Recent times have not been easy for European investment managers. The credit crunch that followed the collapse of Lehman Brothers Holdings three years ago dealt a blow to the use of standard benchmarks. After all, why target an index if even outperformance can produce negative returns.
More recently, the euro zone debt crisis and related worries about debt levels in the U.S. have thrown into doubt, if not permanently tarnished, the decades-old received wisdom that rich-country government bonds are ultrasafe. And equities have problems of their own. The prolonged weakness of Western economies has sparked fears of a Japan-like rut that could produce low, or nonexistent, growth for a generation. Such a possibility casts a long shadow over the once-prevailing view that stocks will, if granted enough time, deliver decent returns.
With some of the canons of traditional investing lying in tatters, money managers and their clients have been forced to think in a profoundly different way about how to deliver satisfactory performance.
“Given there’s so much uncertainty out there, there’s been a huge resurgence in either tailoring your benchmark or moving more to total return,” says Liz Ward, head of Europe at UBS Global Asset Management in London. “The majority of new mandates we’ve seen this year includes total-return investing. That will probably continue. Similarly, for benchmark-based investing, the lion’s share of new mandates is now against tailored indexes.”
Today’s challenging environment is reflected in the Euro 100, Institutional Investor’s annual ranking of the region’s largest money managers. In times past managers could usually count on a rising tide to lift all boats. But in the current volatile climate, performance can vary widely. Total assets of the Euro 100 stood at €17.5 trillion ($24.3 trillion) at the end of June, up a modest 3.6 percent from December 2009, a measure of the low returns prevalent across many markets. The performance of individual managers varied significantly, though.
Allianz Group, the giant German insurer, remains on top of the list, with €1.69 trillion in assets, up 19 percent from the previous ranking. France’s AXA rises one place, to second, although its assets edged up just 1.5 percent, to €1.05 trillion. Switzerland’s UBS slips one place, to third, even though its assets rose 14.7 percent, to €703 billion. (The bank’s figures represent only discretionary assets, unlike previous years, when they included advisory assets.) France’s Amundi Group is in fourth place, with €691.9 billion, up 3.3 percent; and New York–based BlackRock rounds out the top five, with €643.6 billion in assets, up 12.6 percent.
All of these institutions are grappling with the loss of credibility of benchmark-based investing. Before the crisis more investment mandates were pegged to various standards — ranging from national indexes like Germany’s DAX 30 to regional and global indexes offered by the likes of MSCI to their equivalents in the fixed-income world — than to any other strategy. But crisis-driven losses have burned investors and sent managers scrambling to devise alternatives.
At M&G Investments, the fund management arm of Britain’s Prudential insurance group, pension fund clients are increasingly looking at the bottom line. “In the last several years, we’ve seen a lot more mandates which have been much more focused on delivering absolute returns,” says Simon Pilcher, a member of the board of M&G and head of fixed income. “It’s become a more common principle that we’re investing actual dollars and actual pounds to pay actual pensions rather than relative dollars and relative pounds to pay relative pensions.” Prudential’s actual and relative standings show good progress in the Euro 100. The company rises three places, to No. 11, after an 18.7 percent rise in assets, to €387 billion.
Fund managers say an increasingly common target for new mandates is to achieve a total return of cash (effectively, bank deposit rates) plus 4 percent, or 3 percentage points above a client’s domestic inflation rate.
Charles Prideaux, head of institutional investing for Europe, the Middle East and Africa at BlackRock in London, says one common way for pension funds to achieve a positive total return is to start off with fixed-income assets that can provide a reliable return that matches predicted liabilities, and then add on some higher-return, higher-volatility assets such as equities. The equities should be from companies with high dividend yields backed by strong dividend cover. Prideaux says BlackRock looks for “companies with a good track record of being able to grow their earnings dividends persistently in a variety of different economic circumstances. They’re not just reliant on cyclical economic growth.”
Total-return strategies aren’t the only factors pushing investors to seek tailored benchmarks. In some cases, investors are looking to avoid specific risks. Jay Ralph, chief operating officer of Allianz Global Investors, an arm of the German insurer, points out that investors in Italy and other peripheral euro zone countries previously used their home countries’ sovereign bonds as risk-free benchmarks. That’s no longer the case now that fears about those governments’ solvency have pushed yields above 5 percent for Italy and Spain, and much higher for Greece, Ireland and Portugal. “The Italian government isn’t a risk-free benchmark anymore, so many are looking to the German Bund instead,” says Ralph, referring to German government bonds. The American executive is due to become chairman of Allianz Asset Management, which encompasses AGI and Allianz’s U.S. subsidiary, Pacific Investment Management Co., in January, succeeding Joachim Faber.
