As the rate of innovation in investment management shows no sign of letting up, Greg Bright gazes into his crystal ball to see what awaits financial advisers.
Funds managers, investment bankers and other providers of investment products are clever people. They spend a lot of time devising new and improved ways to eke out higher returns or reduce risk.
The result, an increased pace of innovation of investment products, has picked up in recent years with the greater acceptance of hedge fund-like strategies and other less-liquid investments, such as private equity, infrastructure and – dare we say it – higher alpha fixed interest instruments such as collateralised debt obligations (CDOs).
For the product providers this is all good news, especially when coupled with an increasing investor preparedness to pay higher fees for higher returns. However, advisers and their dealer groups have tended to lag behind the large institutional investors in the adoption of many of the new products and strategies.
At times, such as with the sub-prime crisis gyrations in August, they and their clients are probably grateful for the lag. Not too many advisers bothered to negotiate a basket of CDOs for their clients. The Basis Capital and Absolute Capital losses were relatively small and well managed as far as crises go.
‘Advisers have to come to terms with a new way of thinking about investments’
But in the long run, advisers have to come to terms with a new way of thinking about investments.
And they will have to come to terms with other likely changes, including greater internet usage, ever-increasing compliance issues, a changing regulatory environment, demographic changes, an ever-increasing focus on fees, more demanding clients, competition for talent … The list goes on.
The one constant among all these changing pressures is that there will never be a substitute for sound advice, made with full knowledge of a client’s circumstances and with a proper handle on the range of available options.
Steve Helmich, the director of financial planning, advice and services at AMP, says that the overall trend will be for planners to have deeper relationships with their clients.
Their advice will focus more around strategy and structure. He says that an adviser, who attempts to pick turning points in markets or make other similarly difficult investment decisions, is setting himself up for trouble.
But the dealer groups and research houses have already felt the pressure to provide increasingly sophisticated investment offerings. This demands more risk control and better education – at the planner as well as the client level. The big leap of faith that planners will be asked to take is that the new-style asset allocation being rapidly adopted by institutional investors marks a secular trend, not just a fad.
The old way of splitting a portfolio into growth assets – usually around 70 percent – and defensive assets is long gone for two reasons: many new investments cannot be neatly classified as growth or defensive; and what matters most now is that each asset class or type of investment is lowly correlated with the others.
Why this may be a leap of faith is that it is based largely on the strategies developed through the 1990s by the big US university endowment funds. Endowment funds do have many of the characteristics of large super funds, such as guaranteed cashflow and long-term horizons, but perhaps not for the average private investor. And apart from the tech bubble of 1999-2000, the sample period has really been one long bull market. The model is useful for a vast array of investment strategies and managers to complement plain vanilla exposure to the major markets.
A common way is for the portfolio to be split between beta sources, the major markets, and alpha sources, which is the outperformance demonstrated by skill or luck. The beta will still make up the major part of a portfolio: typically 70-80 percent.
This will be gained by futures, swaps or index funds for Australian equities, international equities and Australian and/or global bonds. Some may have a passive exposure to listed property in their beta allocation and even a range of ‘alternative betas’ such as commodities, emerging markets and exotics.
The alpha sources may be numerous. They will range from the conservative end of the spectrum with credit-style hedge funds and slightly levered long/short equity funds and market neutral funds, to the higher-risk strategies of private equity, opportunistic property, and global macro hedge funds, as examples.
Other institutional investors may also split the categories as listed and unlisted, because of the different skill set required to analyse them and their different liquidity characteristics. They do not have to concern themselves with whether or not to include a share in an infrastructure investment, for instance, as a bond or equity.
Most of the new-style strategies will have a significantly lower exposure to Australian equities, practically no Australian bonds or cash, but with various forms of property.
Managers are paid well for their alpha but not for their beta. The separation of the two, however, is proving easier said than done, especially in some asset classes.
In theory, this sort of portfolio will outperform a traditional portfolio by one to two percent a year, with some consistency, but also with significantly reduced volatility. The greater certainty of the return, through the reduced volatility, should make such a portfolio ideal for the financial planning market too. This is because it is much easier to overlay some form of guaranteed income through portfolio insurance to offer to the retiree market.
