10 Key Trends in Asset Management

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By Garry Evans

We are in an unusual investment world of ultra-low interest rates, swings between risk-on and

risk-off, and investors demanding yield, low fees and limited risk

This raises big challenges for the investment management industry. We identify 10 trends that

are shaping the industry from the decline of hedge funds and the growth of multi-asset

funds, to the relentless rise of ETFs and the stirring interest in ESG

These trends should be positive for credit, high-yielding equities and alternative assets (such aslong-term debt financing and structured derivatives products)

Disclosures and Disclaimer This report must be read with the disclosures and analyst

certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it

The 10 key trends changinginvestment managementand how they will affect asset prices

Multi Asset Strategy

September 2012
https://www.research.hsbc.com/midas/Res/RDV?p=pdf&key=zhuwZHuWML&n=344246.HTM


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The 10 trends shaping the investment world

We are in a very unusual investment world. Interest rates are at historical lows, equities more volatile

than normal, different assets classes abnormally correlated and demographics are altering savings patterns

in rich countries.

These developments have already caused big shifts in investment flows over the past five years. Investors

have switched massively from equities into bonds, moved their money into index funds and ETFs, and

searched for new ways to achieve return without too much risk.

In this report we look at how investor behaviour is changing and what this means for investment

management businesses. We identify 10 themes that we believe will shape the future of the industry over

the coming years. Not only is an understanding of these important for strategy planners at investment

management firms (and we held discussions with many CEOs and CIOs of investment firms in the

preparation of this report), we think these trends will affect asset prices too. Will the search for income

push down yields on credit to ridiculous levels? Will investors completely abandon equities because of

their volatility? Will demand for alternative assets (infrastructure financing, distressed debt, derivative

structures) push up their prices?

We believe that understanding these sorts of deep underlying trends in investment is important for asset

allocation. It is too easy to get caught up in the day-to-day movements of the economic cycle. Thinking

about long-term drivers, such as demographics, changes in wealth or market micro-dynamics, can help

improve investment decision-making. We believe the ideas and copious data in this report will prove

thought-provoking for anyone interested in understanding these shifts.

After an introductory section, which analyses the macro background and describes the state of the

investment management industry today including projections for its future growth each chapter of this

report details one of the trends, with our assessment of its implications of each for asset prices.

There are some common threads running through the trends. In brief, these are: the struggle to produce

income in a low interest-rate world (via credit, high dividend yield equities or illiquid investments); the

desire to tailor risk (though risk-minimising products and absolute return multi-asset funds); and the shift

to passive investments such as index funds and ETFs, which has begun to hurt hedge funds too.

Summary

How is a world of low interest rates, risk aversion and unusually high

correlations affecting the investment management industry? We

identify 10 trends changing how investors invest, and assess their

impact on the price of assets


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Our 10 trends are:

1. Average US BBB-rated five-year corporate bond

0

2

4

6

8

10

03 04 05 06 07 08 09 10 11 12

YieldSpread

The search for yield. With risk-free rates so

low, investors are desperate for income. They

have already piled into bonds. Credit remains

in a sweet spot, though issuers are attracted

by the low interest rates but, for investors,

spreads over government bonds remain

decent (Chart 1). We think dividend yield

stocks remain attractive, too. Many investors

argue its too late to buy them but in the US,in particular, income funds still comprise only

3% of equity mutual funds. Page 13Source: Bloomberg

2. Total return indexes* (log scale) since 1988

4.5

5.0

5.5

6.0

6.5

88 90 92 94 96 98 00 02 04 06 08 10 12

EquityBondCash

The death or rebirth of equities. Bill

Gross of Pimco says the cult of equity is

dead. But equities have actually outperformed

bonds over the past 10 years, although

admittedly with high volatility (Chart 2).

Perhaps a bigger risk which bond houses

are worrying about is the bursting of the

bond bubble: could 2014 be another 1994? At

the very least, with cash yielding zero and

high-quality government bonds 1.5%, it

seems likely that equity returns will beat

these over the next 10 years. Page 17 Source: Bloomberg, MSCI (*Equity=MSCI ACWI TR Gross, Bonds=JP Morgan

Aggregate Bond Index TR Unhedged USD, Cash=3-month T-bills)

Risk minimising strategies. Investors ideally would like equity-style returns with bond-like

volatility. Thats rarely possible. But fund managers are developing products that offer different

combinations of risk and return. Such strategies include: multi-asset funds, long/short equity

strategies, risk parity products, minimum volatility equity funds and using options to target a level of

risk. Page 20

The growth of multi-asset. The fastest growing type of risk minimising strategy, especially in the

UK, is the absolute return fund, most famously Standard Lifes GARS. Such funds target Libor-plus

absolute returns, with bond-like volatility and costs lower than hedge funds. They have their

detractors (do they really create alpha, or are they just leveraged bond funds?) but look likely to grow

further, even in the US where they have yet to take off. Page 22


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3. Cumulative net inflows into mutual funds worldwide (USDbn)

-600

-400

-200

0

200

400

600

800

01 02 03 04 05 06 07 08 09 10 11 12

USDbn

Passiv e Activ e

The shift to passive. A third of active equity

money has shifted into passive funds in the

past 10 years (Chart 3). We think passive

encroachment is likely to continue, since

active funds empirically underperform on

average (with higher costs). But indexing

strategies are likely to get smarter: some

indexes outperform others, for example the

equal-weighted S&P500 has beaten the

regular (market cap weighted) S&P500 by

37% in the past decade. Page 24Source: EPFR

4. Assets of exchange-traded funds (USDbn)

0

200

400

600

800

1,000

1,200

1,400

1,600

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012*

US Europe Other

The relentless rise of ETFs. ETFs have

reached USD1.5trn (up from USD105bn in

2001 Chart 4). But there are issues with

these, too. Are ETFs suitable for bonds?

Some overly sophisticated ETFs have blown

up spectacularly: will this invite the

regulators attention? The two keys for future

growth are (1) whether active ETFs take off,and (2) the trend of retail financial advisors

being remunerated by fees rather than

commissions on the products they sell (ETFs

dont pay a commission). Page 28 Source: Blackrock (*end-Jun)

5. Cumulative performance of hedge funds

100

150

200

250

300

350

00 01 02 03 04 05 06 07 08 09 10 11 12

HF index

L/S equityMacro HFs

The decline of the hedge fund? Hedge funds

have struggled to perform recently (Chart 5).

The average hedge fund is up only 2.5% so

far this year. The underlying problem is that

the hedge fund community has become so bigthat it has arbitraged out most of the alpha.

Like active equity funds, hedge funds in

aggregate cannot by definition outperform.

Moreover traditional fund managers are

increasingly converging with large hedge

funds and they dont charge fees of 2% and

20%. Page 31 Source: Bloomberg, EurekaHedge


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6. Illiquidity premium estimate, by asset class

0

100

200

300

400

500

Equity Corporate

bonds

Government

bonds

Covered

bonds

bp

Harvesting the illiquidity premium. Most

investors have a strong preference for

liquidity. But some notably pension funds

and insurers dont always need it and may

be overpaying for it. Amid the desperate

search for income, they may see the attraction

of the extra yield available in illiquid assets

(Chart 6) such as infrastructure, real estate

finance and private debt (structured like

private equity, but providing debt financing).

Page 34 Source: Adapted from Barrie & Hibbert(www.barrhibb.com/documents/downloads/Liquidity_Premium_Literature_REview.pdf)

7. Global pension assets (USDtrn)

0

5

10

15

20

25

30

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Autonomous pension funds Pension insurance

Other managed funds

Where will the money come from? Defined

benefit pensions are dwindling (Chart 7). The

growth areas for investment management

companies in the next few years will be

personal pensions, Asian high net worth

individuals and sovereign wealth funds. But

each of these will demand more sophisticated

products and solution-based services. Page 36

Source: OECD

8. SRI assets under management (USDtrn)

0

2

4

6

8

10

2005 2007 2010

US SRI AUM ($tn) Europe SR I AUM ($tn)

The challenge of ESG. Plan sponsors,

particularly public pension funds in Europe,

are increasingly focusing on environmental,

social and governance issues. So far, most

fund managers pay only lip-service to this.

