comparable level of income to that generated by a straightforward savings account just a few years ago.
The fund management industry has come up with a number of solutions. The first is the enhanced income strategy, where fund managers employ a covered call strategy to enhance the yield of a fund. In general, this will top up a yield of 4-5% by 2-3%, depending on the strategy. Managers have been doing this on a smaller scale since developments in the Ucits legislation made it possible, but this is the first time specific funds have been created to house the strategy.
Global income has also become a popular route for income seekers. A growing number of global equity funds have been launched on the back of worries over increasing homogenisation in the UK equity income sector. The credit crisis focused investors’ minds on diversification as an increasing number of global companies started to pay dividends. Global income funds now have their own sector and have attracted significant fund flows.
Global income also seeks to address the weak climate for growth. It means income seekers are no longer confined to low-growth markets to generate a yield from equities, but can look to Asia or other emerging markets. Also, they may be able to bring about stronger growth in income because, in theory, corporates in those regions should be able to grow faster. A similar phenomenon is at work with the popularity of emerging market debt. A new asset class just five years ago, flows into the sector have run into billions as investors have sought an alternative to developed market government debt.
The post-credit crisis environment has also created a higher correlation between asset classes with which investors have to wrestle. A recent Morningstar survey showed that, “based on the average daily correlation over the trailing six months, correlations have risen from roughly 10% in 1994 to 66% at the end of 2011”.
The group’s research found S&P 500 sectors have also become more highly correlated with the S&P 500. Between 1994 and 2008, the average sector correlation
of monthly returns with the index was 69%, but that has increased to 84% over the past four years.
“Investors will have to look further afield for diversification into a broader range of asset classes and be more creative in the way they blend portfolios”
No single sector showed a fall in correlation. The least correlated sector, utilities, saw a rise in correlation from 38% to 67%. The correlation between large-cap and small-cap stocks was recently at its highest level in 60 years. The phenomenon also exists in domestic versus international stocks. Morningstar found betas have increased in line with correlation, meaning individual stocks’ responsiveness to the market has moved higher.
What should this mean for investors? It is likely they will have to look further afield for diversification into a broader range of asset classes and be more creative in the way they blend portfolios, ensuring they are genuinely diversified and take account of the shift in correlations over time.
A number of fund strategists have pointed out that “buy and hold” is unlikely to work in a low-growth, highvolatility market. Investors have to be on top of their portfolios and more nuanced in their asset allocation. Fortunately, these asset classes are increasingly available through absolute return funds, specialist investment trusts and other market innovations.
The retail distribution review is also shaping the industry. In particular, the increased focus on costs is likely to force a shape-up from some fund groups with small, under-performing funds.
The confusion between value and cost is discussed in the early part of Invest, but there is no doubt that the unbundling of charges will focus theminds of investors as to where they are getting value and where they are not. Mediocre active managers charging higher fees for unimaginative management are likely to be exposed by the changes in regulation.
This does not necessarily mean investors will demand to shift fund managers. Inertia is powerful across all parts of financial services, but this is a poor reason to be unprepared. Fund management groups are, in many cases, splitting their fund ranges into high-octane, alpha-seeking funds and lower cost semi-active funds that manage close to a benchmark, believing that, ultimately, this is what clients will be looking to buy.
The retail distribution review is also likely to expand the range of asset classes considered and employed by fund strategists. Under current guidelines,
to call themselves independent, advisers will have to prove they have considered all possible investments for each client. While this is contentious and still under review by the Financial Services Authority, investment managers are unlikely to be able to restrict their recommendations to a narrow range of unit trusts or Oeics.
More portfolio management is likely to be done by specialists – stockbrokers, fund of funds managers, discretionary portfolio managers – as advisers increasingly outsource this specialism. This should mean more sophisticated portfolio management and nuanced risk management. In theory, with more power in the hands of specialists, brand should become less important, which will focus fund flows on the genuine alpha-generators in the sector.
The one thing that might derail this is the vogue for model portfolios. Some have warned there is a danger that advisers place business risk over investment selection, leading to increasingly homogenised model portfolios, focused on a few big fund management names – the “no-one got fired for recommending IBM” problem.
However, ultimately better advisers will ensure their clients are getting genuine value for money from an outsourced investment solution rather than an off-the-shelf collection of big brand names.
The active management industry is changing, but it has proved remarkably adaptable in the past and is already demonstrating it is prepared for the new era.