The sustainability of traditional asset management is being tested by questions about its role in society, at the same time as the investment world, and beyond, changes evermore rapidly. Predicting its future is very difficult. However scenarios can be used to contrast the most likely future with the most desirable future. This approach yields useful insights into what needs to change to get to a better place. I use this approach below – and I also use the ‘rule of three’, three times: three lenses, three issues, and three choices.
An assessment of the investment industry should consider:
1. Investment strategies
2. Organisational effectiveness
3. Societal legitimacy
The first is a logical starting point – how should we construct client portfolios, and evolve them through time? Is the growth of index-tracking a good or bad thing and how should smart beta or factor investing influence portfolios? We must start with the acknowledgement that, in aggregate, the investment industry will deliver market returns less costs.
In broad terms, organisational effectiveness refers to the efficiency with which investment organisations convert inputs into outputs. As there is a cost to restructuring organisations, they tend to remain fairly stable until sufficient evidence implies that change is really necessary. A quick scan of the horizon shows the approach of digitisation/roboadvice, the retailisation of pensions, the professionalisation of asset owners, and regulatory change. Throw in softer considerations, such as culture, and organisational change seems inevitable.
And then there is societal legitimacy, or the licence to operate. Any industry that loses its licence to operate eventually suffers. In Australia, the size of the self-managed super fund sector (where individuals reject mainstream offerings and run their own portfolios) is generally considered to be evidence of a damaged licence to operate for the mainstream industry. Any regulation that imposes a fee cap is sending a clear message about how the investment industry’s value proposition is regarded. The growing pressure for the industry to improve the diversity of its employees is also connected to the idea of societal legitimacy.
1. Complexity frameworks, models and coping strategies
The world is a complex, fast-changing, inter-connected place. The investment industry can increasingly be characterised by the popular epithet ‘VUCA’ – volatile, uncertain, complex and ambiguous (used initially to describe the new operating environment after the relative geopolitical calm of the cold war)
Volatility: We expect significant time-varying volatility in future market prices, together with asymmetry and fat downside tails. This requires the building of investment edge through investment intelligence, and applying parsimony to risk models.
Uncertainty: Inability to assess future expectations for return, or to objectively assess risk (Lo and Mueller, 2010) and can be accommodated through the use of deductive processes to derive model parameters and by allowing for estimation uncertainty in risk models and risk assessment.
Complexity: Markets are constantly moving and adapting; they are reflexive, non-linear and discontinuous. Coping strategies include:
Ambiguity: Given volatility, uncertainty and complexity, the assessment of future states is a matter of subjective beliefs. As there is no equilibrium to fall back on, the adoption of a beliefs based investment framework, which makes explicit allowance for behavioural biases, can be a helpful strategy.
The likely future is one where the industry does not use complexity in its frameworks, models and coping strategies and consequently suffers negative outcomes. Grappling with complexity is hard work, humbling and depressing; there are no easy answers and any real control over outcomes is limited. These features, among others, make the adoption of a complexity framework unattractive to the majority of organisations.
Understandably, the ideal future is one in which the industry overcomes these issues and there is wide-scale adoption of the framework and coping strategies – with the payoff being improved outcomes. Those improved outcomes would be both at the individual level, where organisations are better able to manage within and adapt to changing conditions, and at the aggregate level, where more robust organisations deliver lower levels of systemic risk. Achieving a more desirable future requires more enlightened thinking and the wide propagation of successful narratives and outcomes by exemplar organisations that apply themselves to this progressive thinking and action…Article continues in the Autumn 2016 issue of Professional Investor [login required].