But momentum is building (Chart 8) and

companies with superior ESG policies and

disclosure might start to outperform. After

all, who wants to buy a company with poor

corporate governance, which pollutes or treats

its staff badly? Page 42Source: US SIF, Eurosif (definitions differ slightly)


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Implications for asset pricesThe search for yield should be positive for credit and for high dividend yield stocks, both of which remain

attractive in our view. Equities in general may struggle for a few more years as global economic growth

remains low, but the basic concept that equities have a risk premium and therefore generate greater

returns in the long run will not disappear. If investors become more willing to buy illiquid assets to

boost yield, the pricing of long-term loans, commercial real estate and infrastructure finance should be

positively affected. The development of multi-asset funds should aid the development and liquidity of

more esoteric asset classes and derivatives products. We believe the further growth of passive funds and

ETFs will keep inter-market and intra-market correlations high.


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Introduction: an unusual world 7

Cyclical or evolutionary? 7

The search for yield 13in credit and dividends 13

The death or rebirth ofequities 17Problem is volatility, not return 17

Risk-minimising strategies 20Tailoring risk, not return 20

The growth of multi-asset 22GARS and all its friends 22

The shift to passive 24Its hard to beat an index 24

The relentless rise of ETFs 28Attractive but problems too 28

The decline of the hedge fund? 31

Is there any alpha left? 31

Harvesting the illiquiditypremium 34Do you really need liquidity? 34

Where will the money comefrom? 36

The sources of growth 36

The challenge of ESG 42Unavoidable momentum 42

Disclosure appendix 46

Disclaimer 48

Contents


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Cyclical or evolutionary?

We are in a very unusual investment world.

Interest rates are at historical lows, equities more

volatile than normal, different assets classes

abnormally correlated (the risk on-risk off

phenomenon) and demographics are altering

savings patterns in rich countries.

These developments have already caused a big

shift in investment flows over the past five years.

Investors have:

Sold equities and bought bonds in huge

volumes: in the US since end-2007 bond

mutual funds have seen inflows of USD920bn

and equity funds outflows of USD430bn.

Loaded up on risk-free assets. But the supply

of these has shrunk (according to the BIS,

AAA-rated government paper now totals only

USD12trn, compared to USD26trn in early

2011 Chart 1). This has pushed down their

nominal yields to below zero in some cases.

Increasingly understood that active equity

fund managers in aggregate underperform

benchmarks (even before fees) and so moved

heavily into index funds and ETFs.

Searched for new ways, other than equities, to

achieve a decent return without too much risk.

This has led to the development of absolute

return (or diversified beta) funds and risk-

minimising strategies.

1. Credit risk of pool of government debt

0

5

10

15

20

25

30

35

40

01 02 03 04 05 06 07 08 09 10 11

AA to below AA+

AA+ to below AAA

AAA

Source: BIS (Ratings used are the si mple averages of the long-term foreign currency

sovereign ratings from Fitch, Moodys and S&P.)

Is this a permanent structural change, or will we

eventually go back to the old normal? Probably abit of both. The side-effects of the 2007-9 Global

Financial Crisis will eventually wear off (though

Introduction: an unusualworld

Low rates, high volatility, high correlation the world has changed

Fund managers are struggling to cope: how to find returns without

too much risk, and provide solutions to investors with new needs

We indentify three threads: the search for income, tailoring risk,

and the continuing shift from active to passive

Garry Evans*StrategistThe Hongkong and ShanghaiBanking Corporation Limited

+852 2996 [email protected]

*Employed by a non-US affiliateof HSBC Securities (USA) Inc,and is not registered/ qualifiedpursuant to FINRA regulations


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this may take a few more years), with interest

rates, volatility and correlations returning to their

historical norms.

But there has been some evolution too. Investors

behaviour is likely to have changed permanently:

Investors will increasingly question whether

hedge funds can generate alpha and whether

they deserve fees of 2% and 20% even if

they can.

Retail investors will demand access to the sort

of absolute return strategies that hedge

funds previously specialised in and at a

reasonable cost.

There will be more demand for solutions:

whether liability-matched investments for a

defined benefit (DB) pension fund that is

winding down, or a to-and-through

personal pension plan for an individual due

to retire in five years who wants to fix

post-retirement income.

Interest in buying stocks in companies with a

strong ESG (environmental, social and

governance) record will increase. This is not

idealistic green talk after all, who wants to

own a company with poor corporate

governance or which treats its staff badly?

Many of these themes are fairly obvious, and have

been under way for a number of years. But how

the fund management industry will be affected by

them is not yet at all obvious. Like any business,

an investment management firm has to pick a

strategy: should it rush into all these new areas

(ETFs, absolute return funds, pension solutions,

ESG) or should it decide to focus? Is it better to

be a large global investment house or a focused

boutique or hedge ones bets by becoming a

multi-boutique umbrella organisation?

These trends will affect asset prices too. If

investors abandon equities for a generation, PE

multiples would contract further, as they did in the

1970s or after the Great Depression. Further

growth in ETFs and index products could push

correlations up further. A rise in demand for

alternative assets (infrastructure financing,

distressed debt, derivative structures) could shift

the prices of these assets. As banks in Europedeleverage, infrastructure lending, leasing and

other forms of long-term finance could pass to

institutional investors, in a form of

disintermediation, which could bring down

borrowing costs.

2. Demographic trends: % of population aged 35-54 in DM 3. Demographic trends: % of population aged 35-54 in EM

20%

22%

24%

26%

28%

30%

1990 2000 2010 2020 2030 2040 2050

Developed markets

20%

21%

22%

23%

24%

25%

26%

27%

28%

29%

1990 2010 2030 2050Emerging

Source: HSBC, UN Population Division. NB: MSCI World markets Source: HSBC, UN Population Division.


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Why this mattersThis is a topic that HSBCs strategy team has

tackled before. We believe that understanding the

deep underlying trends in investment are

important for asset allocation. It is too easy to get

caught up in the day-to-day vicissitudes of the

economic cycle. Thinking about long-term

drivers, such as demographics, changes in wealth

or market micro-dynamics, can help improve

investment decision-making.

Earlier this year, for example, we published a

report (Who will buyby Daniel Grosvenor, 3

February 2012) which argued that demand for

equities is likely to remain structurally weak due

to prolonged risk aversion, regulatory changes and

deteriorating demographics. In particular, ageing

populations in the developed world (Chart 2) will

tend to own fewer equities. This, the report

argued, could keep DM valuations depressed, but

EM should be immune (partly because of itsbetter demographics Chart 3).

We also described the growing importance of

emerging markets investors inAsia buys Asiaby

Herald van der Linde and Devendra Joshi , June

2012. Asian equity markets have traditionally been

dominated by foreign investors or speculative local

individuals. But this is changing, as Asians diversify

their wealth into financial assets, and pension

systems develop across the region.

Our colleagues in quantitative strategy have also

looked at the risk on-risk off phenomenon (their

latest report isRisk On Risk Off: Fixing a

broken investment process, by Stacy Williams,

Daniel Fenn and Mark McDonald, April 2012).

They suggest ways in which fund managers can

adapt their investment process to cope with the

phenomenon and take advantage of it.

For this present report, we met with CEOs, chiefinvestment officers and senior business managers

at almost 20 investment firms in the US and

Europe. These ranged from niche long-only equity

specialists to opportunistic macro hedge funds,

from major ETF providers to large global multi-

asset investment managers. Naturally most of the

senior managers had a bias based on what they

specialised in: equity houses tend to believe that

actively managed equity will come back, and

passive specialists argue that in future everything

will be indexed.

But our conversations gave us a good idea of thesort of concerns investment managers have when

they are being candid. Bond houses worry about

how to cope with the crash in bond prices that we

believe is inevitable in the future. Active

managers worry whether its too late to enter the

index ETF business or whether they should try

to structure their active funds as ETFs. Many

managers are struggling to create innovative

products risk-hedged funds, absolute return

strategies, pension-friendly structures in a worldwhere their revenues have stagnated and so R&D

budgets have been cut.