The task of designing new benchmarks is complicated by inconsistencies between today’s market conditions and some regulations. Greg Ehret, head of EMEA at State Street Global Advisors in London, notes that Europe’s new Solvency II rules won’t require insurers to hold any capital against investments in European government bonds — even those of countries such as Italy and Spain, where spreads have risen sharply — but will require capital for holdings of high-rated corporate debt. Such a rule provides a perverse incentive considering that many investment managers are encouraging investors to buy corporate bonds, believing that many of them offer a better balance of risk and reward than several sovereigns. To respond to the capital rules as well as the firm’s own assessment of risk, State Street has constructed portfolios for some clients that restrict sovereign holdings to German, French and Dutch debt. “We’re asked to engineer different solutions for clients at a far greater rate these days,” says Ehret. Such strategies, however, offer little relief to investors with sizable existing sovereign holdings, he adds. “Most clients cannot afford to take the consequent haircut on yield to make this kind of move,” explains Ehret.
M&G has also adopted a new fixed-income hierarchy for its clients that is radically different from what prevailed only a few years ago, according to Pilcher. “The lowest risk includes very high-quality asset-backed securities, nonfinancial corporates including utilities, and then sovereigns, with banks at the bottom,” he says. M&G holds €13 billion in asset-backed securities.
For investment managers, the growing trend toward total-return investing creates challenges of its own. Such an investment style demands that managers be able to look across asset classes to find the best returns. As a result, many firms have restructured their teams or recruited new talent.
Edinburgh-based Standard Life Investments — which slips two places, to No. 34, despite a 13.4 percent rise in assets, to €174.8 billion — established a multiasset investing team in 2008 and has increased its staff to 24 investment professionals. The firm has had inflows of more than £700 million ($1.1 billion) over the past year into its MyFolio range of multiasset retail funds, which were introduced in 2010 and seek to limit risk by investing in a wide range of U.K. and international equities and bonds, as well as commercial property. The majority of the funds use absolute-return strategies.
The demand for the funds has been surprising because advisers normally want to see a three-year track record before steering clients to a fund, says Jacquie Kerr, who heads the company’s business with financial advisers in the U.K. “We’ve had quite a number of bad years in a short space of time” in global markets, she says. “This has probably created a legacy of more risk-averse investors, and that’s why the industry’s seen growth in absolute-return sectors.”
Deka Investment, one of the biggest retail managers in Germany, has two teams that invest across asset classes and regions to create absolute-return products: a 14-strong Multi-Asset Class Total Return group and a nine-strong Quant Asset Allocation Products group. Victor Moftakhar, chief investment officer at the firm, thinks retail interest in absolute-return products will continue to grow because slow economic growth in developed countries limits returns from conventional strategies. “The classic long-only model has been changing into an absolute-return, multiasset-class model — where instead of buying into a particular asset class, investors buy into a particular risk-return budget,” he says.
Deka currently manages €6.6 billion in absolute-return equity products, up from €2.4 billion at the end of 2009. The Frankfurt-based firm jumps five places in the ranking this year, to No. 36.
Other money managers are finding even bigger opportunities in the heightened risk-aversion of their clients. Full fiduciary mandates, under which a pension fund awards the management of its entire portfolio to an outside firm, have more than doubled in the past 18 months at Allianz, says Ralph. Such mandates allow the manager to monitor risk and correlations over a client’s entire range of asset classes. Ralph says Allianz is also seeing increased demand for risk management overlays, which use derivatives to buy downside protection for stock and bond holdings.
More sophisticated products don’t come cheap, of course. Personnel costs have risen as fund managers “focus on increasing the size of their existing teams,” says Martin Huber, a director at McKinsey & Co. and co-author of the consulting firm’s annual survey of European asset management. Nonpersonnel costs for information technology and market data have also increased, he adds. In today’s low-return, high-volatility environment, however, customers are looking to keep expenses as low as possible. The result, says Huber, is a challenging outlook. “Profit margins in Western Europe will remain below precrisis levels until at least 2013,” he predicts. • •