Costs, Cost/Benefits and Value Destruction

Have we lost our way?Anne Cabot-Alletzhauser

June 2016

Let’s use today to really get to the heart of the matter

How did we get into this

mess?

What’s wrong with the

model?

How do we get out of this

pickle?

If regulators decreed that all-in fees were capped at 75 bps

We would survive as an industry (Most of us)

How did we get into this mess?

The origins of modern day

asset management

Understanding the

concept of fiduciary

“No man can serve two

masters”

How we got to fees based

on AUM.

“Don’t worry your pretty little head young lady….we’ll take care of

you”

And they did….establish cash flow first, invest surplus in “special interest shares”

How did we get into this mess? – financial planning 1970’s

Impact of democratization of investing

Traditional wealth management

model

Stronger regulatory protections

make mutual funds accessibleShift from DB to DC

Discretionary:

Advisers focused on cash

flow matching first, then

invested the surplus into

individual shares

DB schemes

Source: Investment Solutions

Exponential growth in mutual fund

(unit trust) industry

DC schemes to provide top-ups

Equities being touted as the

antidote to inflation

Performance objectives –

benchmarks, competitors &

performance tables

Emergence of multimanager fuels growth in specialist

mandates

Academic insights into performance drivers expands

exponentially

Bull markets of 2000’s drives all asset classes – making

balanced managers appear as kings

Performance outcomes

become primary driver of

fund flows

Intense debate about

“ethical reporting”

Harsh reality was technology

limited any other option to

past performance criteria

First passive funds are

introduced

As the world turns…for Asset Managers – what changed

over the last 30 years

How business models changed

Fees on AUM

Asset Mgt as profession morphs into Asset Mgt as business

Managers rewarded on benchmark outperformance

“Codes of Ethics” relax

Financial service companies as listed companies

Asset managers absorbed by financial service companies

Asset gatherers vs. alpha hunters

The rise of performance fees

Industry pushed back call for “fiduciary” designation

How we learned about what

drives performance outcomes

1974 William Sharpe – Adjusting for Risk in Portfolio Performance

1975 – Charles Ellis and The Loser’s Game

1987 – Barr Rosenberg: Multi-factor Risk

1989 – Grinold: Fundamental Law of Active Management

1992 - Contribution of style –William Sharpe

2001 – Generalised fundamental law of active management – transfer co-efficient

What drives performance

What drives performance

2.3%0.315.0%Multiple Constraints

3.7%0.495.0%Turnover limit 25%

3.5%0.475.0%Market-Cap Neutral

4.3%0.585.0%Long only

7.3%0.985.0%Unconstrained

Expected Active

Return

Transfer Co-

efficient

Active RiskPortfolio

Constraint

A

- 70%

reduction

in

performan

ce

The more concentrated the market,

the lower the transfer co-efficient =Less performance from

manager skill

Source: Clarke, da Silva, Thorley 2002

How well do we understand…

Source: Michael Mauboussin 2010

What factors determine whether activity driven more by skill or luck?

• Can you intentionally lose? If so…indicates skill required

• Does practice improve outcomes?

• Do outcomes revert to the mean? If so….luck element high

• Is there evidence of transitivity? If “A” beats “B” and “B” beats “C” then “A” should beat “C”

• How many factors involved in path to success?

Is our world changing?

The rise of the

professional

asset manager

and it’s impact

on performance

The need to

reinvent “active”

management

Is our world changing?

Story grafting

Shrouded

attributes

How bad can the impact of costs be?

3%

15 %

34%

Assuming manager has

50/50 skill, if costs are

1.5% only 15%

probability of investor

success

This is not an argument for passive,

There is no such thing as a purely passive

investment

You still have a target to hit – how will you get

there?

Someone has to determine the asset mix, the

indices to use, the allocations over time

The key to unlocking the true value of a

professional manager is to find the solution that

has the highest probability of meeting your

funding goal

Costs matter – understand them

This not an argument for passive

It’s not about highest return

It’s about matching the strategy to the time

frame and the certainty you require that you will

get there

Income, protection from loss, growth, liability

matching all demand different investment

strategies

The “new active manager” who wins this game

will be the one who can put it all together

Who is responsible for member outcomes?