The global investment industry today

Before we try to draw out some threads from the

10 trends in investment management we have

identified, some background.

4. Assets under management (USDtrn, end-2010)

Insurance

funds, 24.6

Pensionfunds, 29.9

HFs, 1.8

SWFs, 4.2

ETFs, 1.3

Mutualfunds, 24.7

PE, 2.6

Source: TheCityUK estimates

How big is the global investment industry?

Conventional assets (pension funds, mutual funds
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and insurance) total about USD80trn, split

roughly evenly between the three (Chart 4). The

AUM of these institutions has doubled since

2000. Hedge funds manage around USD2trn, and

private equity funds a little more than that. Add to

this sovereign wealth funds which, in their pure

form, have assets of about USD5trn; include FX

reserve managers and other sovereign institutions

(such as national pensions or development funds)

and the total reaches about USD20trn. ETFs

comprise another USD1.5trn or so. Private wealth

is harder to figure out: various estimates put it at

between USD26trn and USD120trn. At the top

end of estimates, the total amount of money

available for investment firms to manage exceeds

USD200trn almost 3x global GDP.

The US is still the largest source of funds, with

USD35trn out of the USD79trn in conventional

assets globally (Chart 5). That is 224% of US GDP.

The UK, though much smaller in absolute terms, atUSD6.5trn, is the biggest in proportion to GDP, with

conventional funds representing 257% of GDP

(although some of that comes from money

domiciled in the UK but not from UK nationals).

5. Source of conventional assets, by country (USDtrn)

0

5

10

15

20

25

30

35

40

US

UK

Japan

France

Germany

NL

Switz.

Other

Pension funds Insurance assets Mutual funds

Source: TheCityUK estimates based on OECD, Investment Company, SwissRe and UBS

data. (Figures are for domestically sourced funds regardless of where they are managed.

No reliable comparisons are available for total funds under management buy country.)

and the chances of it growing

There is no reason to suppose that the rate ofgrowth of institutional assets will slow over the

coming years. Over the past decade, conventional

assets have grown at a compound annual rate of

7.1%. While it is likely, in our view, that global

economic growth will be lacklustre in coming

years as the after-effects of the Global Financial

Crisis are worked off, this does not mean that

global savings will be stagnant. Indeed, quite the

opposite. Households and companies are likely to

increase their savings as they stay risk averse (and

governments are likely to reduce fiscal deficits,

albeit slowly).

The IMF projects that US and UK gross national

savings, which have already improved modestly

since 2009 (to 12.9% of GDP from 11.5% in the

case of the US), will continue to increase over the

next five years, with the US reaching 17.8% by 2017

(Chart 6). China, meanwhile, is unlikely to reduce its

savings rate much, despite efforts to get households

to spend. Australia has already made some headway

in raising its savings rate since its bubble in the early

2000s. Japan is the only major economy where theratio may fall, as retirees start to eat into their

savings. All this suggests that the savings glut, which

drove the fall in interest rates and strong equity

performance in 2003-7, will not disappear.

6. Gross national savings rate, selected countries (% of GDP)

0

10

2030

40

50

60

80 85 90 95 00 05 10 15

UK US AU CH JP

F

Source: IMF

And, at the same time as savings grow, companies in

the developed world are unlikely to need to raise

much money for the next few years. Corporate cashholdings are at record highs, especially in the US,

and companies are being cautious about capex.


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Dividend payout ratios are very low (31% in the US

last year, for instance). This suggests that large listed

companies, at least, will not need to raise much

capital, either debt or equity, for the next few years

although capital-hungry emerging markets

companies, of course, will.

As countries get richer, they tend to increase the

amount of institutional assets under management

and increase the amount invested in equities and

bonds (rather than placed in bank deposits), asshown in Charts 7 and 8.

7. Increasing wealth brings growth in institutional assets

0%

10%20%30%40%50%60%70%80%90%

1970 1980 1990 2000 2010 2020

UK US Germany

% of household w ealth in institutional assets

Bubble size = per capita GDP (PPP)

Source: HSBC, CEIC

8. amid withdrawals from bank deposits

0%

10%

20%30%

40%

50%

60%

70%

1970 1980 1990 2000 2010 2020

UK US Germany

% of household wealth in bank deposi ts

Bubble siz e = per capita GDP (PPP)

Source: HSBC, CEIC

This suggests that, as long as emerging markets

continue to develop (which in most cases we think

likely), then not only should the pool of potential

savings grow, but the proportion of the pool

available for international investment institutions

to manage should grow even faster. Not that this

will be without challenges: how do London or

New York-based investment managers get access

to wealth held in China or India, which is still

highly restricted in where it can invest and mostly

off limits to them?

Indeed, a well-read report by the McKinsey

Global Institute The emerging equity gap: Growth

and stability in the new investors landscape,

December 2011, argued that the growth of

international securities ownership by emerging

market investors will be essential if the role of

equities in the global financial system is not to be

reduced in the coming decades. In particular,

emerging market investors will need to triple theirallocation to equities if companies in these

countries are not to be starved of equity capital.

Common threads

In this report, we highlight the 10 trends that we

think will drive the investment management industry

over the next few years. Understanding these trends

and considering their implications will be

important both for investment institutions in

planning their strategies, and for investors interested

in the impact of these trends on asset prices.


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Inevitably, there are some overlaps between the

10 trends. Broadly, we see three threads running

between them.

The search for income. With interest rates so

low, investors are desperate to generate

income. This has triggered demand for credit

and high dividend yield equities, which we

expect to continue. It is also forcing investors

to consider whether they are overpaying for

liquidity, and to look at harvesting a premiumfor investing in illiquid instruments such as

infrastructure and private debt funds.

Tailoring risk. Modern derivative techniques

make it possible to tailor risk to an extent.

Investors scared of drawdowns can hedge fat-

tail risk. Fixing a return is not possible (except

for a very low return); tailoring a level of risk

may be easier. This concept has spawned the

development of risk parity funds and a boom in

multi-asset absolute return funds.

A continuing shift from active to passive.

Academicevidence strongly suggests that

active equity fund managers in aggregate

underperform their benchmarks. That has

pushed investors over the past decade from

active to passive funds, especially ETFs a

trend we expect to continue. It is also forcing

a rethink of the role of hedge funds, which

have grown so large that in aggregate they nolonger seem to be able to produce superior

performance either.

In the following sections, we describe in detail the

10 trends we have identified and analyse their

implications for asset prices.


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in credit and dividends

With cash yielding zero and top-quality

government bonds little more than 1.5%, it is

unsurprising that investors are scrambling to pick

up yield. Indeed, one could even say that the

market has become obsessed with income.

1. Cumulative net flows to bond funds worldwide, by type

-100

-50

0

50

100

150

200

250

300

07 08 09 10 11 12

USDbn

GovtCreditOther

Source: EPFR (Other includes muni funds, MBS funds, total return bonds, and funds

able to invest in a mix of bond types)

Look at flows into bond mutual funds recently. It

is well known that these have been very healthy,

totalling USD580bn over the past three years

according to EPFR. But, for the past 12 months at

least, bonds flows have been predominantly into

credit funds (for example, corporate, high yield or

EM bond funds) with even a small net outflow

from government bond funds (Chart 1).

The sort of funds selling well is clear from the list

of the largest fund launches year-to-date. The top

20 new US-based funds, ranked by assets under

management now (Table 2 overleaf), include 10

bond funds, two asset allocation funds and only

eight with an equity focus (remember, this is for

the heavily equity-centric US market). Three of

the best-selling funds include the word income

in their names.

Credit is in a sweet spot. Interest rates at which

corporates can issue are at historic lows. But, at

the same time, spreads over US Treasuries are

quite high, making the bonds attractive for

investors too.

In the US, for example, BBB-rated five-year

corporate bonds currently yield only about 2.8%

the lowest for decades but that represents a spread

over Treasuries of around 200bp, well above the

average of 130bp from the 2003-7 period (Chart 3).

