Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Storm warning: Mercer on manager business risks
Fund manager business risks have spiked upwards during the coronavirus crisis with further fall-out likely as the shockwaves reverberate, according to a new paper by Mercer. The firm sees the possibility of casualties and M&A activity, but not yet a widespread collapse of funds management firms.
The ‘Riders on the storm’ report, authored by David Scobie, says the COVID-19 market disruption has put a strain on fund management business models across the world. While the quick bounce-back for the March market lows may have papered over many cracks in fund management businesses, the Mercer study says investors need to pay closer attention to any underlying issues highlighted by the recent volatility.
“At this stage we don’t anticipate a widespread collapse of asset management firms, assuming markets maintain or kick-on from current levels. However, we do see scope for an increase both in outright casualties and in M&A activity. At a minimum, cost reduction will be to the fore, particularly where short-term earnings expectations need to be managed (often felt most keenly by listed entities),” the paper says.
“Some managers, particularly but not limited to boutiques, may be travelling ‘close to the wind’ in terms of breakeven profitability levels,” the paper says. “Firms experiencing most stress are likely to be those relying on just one asset class for revenue, or those which are still in the establishment phase and may have been subscale even prior to the downturn.”
As well as quizzing managers about business continuity plans, the paper says Mercer has also been watching for evidence of ‘style drift’, increases in redemptions and stress on out-of-favour strategies.
“At a business level, we’re looking for any indications that an asset manager may be experiencing cashflow challenges,” the report says. “We have seen isolated cases of firms putting their hands up for financial assistance schemes offered by Governments. This has the potential to reflect something more chronic underlying the business.”
Scobie, the head of consulting in Mercer’s New Zealand business, said the renewed focus on manager business strength across the 12,000 or so strategies Mercer regularly reviews had resulted in a few tweaks at the margins.
“Inevitably there have been some incremental changes in our views, though probably not by as much as could have been expected (to this point), helped by the rebound we have seen in markets,” he said.
And while boutique firms could be most at risk from business disruption, Scobie said stand-alone fund managers have a few factors in their favour.
“On the one hand boutique-type firms will often not have the financial wherewithal of larger firms, but they can have the ability to react and pivot more quickly,” he said. For example, the paper says staff-owned firms have more ability to defer, or reduce, salaries in lieu of longer-term incentives to ease the impact of any short-term revenue loss.
“It remains appropriate for investors to allocate some of their assets to boutique-type firms where the anticipated rewards outweigh the perceived risks,” Scobie said. “Recent market conditions have highlighted the potential downside of allocating to boutiques, particularly relating to business risk, but we maintain that the net benefit remains in certain instances.”
The report says even if some managers do fold, investor assets should not be at risk as most funds use third-party custodial arrangements. But, regardless, investors should be more attuned to fund management risks in a tough economic and social environment. “There is no shortage of issues to be wary of,” the paper says. “For Mercer’s part, by doing the right legwork we aim to be quick to update our advice to clients if we identify signs of weakness at an asset manager and recommend switching to another which can more ably ride out the storm.”
– David Chaplin, Investment News NZ