The portfolio should also have a lower likelihood of a negative return in any given year because of the low correlations between the types of investment, which is another thing that private investors may be more concerned about.
A commonly raised question about the new type of asset allocation is how the portfolio will behave in a crisis, when all correlations tend to go to one. The August credit crunch has provided some useful evidence that, even where it does occur, it is very short lived.
The other question concerns liquidity. The inability by some hedge fund managers to sell their CDOs in the first half of August certainly cost them money. But supporters of the new way point out that this potential problem can be easily overcome through diversification. One thing which remains unchanged from Modern Portfolio Theory is the wisdom of diversification.
THE NEW MODEL
Jeff Rogers is considering a movement in this direction. Rogers recently took over as chief investment officer at ipac, based in Sydney, after leaving the Victorian Funds Management Corporation, which acts as a multi-manager for Victorian Government funds.
Rogers admits that, from an investment perspective, what is feasible in the future may be different from what a financial planner may be able to include in a plan.
“There’s been significant innovation in capital markets in general over the last 10 years,” he says.
“A group like us will be able to take advantage of those innovations to build better portfolios.”
He adds, though, that some of the less sophisticated portfolios have performed very well over recent years, somewhat by happenstance.
“If you were loaded up with Australian equities you have done well. Nevertheless, ipac’s bundled investment options are likely to end up with less in Australian equities, which will be used to fund other investments.
“Ultimately, we will have more diversity,” Rogers says.
The majority of portfolios will still consist of “cap-weighted benchmark relative return strategies” which make up a large part of investor wealth.
However, there will be two new directions, Rogers believes.
One is an insurance element that will be overlaid over the broad market exposures, especially for clients in their retirement phase.
“There will be a new generation of fairer, capital-guaranteed strategies … operating as an overlay over existing structures. These will be less expensive, more transparent and reasonable for the financial risks by the counterparty. Innovation will allow that to happen,” he says.
Such overlays will provide investors with a better option than holding an increasing proportion of their assets in cash or short-dated bonds as they get older.
And rather than relying primarily on Australian equity and global benchmark-driven investments, other sources of return will be introduced.
“There will be more alpha that’s detached, so it will be cash plus the skill of the managers. We envisage an alpha pool with a target return of cash plus three to four percent and it shouldn’t matter whether equities are up or down. It will smooth the ride in the draw-down phase,” Rogers says.
“Then we’ll have alternative beta, starting off with direct property, private equity, commodities and listed infrastructure.”
THE PLANNER CHALLENGE
Of course, not all planners, even those who are part of a large dealer group, will progress down this route. Rogers believes there will be a bifurcation between those who stay predominantly in listed markets and those who use more of the alternatives.
But planners have to be aware that they are giving up some potential return if they rely solely on listed markets and therefore will have to be much more conscious of funds management costs. If they stay in listed markets they will have to be either unusually good at picking managers or pay very little for the beta component of those managers’ returns.
Planners who go down the alternative route also have to be aware of potential pitfalls. Governance of a range of new investments requires a large internal staff and specialist consultants. This is going to stretch the resources of most dealer groups and research houses.
In private equity and hedge funds, the spread between the best performing manager and the worst is much wider than among long-only Australian equity managers, putting more pressure on manager selection.
And performance fees, which litter the alternative landscape, do not always represent true alignment of interests between manager and investor.
There’s the ‘option’ element, for instance. This refers to the case of a manager outperforming by a big margin in one year and getting a big performance fee, underperforming in subsequent years, and still getting a base fee for it. There are also bigger issues relating to access and capacity in the alternatives sector compared to the broad markets.
The role of the platform providers will also come under pressure in this new environment. With an ever-increasing array of investment options, planners, or their dealer group researchers, will need to put in extra work to understand the underlying managers and strategies in some of the new bundled options.
The differences between many hedge fund strategies can be vast, even if they look similar on the surface. And the impact will be exacerbated by different levels of gearing.
DEALING WITH REGULATION
While predicting future investment strategies is difficult, predicting future legislation and regulation is probably impossible. Most industry practitioners believe that in areas where there should be improvement, such as in transparency of services and charges, it would be better for all involved if this was done by the industry rather than the Government.