The same is true in emerging markets. The HSBC

Asian Dollar Bond Index (Chart 4) currently has a

record low yield of 3.7% but the spread over

Treasuries is a still attractive 300bp.

This is why lots of bonds have been issued this

year: August, for example, with over USD120bn

of issuance according to Dealogic, was the highest

August on record and more than double the

USD58bn average for August. Sub investment

The search for yield

With risk-free rates so low, investors are desperate for income

Credit is in a sweet spot, with issuers enjoying record low

borrowing costs, but investors finding decent spreads

We think dividend yield stocks remain attractive too


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grade issuance in August totalled USD27bn, up

from USD1.3bn the same month in 2011.

3. Average US BBB-rated five-year corporate bond

0

2

4

6

8

10

03 04 05 06 07 08 09 10 11 12

YieldSpread

Source: Bloomberg

Investors are clearly now having to take more risk

to get yield. Fund houses report that investors who

20 years ago would not have touched BBB credits

will now buy almost anything for yield. One

example is bonds from riskier emerging markets.

Ten-year paper from the Philippines, a BB-rated

issuer, now yields only 2.5%. Investors have been

buying bonds from countries such as Gabon,

Belarus, Nigeria and Vietnam. But five-year

bonds even from Gabon (BB-rated) now yield

only 3.8%. You have to stretch to Belarus (B-) to

get a decent yield, just over 10%.

4. HSBC Asian US Dollar Bond Index

0

2

4

6

8

10

12

00 01 02 03 04 05 06 07 08 09 10 11 12

Yield Spread

Source: HSBC

This could all go very wrong. Credit spreads are

supposed to compensate investors for the

probability of default. At the investment grade

part of the credit spectrum, defaults are rare, but at

the sub-investment grade end they are less so. At

present, the combination of low rates on high

quality government bonds and relatively wider

credit spreads, combined with very low default

rates, places credit in a sweet spot; compared to

some other assets classes. However, in an

2. Largest mutual funds launched in the US this year

Ticker Name Manager Inceptiondate

Asset class Objective AUM(USDbn)

TGIRX US Int'l Value Fund Thornburg 5/1/2012 Equity International Equity 26.5OIBIX US Int'l Bond Fund Oppenheimer 1/27/2012 Debt International Debt 12.6WAPRX US Core Plus Fund Western Asset 5/1/2012 Debt Govt/Corp Intermediate 9.6OSIIX US Global Strategic Income Fund Oppenheimer 1/27/2012 Debt Government/Corporate 8.6OGLIX US Global Fund Oppenheimer 1/27/2012 Equity Global Equity 8.3PSTQX US Short Term Corp Bond Fnd Pridential 3/2/2012 Debt Corporate/Preferred-Inv Grade 8.0AEMSX US Emerging Markets Fund Aberdeen 2/27/2012 Equity Emerging Market-Equity 7.5OIGIX US Int'l Growth Fund Oppenheimer 4/27/2012 Equity International Equity 6.2MSKHX US Mid Cap Growth Portfolio Morgan Stanley 6/15/2012 Equity Growth-Mid Cap 6.0MSFKX US Total Return Fund MFS 6/1/2012 Asset Allocation Balanced 5.8PEFAX US EM Fundamental IndexPLUS Pimco 5/31/2012 Debt Index Fund-Debt 5.4CMCPX US Active Portfolios Multi-Manager Core

Plus Bond FundColumbia 4/20/2012 Debt Government/Corporate 4.7

OBBCX US Mortgage Backed Securities Fund JP Morgan 7/2/2012 Debt Asset Backed Securities 4.1JQLAX US Life Aggressive Fund John Hancock 3/1/2012 Asset Allocation Flexible Portfolio 3.7OEIIX US Equity Income Fund Oppenheimer 4/27/2012 Equity Value-Large Cap 3.3MIDLX US Int'l New Discovery Fund MFS 6/1/2012 Equity International Equity 3.2JIPPX US Strategic Income Opportunities Fund John Hancock 3/1/2012 Debt Global Debt 3.1WABRX US Core Bond Fund Western Asset 5/1/2012 Debt Govt/Corp Intermediate 3.0MFBKX US Bond Fund MFS 6/1/2012 Debt Government/Corporate 2.8JDVPX US Disciplined Value Fund John Hancock 2/29/2012 Equity Value-Large Cap 2.8

Source: Bloomberg


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environment of low growth rates, credit quality is

at risk of deterioration and, if default rates begin

to rise, the credit spreads sought by investors

could widen significantly.

Income from equities

The other obvious place to turn for yield is

equities. With the dividend yield on global

equities currently averaging 3.2%, the spread over

government bonds is the highest since the 1950s.

Investors have been buying into this theme

enthusiastically over the past two years. There

have been almost USD80bn of flows into

dividend funds over this time (Chart 5), making it

the most popular of the themes tracked by EPFR.

Oddly, the theme has not been so popular in the

US. Maybe there are definitional differences but

US income funds tracked by ICI have seen net

outflows of about USD11bn over the past two

years (Chart 6). Income funds comprise only 3%of outstanding US equity mutual funds (compared

to 33% for growth and aggressive growth funds).

5. Cumulative net flows into mutual funds by theme

-20

0

20

40

60

80

00 01 02 03 04 05 06 07 08 09 10 11

USDbn

Div idendBalanced/multi ass etGoldCommodity

Source: EPFR

There are a number of explanations for the lack of

interest in dividend funds in the US. The dividend

yield in the domestic market is quite low (2.6%

compared to, for example, 4.3% in Europe), since

companies prefer buy-backs which are more tax

efficient. The tax on dividends (currently 15%) is

due to rise next year as part of the fiscal cliff to

an investors marginal tax rate, i.e. as high as40%; this is causing uncertainty. It may be simply

that investors are just too nervous of equities to

touch even ones with good income.

6. Cumulative net flows into US equity mutual funds, by type

0

100

200

300

400

500

600

700

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

USDbn

International

Growth

Balanced

Agg growth

Global

EM

Sector

Income

Source: ICI


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Many CIOs argue that it is just too late to buy

dividend stocks, since they have already

performed well. We disagree. The global dividend

yield has not fallen much: it peaked at 4.4% in

early 2009 at the market trough, but has been

fairly steadily around 3% for the past three years.

High dividend stocks have not outperformed that

much yet either. For example, the global MSCI

High Dividend Yield Index has beaten MSCI

World by only 7% over the past three years

(ignoring the dividends paid). And the MSCI

USA High Dividend Yield Index (launched in

January this year) has performed just in line with

the headline MSCI US year-to-date.

Implications for asset pricesThe search for yield will continue if, as we expect,

risk-free government bond yields remain low for

some time to come. That suggests to us that both

credit and high dividend equities will see further

inflows, and therefore a contraction in bond

spreads and rise in equity prices.


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Problem is volatility, not return

Bill Gross, Co-CIO of Pimco, famously

announced this August that the cult of equity

is dead.

But the truth is not that simple. Indeed, many

bond fund managers are worrying more about the

crash in the bond market that we believe is

coming, and thinking about how to position

themselves for it.

Certainly over the past few years, investors have

switched massively away from equities and into

bonds. Since the end of 2007, USD920bn has

flowed into bond mutual funds in the US and

USD430bn out of equity funds (Chart 1).

This is not only because of the equity bear market

of 2007-9. The trend has been accelerated by

demographics in developed economies (older

people hold fewer equities) and by regulation, as

regulators, especially in Europe, pushed pension

funds and insurers to derisk their portfolios.

1. Cumulative net flows into US mutual funds (USDtrn)

0.0

0.5

1.0

1.5

98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

Equity fundsBond funds

Source: ICI

But have equity returns really been that bad?

Many investors talk about the past 10 years ashaving been a structural bear market for

equities. But the fact is that over that period the

total return from global equities (a compound

annual rate of 8.0%) has been better than the

return from global bonds (5.2%).

Of course, the picture is a little more complicated

than that. The return depends greatly on the

starting-point: the 10-year return for equities is

flattered by the fact that August 2002 was close to

the bottom of a bear market.

