According to Principal Global Investors (Australia) chief executive Grant Forster, market volatility is exposing backward-looking risk models.
A recent Principal sponsored report, Market volatility: friend or foe?, identified a number of key themes, one of which is how investment managers can help their clients benefit from the current market volatility.
Since 2008, markets have displayed unusual volatility. There is no precedent for so much fluctuation or for asset classes moving in lockstep with such uniform correlation.
Market commentators expect this volatility to remain – at least until the sovereign-debt crisis in the West is resolved. For investors, this leaves the question of how – or if – they can take advantage of the opportunities that this environment offers.
While most asset managers acknowledged that volatility can mean opportunities, precious few felt confident that they had the skills to convert turbulence to strong returns.
At the same time, they recognised the 2000s as a “lost decade” for investors and that avoiding a rerun requires re-evaluating standard investment approaches. A tall ask in itself, this has been made all the more difficult in an environment where many investors have been burned and are reluctant to venture back into stormy seas.
Scale and scope
According to those questioned by report researchers, one frequent barrier to finding new investment approaches over the past two decades has been the pursuit of scale and scope in investment management.
The rise of specialist mandates has meant that the traditional “craft” heritage of asset management has been diluted, as has the speed and flexibility required to cope effectively with volatility.
In the view of those surveyed, there is now an industry-wide shortage of managers with the big-picture skills to make the right tactical choices about asset allocation. A belief that investment managers need to “dump the mental baggage to improve track records” came through loud and clear.
Dumping mental baggage may seem relatively straightforward, but changing long-held investment practices isn’t easy. Sticking doggedly to a buy-and-hold mentality and relying too heavily on backward-looking risk models are both common practices identified as needing to change.
Realism, engagement, flexibility and solutions
In the end, four key areas were identified as crucial.
Firstly, investment managers need to improve their ability to understand price dislocation and avoid unrealistic claims about returns. They also need to align their interests more closely with those of their clients and institute incentives that share both pain and gain. When this is achieved “clients are not too worried about returning to the table because we are their co-investors, who eat our own cooking”.
Increased communication between investment manager and client was a second area of concern, with a real need for managers to go beyond cursory reporting to engage closely with clients cited.
Thirdly, it was considered that investment managers need to encourage free-thinking and high-conviction investing within their teams, as this promotes the speed and flexibility necessary to navigate turbulent markets.
At this point it is important to acknowledge that many investment managers also felt that clients should acknowledge some responsibility for their poor returns. The herd instinct can see investors make decisions contrary to their own interests. It is easy to become trapped in the greed/fear cycle and to make decisions akin to selling a bet on a horse half way through the race.
Finally, what comes across most clearly from the report is that the big-picture understanding of investing was lost when specialist mandates replaced balanced ones, and that investment managers have spent too much time providing products, not solutions.
Dynamic asset allocation means understanding clients’ overall goals and spending more time focusing on investment fundamentals, even if that means diverging from the herd and sticking your neck out.
Investment managers need to inject a dose of realism into their investment and this means focusing on fundamentals in asset allocation, not complex financial models.
Grant Forster is CEO of Principal Global Investors (Australia). The full report can be viewed by clicking here.