The World As We Know It

Employee

Benefit

Consultant

Actuary Asset Consultant Asset

Manager

Administrator

Function Structure of the fund

Benefits Structure and

delivery

Fund administrators

Asset/liability

modelling exercise

Structure the investment

solution to meet member

needs

Identify who the best blend of

managers would be

Manage the assets Member record

management

Output Fund rules, fund policies

Benefit payouts

ALM output with

strategic asset

allocation solution

Monitor performance, monitor

compliance

Alpha

Beta

Benefit statements

Projection statements

Reality of

role

Spend more time doing

administration functions

than showing necessary

value-add.

Only large funds

typically request

ALM’s

Spend more time

selecting/defending/switching

managers than assessing

whether members are

meeting their goals

Great marketing

Time

required

Quarterly

Semi-annual

Annual

Once every three

years

Could be daily valuations but

more likely, financially

insolvent

Daily focus Daily

Charge

structure

Retainer / Fee Set Fee i % of AUM Variable: % of payroll,

per transaction etc.

How costs distribute in a pension fund?

Cost allocation on basic

off-balance-sheet fund

Consulting = 5.6%

Asset mgt = 39%

Cost allocation after 30

years

Consulting = 2%

Asset Mgt = 79%

The Great Pension Fund Conundrum

A problem –

The Value Chain (2002 discussion):

Consultant Investment

Manager

Broker Custodian Performance

Measurer

1 1/2 1/21527 3

Source: Watson Wyatt

Does the fee structure influence how seriously each participants’ role is taken?

Does it make sense that we reward the consultant’s contribution the least?

Who has the best models

and highest R + D expenditure?

Trading Houses ConsultantsAsset Managers.

Time frame

Importance

funding

est. time to

dismissal

day trade yearly 40 years

12

1 day three years ?

Perhaps it’s time we considered a new model

The case for the uber consultant

Until government policy can

fill the gaps funds have a

serious need for “gap

closers”

Will our clients pay for it?

But will regulators allow it?

The uber-Consultant Model

Manage employer policy

and fund policy gaps.

Provide the relevant

analysis of the membership

demographics and

behaviours to establish:

member needs,

suitable targets,

suitable default solutions

and

a suitable asset allocation

and investment solution to

meet member liabilities

Define and manage risk

budget for the fund’s

investment strategy.

Consider appropriate platform

and cost structure to address

member profiles

Monitor member progress to

established goals.

Measure and monitor impact

of trustee decisions on

member outcomes.

Ensure appropriate

communications of all these

points to all relevant

stakeholders.

The uber-Consultant toolkit

Asset liability modelling tools,

Risk budgeting and risk

management tool,

Aggregated reporting and

attributions analysis for funds,

Tools and models for member

projections and for building

asset class return

assumptions.

Member progress monitoring

tool

Strategy stress testing

Here is our real challenge

What if regulators capped fees at 75bps all-in?

How would companies cut back to accommodate?

The solution

Compulsory Investments Mandate “Active” design of solutions that

algorithmically adjust exposure to different building blocks to meet goals Growth

Income

Capital protection

Designed around a risk budget

Selection (or termination) based not on performance but ability to maintain control and meet goals

Why do we gamble with compulsory funds?

Discretionary Investments Mandate Manager can charge whatever

they believe is fair for their value-add

Traditional highest return for specified level of risk

Or..whatever

Go for it!

Combining our uber consultant with our goals based

manager (using compulsory savings mandate)

Manager focuses on outcomes – all the way down to the member outcome

In aggregate we should be able to reduce costs

Asset manager fees would most definitely come down but should also compensate investors with better risk-adjusted returns

On the consulting/actuarial side we’ve streamlined and focused the service to deliver measurable outcomes

This now warrants a more serious compensation consideration

The solution

Where does that leave us? Costs need to come down….!!!

We are paid too much for

doing the wrong job and

too little when we need to

do the job right

As an industry we are

spending money on the

wrong things - costs

balloon to support

elements that add little

value

Where are the regulators

on demanding that our

“vehicles” are

“roadworthy?”

We pay high costs for

compliance – but have

we considered whether

this is the right

compliance

Give us the cap – Get the right message out

then let us get on with it!