The death or rebirth ofequities

Bill Gross says the cult of equity is dead

But equities have actually outperformed bonds over the past 10

years, although admittedly with high volatility

A bigger risk is the bursting of the bond bubble: could 2014 be

another 1994?


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And equities have been particularly volatile over

the past decade or so (Chart 2). In the bull market

of 1992-9, equities produced a much smoother

annual return of 16% with volatility of 13%,

compared to a 6% return for bonds with a

volatility of 5%. Over the past 10 years, the

volatility of bonds has been pretty steady, at 6%,

but the volatility of global equities has risen to

19% (Tables 3 and 4).

2. Total return indexes* (log scale) since 1988

4.5

5.0

5.5

6.0

6.5

88 90 92 94 96 98 00 02 04 06 08 10 12

EquityBondCash

Source: Bloomberg, MSCI (*Equity=MSCI ACWI TR Gross, Bonds=JP Morgan

Aggregate Bond Index TR Unhedged USD, Cash=3-month T-bills)

3. Compound return from different asset classes

Equity Bond Cash

1 year 9.8% 1.4% 0.2%2 years 8.1% 5.2% 0.2%5 years -0.9% 6.4% 1.1%10 years 8.0% 6.7% 2.1%20 years 7.1% 6.4% 3.5%1992-1999 16% 6% 5%Since 1988 7.2% 7.1% 4.3%

Source: Bloomberg, MSCI

4. Annaulised volatility of different asset classes

Equity Bond Cash

1 year 20% 4% 0%2 years 18% 5% 0%5 years 24% 6% 0%10 years 19% 6% 0%20 years 17% 6% 0%1992-1999 13% 5% 0%Since 1988 17% 6% 0%


That volatility explains a lot. Retail investors and

regulators have been made very nervous by the

big swings in stock prices. It will take a lot for

them to get confident in equities again. Many

equity fund managers worry that one more crisis

or another nasty bear market in the near future

would put investors off equities for a generation,

as happened after the 1929 stock market crash.

The high volatility also explains the big flows into

passive funds in recent years (discussed in a later

section): volatility makes it hard for active or

thematic fund managers to perform well.

But there are issues for bond markets too,

valuations for a start. The interest rates on top-

rated government bonds are at unprecedently low

levels: the 10-year US Treasury yield, for

example, fell below 1.4% this summer, the lowest

since at least the late 19th century (Chart 5).

5. 10-year US Treasury bond yield (%)

0

2

4

6

8

10

12

14

16

1880 1900 1920 1940 1960 1980 2000

Source: Robert Shiller

Meanwhile, equity valuations, while not

exceptionally low, are certainly well below long-

run averages: the forward PE on the S&P500, for

instance, is currently about 12.5x, compared to a

140-year average of 13.6x (Chart 6).


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6. One-year forward PE, S&P500 (x)

0

5

10

15

20

25

30

35

1870 1890 1910 1930 1950 1970 1990 2010

Source: Robert Shiller, IBES, MSCI

Indeed, the best way for investors to regain

confidence in equities would be if bond prices were

to crash. This might be caused by a rise in inflation

or signs that the Fed and other central banks were

looking to begin unwinding their unothodox

monetary easing measures. Some CIOs have started

to worry whether 2014 could be another 1994 (when

the Fed raised rates unexpectedly and sent bonds

crashing). How could bond houses stay relevant in a

rising rate environment?

Indeed, several we spoke to have begun to prepare

for this eventuality, and started to consider how

they might enter the equity business. Grosss

Pimco set up four equity funds for the first time in

2010, and others are starting to address this, also.

Other traditional bond houses told us they were

looking at specialising in equity tactical asset

allocation, using ETFs to execute country and

sector bets.

They key question, then, is whether the recent

volatility in equities and the shift in investors

preferences to bonds are structural or cyclical.

The answer is that it is surely a bit of both. With

the debt overhang in the developed world likely to

hold down growth for a few more years, policy

uncertainty and low inflation will probably keep

interest rates low and equity markets on edge. But

this will not last forever.

And, in the meantime, investors will struggle tomake decent returns from bonds at current levels.

The financial textbooks may dictate that as an

individual nears retirement he or she should sell out

of equities and own only bonds. That might have

worked when interest rates on government bonds

were 7% and a 65-year-old could expect to live

only 10 years. But it certainly doesnt work with

bond yields at 1.5% and life expectancy of 80-85.

Implications for asset prices

Our conclusion is that equities are likely to

struggle for a few more years, with economic

growth in the developed world anaemic. But the

basic concept that equities have a risk premium

should not disappear. And we would have a high

degree of conviction that the total return from

equities over the next 10 years will be higher than

that from cash or government bonds (admittedly

not a big hurdle).

The problem to solve is investors perception that

equities are risky. But there might be ways to

reduce the riskiness of equities, without sacrificing

too much of their return. We examine the idea of

risk-minimising strategies in the next section.


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Tailoring risk, not return

What all investors would ideally like is a good

return with low risk. Of course that is impossible,

but fund managers are increasingly designingproducts that give at least a decent return (or

income) with some downside protection or

reduced volatility.

The key insight here is that, while it is impossible

to fix return, it is possible to tailor risk to a

degree. One could, for example, buy an equity

index together with a put option, thus giving up

some income in return for a pre-determined limit

to drawdown. Investors have a reduced tolerance

for drawdown after the upheaval of 2008; fund

managers can structure their offerings with the

aim of avoiding an outlier outcome.

Such products are not new (private banks have for

at least 20 years sold capital guaranteed equity

indexes, where the dividend stream is used to buy

downside protection). But, in a world where

investors are hungry for yield but nervous of

equity risk (as we saw in the previous two trends)

they are increasingly popular. They are alsobecoming more sophisticated and nuanced.

There are many such structures around.

The fastest growing, especially in the UK, are

multi-asset funds (aka diversified beta or

diversified growth), which we discuss indetail in the next section. These aim at

absolute returns in a range of assets, with a

targeted level of volatility. Essentially, they

intend to provide a nice return but with low

correlation to equities.

Risk aware equity services, such as

long/short or market-neutral strategies,

have for long been the territory of hedge

funds, but are increasingly being used by

conventional fund managers.

Balanced funds (with a mix of equity and

bonds, typically 60:40) have long been a

mainstream of retail fund management houses.

But they have often produced poor returns,

mainly because the vast proportion of the risk

lay in the equity portion. A recent

development is risk-parity products, where

risk between the asset classes is equalised, for

example by leveraging the bond portion.

Risk-minimisingstrategies

Investors want equity-style returns with bond-like volatility

Fund houses are developing products that tailor a level of risk in

return for giving up or boosting return

Strategies include diversified beta, risk parity, min vol, call writing


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Minimum volatility equity funds focus on

low-beta stocks in an index, often using a

quants model. They are based on the finding

in some academic research that beta does not

produce the outperformance in the long-run

that it should. These funds, it is claimed, can

produce at least as good performance as a

major index, but with significantly reduced

volatility.

Using options to target a level of risk. Forexample, a fund could write calls and buy

puts to an equal value to specify acceptable

downside risk at the expense of upside. This

could also be done simply, and relatively

cheaply, to eliminate extreme tail risk.

Similarly, a strategy ofpassive-plus with call

writing allows a fund to boost the return on

an index, in return for capping the upside.

Again, the level of the cap can be tailored.

Some funds have experimented with the idea

ofhanging a coupon off an equity fund.

This might look more attractive than a simple

dividend fund, since the coupon, as long as it

was relatively low (for example 2%) could be

fixed for a period, since shortfall is unlikely.

Any dividend payment in excess of that

would be reinvested. This hybrid of bond and

equity characteristics may be attractive to

some investors.

Not that such tailored products are without

problems. It may be hard to explain their

characteristics and attractiveness to retail

investors: as one CIO told us: You cant sell a

Sharpe ratio.