Dan Powell, executive director, sales and marketing, for ING Australia, says: “It would be good to be able to open page two or three of every SOA and find a clear disclosure of all fees and charges. I’m pro both commission and fee-for-service models. That’s not what the customer is saying is relevant. It’s just about transparency.”
ING has commissioned the Neilson Company to survey both planners and clients on a range of questions. (Powell was scheduled to release some findings from the latest research at a session at the FPA conference in late November.) The results show that while client satisfaction with their financial adviser is rising – supporting FPA research on the subject – so are the clients’ expectations. They want value for money.
There are some interesting ‘gaps’ which emerge between the advisers’ views and clients’ views, however. The most pronounced of these gaps include:
• 82 percent of clients but only 31 percent of advisers say the adviser’s track record of recommending good investments is “very important”.
• 83 percent of clients but only 44 percent of advisers say it is “very important” for the adviser to look at all aspects of the client’s financial situation.
• 79 percent of clients but only 52 percent of advisers say it is “very important” for the adviser to clearly outline the service, both initially and ongoing.
• 87 percent of clients and 66 percent of advisers say it is “very important” that the adviser clearly explains the products being recommended.
• 77 percent of clients and 58 percent of advisers say it is “very important” that the adviser takes clear responsibility for the recommendation.
Powell says that while an adviser may effectively outsource all investment decisions, which a lot of experts would suggest is probably in a client’s interests, the customer still believes the adviser “owns” the performance. This may not be a big problem in a benign market, as we have had for several years, but it will put more pressure on the adviser at some stage in the future.
Mark Spiers, the head of BT Financial Group dealer group Magnitude, likens the many issues surrounding the provision of a financial plan, now and in the future, as intersecting like the mechanisms of a clock.
“All the cogs intersect and, depending on their gearing ratios, they have various knock-on effects. Next year, for instance, the number of people leaving the workforce will be greater than the number entering for the first time.”
Adapting to this baby-boomer demographic, coupled with the marvels of modern medicine keeping people alive longer, will obviously mean changes to the average piece of financial advice. Spiers soberly points out that the fastest growing section of the population is people over 100 – admittedly growing from a very low base.
“The best way to look at what the plan of the future will be is to look at who the customer of the future is,” he says.
“This will bring into account a whole range of things. It will be more of the same in one sense but different in others … The plan needs flexibility to cater for people to be still working, at least part time.”
Like ipac’s Rogers, Spiers says capital protection will become increasingly important, including products such as protected equity loans.
Both protection and alternative investments have been very expensive until now. To put them both into a more reasonably priced category will be a challenge for the industry’s manufacturers.
“Not all alternatives are expensive,” Spiers says.
“With ETFs, for instance, they’ve done nothing for years but are starting to take off now. In any case, people don’t mind paying more if they are getting value. But what’s value is different for different people.”
From the point of view of the planner’s practice, Spiers says there will be more “teaming” in the future.
“There will be more of a blurring between the services of banks, life companies and wealth management,” he says.
“The new guard of accountants and the new guard of planners coming through will bring new techniques and ideas.”
In a teamed set-up, the planner may establish the strategy and the accountant handle its implementation, including, say, the establishment and administration of an SMF. The accounting profession will be increasingly involved in traditional planning in some form. As Powell says, the ING research shows that only 17 percent of clients give all their money to their financial planners. An accountant, while not having the same relationship concerning what is done with the money, will at least usually know where all of it is.
The issue of providing advice for the mass market will become increasingly vexed due to the baby-boomer demographic, particularly when coupled with the issue of a severe shortage of planners. The cost of providing advice will have to come down, helped by technology and, with a bit of luck, some regulatory changes.
Powell says that the recent research showed that 37 percent of clients visited their adviser’s website within three months of receiving their advice.
“We didn’t anticipate that this would be so high and we’ll do more research on it. Some adviser sites have wraps and some have links to other information but they are generally fairly basic. Advisers will have to invest more in their websites.”
The trick will be to get the client to do as much of the “pre-work” online before meeting the adviser face to face. However, it is unlikely that the structure of the advice industry will change much, notwithstanding further automation.
“The challenge is to maintain the entrepreneurial growth spirit of a small business at the same time as harnessing technology and complying with all the things they have to comply with,” Powell says.
“People will come up with solutions. This is a belly-to-belly industry and those industries tend to have the same characteristics.”