22 October 2012

300 Club - From short-term salesmanship to long-term stewardship

In the past 30 years, asset management has evolved from a profession to a distribution-driven industry, and shifted from a client-driven approach to being product-driven. In the third paper published by the 300 Club, 'From short-term salesmanship to long-term stewardship: A paradigm shift in the asset management industry', Lars Dijkstra analyses the main developments on the demand side, with a specific focus on the challenges perceived by (Dutch) institutional clients, and the supply side. Moreover, he looks at the position of the asset management industry in 2012.

Lars Dijkstra of the 300 Club said: “Today a growing body of opinion suggests that asset management in its current form adds little value. By far the lion’s share of global savings is controlled by financial conglomerates. These are respectable institutions, of course, but many of them have a short-term focus within an activity they do not even consider their core business. Of the investment funds that are actively managed by the conglomerates, the long-term performance of the majority lags behind the index. Apparently, they fail to convert our savings into profitable production capacity”.

Asset Management in 2012

The asset management profession exists by the grace of expertise, discipline and reliability. What is the position of asset management today in 2012? Unfortunately, the 300 Club is forced to conclude that the asset management industry on average fails in expertise, discipline and reliability. These three aspects are a result of financial conglomerates, lack of focus and short-term career risk.

Financial Conglomerates

The 1980s and 1990s were a period of rapid growth in which a growing number of asset managers became part of a listed financial conglomerate. The global trend of ‘bigger is better’ led to tremendous consolidation, giving rise to a financial industry consisting of very large ‘all finance’ institutions.

Institutional clients often decide in favour of a good reputation, scale size, convenience and presumed solidity and security. However, large size is an impediment and big does not always mean beautiful. In fact, the chances of success decrease as the assets under management increases. What is important is performance; the larger the asset manager, the harder it proves to achieve outperformance. A study by John Bogle illustrated that smaller asset management companies with a limited number of funds perform significantly better than large asset management companies with a large number of funds.

Lack of Focus

Sales departments of financial conglomerates and large asset management firms are driven by a product focus and profit motive, marketing funds that appeal to the public, but most often marketing yesterday’s winner. The question of what the client really needs is insufficiently addressed. Before long, this approach will leave the client disillusioned with disappointing absolute returns. Furthermore, the relative returns of the actively managed investment funds of financial conglomerates are substandard. As a result of an excessively short investment horizon, index-hugging and transaction fees, most investment funds fail to deliver added value after active fees.

Mr Dijkstra, said: “It is no wonder that passive index trackers are one of the fastest growing segments of the industry. However, while they are attractive to investors as they are convenient, efficient and have low fees, tracking a market-cap index means investing most heavily in yesterday’s winners. Moreover, many passive products have been proven to entail substantial risks, as was the case in securities lending and collateral pools, in which cases the seller typically collected the proceeds while the buyers were exposed to the risks.”

Short-Term Career Risk

Business managers running asset management firms often focus on the short-term interests of their shareholders because they want to secure their bonus and their job. Therefore, they are disinclined to take risks that may, in the long run, add value for the client. At the same time portfolio managers are under pressure from benchmarks and have to achieve short-term success or their career will be jeopardised. Achieving short-term success in asset management is by definition based on luck instead of skill. There is a fundamental mismatch in horizon between the interests of pension funds and the interests of asset managers, especially when these managers are part of a financial conglomerate.

“There is a wide gap between what clients need and want, and what many asset managers can or are willing to offer at the moment. The asset management industry will have to reinvent itself, but institutional clients will not be able to avoid the necessary soul-searching either”, said Mr Dijkstra.

Moving From Short-Term Salesmanship to Long-Term Stewardship

Client focus should be the cornerstone of the asset management industry. A sustainable partnership with a long-term aim, in which transparent communication and mutual trust are vital features. New leadership is needed to restore the confidence of clients, and there needs to be a move away from distribution, marketing and product pushing.  Long-term stewardship is crucial in the new approach.  

Mr Dijkstra, continued: “Superior asset management requires two things; creativity and decisiveness. Creativity is a matter of art and science while decisiveness is determined by culture. Art involves skills, focus, specialisation and passion for the profession. Science concerns competence and expertise with respect to our profession. Culture is all about whether small teams of portfolio managers are encouraged to take risks, and whether the right preconditions have been established for decisive action. To realise all this, three conditions have to be met: alignment of interests, focus and long-term commitment.”

Alignment of Interests

The interests of the client, the asset manager and the employees must be aligned. More and more academic studies reveal that this is a crucial aspect. This can be realised by giving employees co-ownership of the company and allowing them to invest in their own products, or as Americans would say: ‘have skin in the game’ and ‘eat your own cooking’. For asset managers, leadership not least implies they have to deliver added value net of fees. This takes courage; the courage to take risks and to be a contrarian and to invest in assets and stocks that are out of fashion.

“In short, it takes the courage to stick your neck out in the interest of the client, even if it means putting your own career at risk. Asset management companies where culture, philosophy and ownership are in the hands of the portfolio managers themselves have a significantly higher chance of creating value for the client”, stated Mr Dijkstra. A good asset manager will not sell clients investment products that he would not buy himself anymore because they are heavily overpriced.

Focus

Further to this, asset managers should be focused and the emphasis should be on a limited number of high-quality activities. The idea is not to offer everything, but rather to make choices under the motto: ‘We do things well or we don’t do them’. This means working with a modest number of specialised products and distinctive investment strategies.

Long-Term Commitment

Lastly, a strong long-term commitment is required, both on the part of the clients and the asset managers. It is essential to move away from short-term driven investment decisions. If there is one group of investors who can afford this luxury, it is pension funds. After all, success in asset management depends on winning gold medals in the marathon, not the 100-metre sprint.

Mr Dijkstra, said: “In order to bridge the gap between what clients want and what asset managers offer, asset management will have to reinvent itself. The tools and options to do so are readily available, but it will require a paradigm shift in the industry. We need to transition from short-term salesmanship to long-term stewardship.”

Press release

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