The products can be quite expensive too. Some

highly risk-averse investors may end up giving

away too much upside to buy insurance. With

implied volatility for equities still high (though

lower this year than for a while), the cost ofoptions protection is high. The lack of

transparency on costs may leave some retail

investors wondering whether the investment bank

selling them the structured product is offering a

good deal.

But for both sophisticated retail investors, with

astute advisers to guide them through the

complications, and for institutions with strong risk

consciousness, for example insurance companies,

products that minimise or at least tailor risk

might be a wise investment.


If risk-minimising products grow further, this

should be positive for the growth of options

markets and for liquidity in the sort of assets that

multi-asset funds typically target.


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GARS and all its friends

Standard Lifes Global Absolute Return Strategies

(GARS) Fund has been causing a stir in the UK.

Since its inception in 2008, it has gathered assets

of GBP11.7bn. It aims to produce an annualreturn of cash plus 5% with an investment time-

horizon of three years (and to have a positive

return over any 12-month period), by investing in

a range of assets and derivative strategies (see

Table 1 for example of its positions). Over five

years it has produced a compound annual return

of 7%, putting it in the 99th percentile of its peers

(with volatility over the past year of only 5%).

The GARS Fund has spawned a raft of

competitors in the UK but not yet in the US,

although by all accounts GARS has started to gain

traction there.

It is the leader of a growing category of multi-

asset absolute return funds, known also as

diversified growth, diversified beta or diversified

return funds. These funds typically target Libor

plus 4% or 5% (or sometimes inflation plus, say,

3%), with volatility lower than equities and often

targeted to be similar to US treasuries (i.e. 4-6%).

They usually use leverage to achieve the targeted

return. In a sense they are similar to hedge funds,

but fees are lower (GARS charges 75bp a year,

with no performance fee) and many are offered to

retail as well as institutional investors.

1. GARS fund: selected positions July 2012

Market return strategies

High yield creditRussian equityKorean equityGlobal index-linked bondsFX hedging

Directional strategiesUS forward-start durationLong USD v CADMexican rates v EURLong BRL v AUDLong equity volatilityEuropean swaption steepener

Relative value strategiesRelative variance incomeUS tech stock v small capEuropean financials capital structure

Hang Seng v S&P volatilityHSCEI v FTSE varianceBroad v financial sector equityFinancial sector v broad credit

Source: Standard Life, public website

The track records of GARS, and of many of its

later-established competitors, have been

impressive. But multi-asset funds have their

detractors, too (and not only among houses late to

the game).

The growth of multi-asset

Funds that target Libor-plus absolute returns, with bond-like

volatility and costs lower than hedge funds, look attractive to us

The success of Standard Lifes GARS has spawned competitors

Multi-asset funds are likely to grow further, even in the US where

they have yet to take off


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Some argue that Standard Life has been lucky to

achieve such good returns (or maybe has done so

only because its fund managers are particularly

talented) and wonder whether similar funds would

be able to replicate the returns. Wont multi-asset

funds in aggregate underperform their

benchmarks, just as active equity managers do

and (as we describe in the section below, The

decline of the hedge fund?) hedge funds may have

begun to do too? That may happen eventually, but

for now the asset class is still so small that it does

not yet face a zero-sum game.

Other critics wonder whether multi-asset funds

are really an alpha product, or simply take beta

risk with leverage. In our view, the answer to this

is that, even if part of the return that multi-asset

funds achieve is beta, timing the beta and

managing asset allocation can be forms of alpha.

A final doubt is that leverage may work with

interest rates so low, but what happens when the

cost of the leverage goes up?

It is also somewhat of a puzzle why multi-asset

funds in the US have failed to take off yet.

Certainly, most CIOs at US funds we talked to

were aware of the GARS phenomenon, but few

have tried to market anything similar. One

problem is that required returns in the US are too

high: pension funds typically assume a return of

close to 8%. Setting up a multi-asset fund with atarget of Libor+7 or Libor+8 would, in the view

of most fund managers, involve taking too much

risk. Retail investors, in the current environment,

also tend to be wary of anything that isnt yield

oriented. Would there be a way to set up income

multi-asset funds?

Implications for asset pricesThe obvious attraction of multi-asset funds

(decent yield with low volatility at a reasonable

cost) means that, in our view, they should

continue to grow rapidly and develop more

diverse structures. Eventually, their flourishing

may push down returns but, for now, they are rare

enough that there is still plenty of alpha to be

picked up.

As multi-asset funds grow, they should aid thedevelopment and liquidity of more esoteric asset

classes (look at the sort of things that Standard

Life holds in Table 1). Most multi-asset funds

implement their strategies through index futures

and other derivative instruments; these should see

improved liquidity too.


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Its hard to beat an index

There has been a massive shift of investment

flows from actively managed funds to passive

(indexed) funds over the past 10 years.

According to EPFR data (Chart 1), passive equity

funds worldwide have seen inflows of about

USD660bn over the past 10 years, and active funds

outflows of USD543bn (one-third of their assets

under management at the start of the period).

1. Cumulative net inflows into mutual funds worldwide (USDbn)

-600

-400

-200

0

200

400

600

800

01 02 03 04 05 06 07 08 09 10 11 12

USDbn

Passiv e Activ e

Source: EPFR

In the US, according to the Investment Company

Institute, inflows to passive mutual funds have

totalled USD427bn over the past 10 years, bringing

the total size of such funds at the end of last year in

the US to USD1.1trn. There have been particularly

big flows into bond funds over the past three years

(Chart 2); these now total USD242bn.

TowersWatson estimates that global assets managed

passively totalled USD7trn in 2010.

2. Annual flows into US indexed funds by type, 1997-2011

-10

0

10

20

3040

50

60

1997 1999 2001 2003 2005 2007 2009 2011

USDbn

Domestic equity World equity Bond & hybrid

Source: ICI

This is unsurprising, in our view. Almost all

academic studies find that in aggregate active

funds underperform their benchmark, particularly

once fees are taken into account. This logically

must be so since, before fees and trading costs, the

average investor must by definition perform in

line with the index. But the turnover of an active

fund is almost always higher than that of an index.

So, even before fees, the average active investor

must underperform. (The only question is

underperform what? a subject we return to

later.) Index funds also typically charge lower

annual expenses, for example usually 20-30bp for

The shift to passive

A third of active money has shifted to passive in the past 10 years

Passive encroachment is likely to continue, since active funds

empirically underperform on average (and have higher costs)

But indexing strategies will need to get smarter: which index?


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an S&P500 index fund, compared to 80-150bp for

a traditional actively managed US equity fund.

Data from Standard & Poors suggest that over the

past 10 years, on average only 40% of large-cap

US funds and 38% of small cap funds

outperformed their benchmarks (Chart 3).

3. % of mutual funds outperforming their benchmark

0

10

20

30

40

50

60

70

80

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Large cap funds Small c ap funds

Source: Standard & Poors (Large cap funds were compared with S&P500, small cap

funds with S&P SmallCap 600)

Will the shift to passive continue? In our view,

almost certainly. Passive funds still comprise only

16.4% of US equity mutual funds (up from 10%

ten years ago). International equity funds run

passively in the US total only USD120bn. Index

funds are still relatively small outside the US.

With interest rates and expected returns from all

assets very low, investors will focus more and

more on minimising expenses. Going passive is

the best way to do this. Sophisticated investors,

such as institutions or high net worth individuals,

will also increasingly separate beta and alpha.

They will do this, for example, through so-called

80:20 solutions, where they have 80% of their

assets in passive market-linked beta assets, and a

20% alpha tranche aggressively managed in

alternative assets (with the market risk hedged

out). They will want to buy the beta portion as

cheaply as possible.

Fans of active investment have a number of

arguments against this. Many claim that, while the

average investment manager may underperform

the benchmark, their firm has superior investment

processes that allow it to outperform consistently.

Unfortunately, academic research shows little

evidence of sticky outperformance.

Others argue that, if an increasing portion of the

investor universe turns passive, there should be

more merit in picking stocks, since they would beincreasingly mispriced. That is an appealing

argument, but not well grounded in logic. Think

of it like this: if there were 98 passive investors in

an asset class and only two active managers then,

after fees and trading costs, the two active

investors would still in aggregate underperform

the index.

Bond houses argue indexing might not make

sense for bonds. Bond indexes are unlike equity

indexes in that they include many more securities,

which change frequently (for example when their

credit ratings downgraded) and most of which

have a finite life. They are usually weighted by

the total outstanding debt of the issuers, which

means highly indebted and risky borrowers

represent a large part of the index. Many active

bond managers claim it is not hard to outperform

bond indexes for these reasons. Standard & Poors

data does not bear this out, though: almost no

category of US-based bond funds has

outperformed its benchmark in aggregate over the

past decade (Chart 4).


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4. % of bond funds outperforming their benchmarks

0

10

20

30

40

50

60

General

intermediate

Government

longfunds

EMd

ebt

Global

income

MBS

HY

2002-2006 2007-11

Source: Standard & Poors

It may be possible to outperform an index when a

large group of investors hold the securities for

non-investment reasons. An example is Japan in

the 1990s, when many foreign investors

outperformed the Topix index simply by

underweighting (or owning no) banks. Bank

stocks were mainly owned by Japanese corporates

for relationship reasons.

But which index?

This all begs the question of which index. Some

perform better than others. A traditional large-cap

market cap-weighted stock index, such as the

S&P500, may not be the best choice. That is

because, empirically, smaller cap stocks

outperform large caps in the long run. Moreover,

when using market capitalisation, expensive

stocks are overweighted. It is well accepted that

value stocks also outperform in the long run.

(There is a possibility, though, that both these

phenomena may just be capturing the greater

illiquidity and higher transaction costs of small-

cap and value stocks.)

So in the US, for example, the S&P500 index has

risen by 50% over the past 10 years, while an

equal weighted index of the same stocks has risen

by 105% (Chart 5).

A further problem is that, when stocks are added

to a popular index, they tend to rise on the

announcement (but before they actually join the

index); similarly, deleted stocks fall before their

removal. A less well-followed index with similar

characteristics might outperform.

5. Performance of S&P500 market cap and equally weighted

0

500

1000

1500

2000

2500

90 92 94 96 98 00 02 04 06 08 10 12

SPX Index SPW Index

Source: Bloomberg

Many passive investment managers understand

these reservations, and have moved to index-plus

or passive-plus strategies. Fundamental indexes,

where stocks are weighted by sales or book value

(or even the number of employees), rather than by

price or market cap, have also grown.


If we are correct to believe that passive

encroachment has years to go, there are many

important implications for asset prices.

6. Average correlation of MSCI country indexes with ACWI

0.0

0.2

0.4

0.6

0.8

1.0

90 92 94 96 98 00 02 04 06 08 10 12

Average


Correlations between markets, and between stocksin a market, have risen consistently over the past

decade. The average correlation between MSCI


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country indexes and the overall MSCI All

Country World Index (Chart 6), for example, has

risen from 30-40% in the early 2000s to 60-70%

by 2010 although they are some signs of it

declining recently, perhaps as flows into equity

funds, whether active or passive, have stagnated.

At the stock level, the implied correlation between

individual stocks in the S&P500 index (Chart 7)

rose to a peak of 80% late last year, from 40-50%

in 2007 (when the correlation contract was firstlaunched on the Chicago Board Options

Exchange).

7. Implied correlation of S&P500 stocks (%)

0

1020

30

40

50

60

70

80

90

07 08 09 10 11 12

Implied correlation

Source: Bloomberg, CBOE

Further growth of passive funds is likely to push

correlations up further, or at least keep them at the

current elevated level.

If bond funds grow in popularity, a similar rise in

correlations may happen between different bond

classes or issuers.

The growth of index-plus strategies or

fundamental indexes might also offer some

arbitrage opportunities in securities lying just

outside the major indexes, or which are large but

underrepresented.


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Attractive but problems too

Closely linked to the rise in passive funds (see

previous section) has been the growth of

exchange-traded funds (ETFs). There arecurrently over 3,200 ETFs around the world, with

assets of USD1.5trn, up from only USD105bn in

2001 (Chart 1).

1. Assets of exchange-traded funds (USDbn)

0

200

400

600

800

1,000

1,200

1,400

1,600

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012*

US Europe Other

Source: Blackrock (*end-Jun)

ETFs have a number of advantages, which explain

their popularity (trading volumes represent around

one-quarter of US stock market turnover). They

can be traded intra-day, giving investors a way to

take (or remove) exposure quickly to a country,

sector or asset class. Their liquidity means that

they are often used by institutions to execute asset

allocation changes. Some participants estimate

that as much as 60% of ETFs are owned by

institutional, rather than retail, investors. The way

ETF units can be created and redeemed by

authorised participants such as market-makers

usually means that they generally trade close to

net asset value (NAV). For retail investors, the

ability to see live prices and trade any ETF via a

discount broker (rather than having to use the

proprietary platforms of various fund management

houses) make ETFs particularly easy to use.

But they also have their detractors. Common

criticisms include:

They are sub-optimal for long-term

investors. Why would these investors want to

trade intra-day, when they could buy an

equivalent mutual fund that guaranteed they

could buy or sell at end-of-day NAV? This

can only encourage short-term speculation,

unsuitable for most retail investors. Moreover,

since ETFs pay exchange fees and have a

bid/offer spread, they should fundamentally

cost a little more than a similar mutual fund.

The relentless rise ofETFs

ETF assets have grown to USD1.5trn

But there are issues: are ETFs suitable for bonds? Will overly

sophisticated ETFs blow up and invite regulators attention?

Key to future growth is whether active ETFs take off


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They are still very much a US phenomenon.

US ETFs have AUM of USD1.1trn but

Europe only USD273bn and the rest of the

world just USD169bn. Regulatory difficulties

still make it hard to set up an ETF in Europe.

The range of available ETFs and their

liquidity is very limited in many countries.

ETFs are best suited to equity index

products. They work much less well for

bonds or other assets. Equity ETFs globallytotal USD1.2trn, but fixed income ETFs have

reached only USD308bn, and commodity

ETFs only USD35bn. Fixed income is trickier

because of the problems inherent in bond

indexes, described in the section on passive

funds above. It is also much harder to

replicate a bond index because of the lack of

liquidity in many of its components.

Moreover, the transparency requirement of

ETFs (in the US they have to publish theirfull holdings daily essential for market-

makers to create new units) means that traders

can see their positions and trade against them.

A number of ETFs have backfired

spectacularly. Some have failed to mirror the

returns on the underlying security or index

they claimed to match. This has been

especially true of gold ETFs. More

sophisticated ETFs that promised a multiple,

or the inverse, of the return on the underlying

have diverged dramatically. The Proshares

Ultrashort MSCI Emerging Markets ETF

(Code: EEV) is one of the most notorious. It

seeks double the inverse of the return on the

MSCI EM index. But when the index fell

49% in the second half of 2008 and so the

ETF should have risen 98% the ETF

actually fell by 30%. It has failed in the past

12 months too, falling by 15% when MSCI

EM fell by only 8%.

The defenders of ETFs say that the resilience of

the industry, despite these blow-ups (and others

such as the flash crash of 2010, which was

partially blamed on ETFs) demonstrates the

products fundamental attractiveness. The chances

are, though, that regulators may clamp down,

particularly on exchange-traded products (ETPs),

which replicate an index or assets through

derivatives rather than by owning (at least some

of) the underlying securities. There are

USD182bn of ETPs, in addition to the numbers on

ETFs quoted above.

The keys for further growth

We expect ETFs to continue to grow. But there

are two key questions that will determine their

rate of growth.

The first is whether active ETFs can take off.

These are somewhat problematical. The

transparency rules mentioned earlier make it hard

to structure, say, a 30-stock high-alpha equity

fund as an ETF, since competitors and traders

would be able to see daily changes in the funds

holdings. Some investment houses, notably Eaton

Vance, claim they have found a way to report

daily holdings that would get round the

transparency problem. But so far the Securities

and Exchange Commission hasnt approved these

ETFs, and indeed has been reluctant to approve

many innovative ETF structures.

Perhaps the highest profile active ETF launch

recently was Pimcos Total Return ETF (Code:

BOND), listed in March this year. In six months,

it has grown AUM to USD2.5bn. The ETF aims

to mimic the Pimco Total Return mutual fund;

both are managed by Bill Gross. But the two have

performed rather differently: in the past six

months the ETF has risen 6.6% and the mutual

fund 3.2%. One reason for this is apparently is

that the larger size of the long-established mutualfund (total assets USDUSD270bn) means it

cannot move in and out of positions so quickly.


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One answer may be quants funds which, rather

than being managed in accordance with the

managers judgement, chose stocks on the basis of

a model. For example, the largest ETF provider,

Blackrocks iShares, is focusing its marketing

efforts currently on minimum volatility equity

ETFs. These use an MSCI Barra model that

optimally chooses low volatility stocks from an

index. Its promoters claim that this allows

investors to keep most of the upside, with

significantly lower volatility. And, indeed, over

the past five years, the MSCI US Minimum

Volatility Index has outperformed the regular

MSCI US by 17%, with volatility of 18%

compared to 23%.

The second key question is how financial advisers

are remunerated. Until recently, FAs were

reluctant to recommend ETFs to their retail

investor clients, even though this might have been

the wisest course since, unlike mutual funds,ETFs do not pay commissions. But the trend is

increasingly for FAs to charge an annual fee of 1-

2% of assets for their advice, and to take nothing

from the investment products they put their clients

into. This makes them more impartial. In the US,

the number of Registered Investment Advisers

(RIAs) has soared as investment professionals

have left wire houses to set up on their own:

estimates from Cerulli Associates suggest assets

overseen by RIAs have tripled over the past 10years to USD1.7trn.

In the UK, the Retail Distribution Review, which

takes effect next January, will ban financial

advisers (including private banks and wealth

managers) from accepting commissions for

recommending investment products to UK retail

investors. Similar moves are afoot in Australia

and Asia. This might all make it more common

for FAs to recommend an ETF-heavy investment

strategy to retail investors and spur the growth of

the product.

Bad news for mutual fund managers

This is good news for the ETF industry, but wont

help conventional fund managers. The ETF

business is largely sewn up by three providers

iShares, State Street and Vanguard which

between them manage 68% of outstanding ETFs.

Other firms have struggled with whether it makes

sense to enter the business, but the only space left

for new entrants is in increasingly esoteric

products, or in low-cost ETFs on plain-vanilla

stock indexes. Both are hard to make profits from,

and ETFs from smaller providers are often

illiquid, making them unattractive to investors.

Indeed, some smaller providers have begun to pull

out: Scottrades FocusShares, for example,

liquidated its 15 ETFs in August and Russell

Investments announced it would scale back its

offering, currently 26 funds. A total of 71 ETFs

have closed in the US this year.

Implications for asset pricesAs with the move to indexation (described in the

previous section), the rise of ETFs raises intra-

and inter-market correlations.

ETFs make it easy even for large institutional

investors to change weighting rapidly. A fund that

decided to raise its weighting in Brazil, for

example, could buy a Brazil index ETF

immediately, and then ask its fund managers to

slowly build up a portfolio of their favoured

Brazilian stocks. So far this has mainly been

limited to equities. But if bond ETFs and style

ETFs (min vol, value, high dividend yield) take

off, the same effect could be seen within and

between other asset classes.


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Is there any alpha left?

Earlier this year, the assets under management of

hedge funds finally regained their previous peak

from 2007, around USD2.2trn. But that was one

of the few pieces of good news for an industry

that has struggled in recent years. In the five years

to the end of 2007, AUM grew at an annual

compound rate of 29%. Since the end of 2008, the

CAGR has been only 12% (Chart 1).

1. Hedge fund assets under management

0

500

1,000

1,500

2,000

2,500

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012*

Assets (USDbn)

Source: TheCityUK and HSBC estimates (*end-Jul)

The reasons are not hard to find. Performance has

been unimpressive in the past couple of years.

Hedge funds tend to do best in absolute terms

during economic expansions and equity bull

markets, such as 2003-7, and in relative termsduring market collapses like the Global Financial

Crisis of 2007-9 (Chart 2).

2. Cumulative performance of hedge funds

100

150

200

250

300

350

00 01 02 03 04 05 06 07 08 09 10 11 12

HF index

L/S equityMacro HFs

Source: Bloomberg, EurekaHedge

But they may struggle during the trendless, risk

on-risk off type of market we have seen recently.

This year, for example, as of end-July the average

hedge fund monitored by EurekaHedge was up

only 2.5% y-t-d. The performance of long/shortequity funds (+1.9%) and funds of funds (+1.7%)

was even poorer. By contrast, global equities have

The decline of the hedgefund?

Hedge funds have struggled in the recent trendless market

The underlying problem is that the hedge fund community has

become so big that it has harvested most of the alpha

Large hedge funds and traditional fund managers are likely

to converge


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risen 7.5% (MSCI ACWI) and global bonds (JP

Morgan Global Aggregate Bond Index TR) 2.4%

so far this year. Its not exactly worth paying two-

and-20 (a 2% management fee and 20%

performance fee) for that sort of performance.

Macro funds have particularly struggled in the

past couple of years. They have been one of the

strongest growth areas since the Global Financial

Crisis (when they performed well), with 10%

growth in AUM in the four years to end-2011

(compared with a 5% decline for the hedge fund

universe as a whole) see Chart 3. But this year

so far macro funds on average have returned only

1.1% and macro funds of funds -0.5%. Last year

too, return was poor: -1.2%. There have been a

relatively small number of consensus macro

trades (for example, betting on a rise in Bund

yields) that many macro funds put on, but which

were unsuccessful. The biggest problem is that

these funds are essentially making calls on the

actions of politicians and central banks, something

that is hard to do.

Many macro funds take an opportunistic attitude

to investing, switching from one strategy to

another as they spot profit-making trades. But thislack of a consistent investment approach has, in

the view of some CIOs we spoke to, turned some

institutions away from macro funds.

Why should hedge funds outperform?

The fundamental problem is that, as with active

equity fund managers, in theory hedge funds

should not be able, in aggregate, to out-perform.

When the universe of hedge funds was small

enough, there was still alpha for them to harvest.

In essence, they were getting their alpha from

traditional long-only fund managers. But, once

hedge funds became a USD1trn-plus community,

they increasingly had to get their alpha from each

other. Many investors believe that hedge funds are

charging alpha fees simply for beta.

So the expensiveness of hedge fund fees isincreasingly an issue. Two-and-20 (or even one-

and-a-half and 15) is much higher than traditional

fund managers charge. Standard Lifes GARS

Fund, for example, has a management fee of

75bps despite aiming for a hedge-fund-like return

(see the section on The growth of multi-asset,

above, for details). More vehicles are becoming

available to allow retail investors to access alpha:

hedge-fund-like UCITS in Europe, dubbed

Newcits, can short and use leverage, forexample. These trends will inevitably put

downward pressure on hedge fund fees.

3. Growth in hedge fund AUM by category of fund, end-2007 to end-2011

8% 12% 2% 13% 10% 5% 100% 6% 9% 2% 7% 11% 2% 13%

-15%

-10%

-5%

0%

5%

10%

15%

Macro

Fixedincome

Convertib

leArbitrage

M

ulti-strategy

EventDriven

EquityLongonly

Total

Sectorspecific

EquityLongBias

Merg

erArbitrage

Distresse

dSecurities

Equitylong/short

Equityma

rketneutral

Emergingmarkets

% of total HF AUM

Change in AUM 2007-11

Source: Barclay Hedge


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Hedge fund managers are responding. Some

larger ones have admitted that their size makes

alpha generation hard, and have returned funds to

their investors or closed to new money. Moore

Capital, for example, returned USD2bn in July.

Others have started to tailor their funds so that

they can sell them to retail investors. AQR Capital

Management, for instance, markets a number of

retail funds with active strategies such as

momentum

Documents

10 Key Trends in Asset Management