Interesting Insights from Mercer

This is a quick writeup about the book 2020 Vision by Mercer. You can read more here:

According to a new book published by Mercer’s investment consulting business, investment managers will need to adapt and innovate to avoid falling into a two-tier industry of outperforming alpha fund managers and those left behind to chase scarce market returns.

The book, 2020 Vision: Investment Wisdom for Tomorrow, captures the views of some of the most influential investment figures from around the world and presents seven key themes that will influence the investment industry during the next decade.

Author and Senior Associate within Mercer’s investment consulting business, Harry Liem, believes the ability to sustain future superior performance will define the funds management industry in the coming years and that only those players who can adapt themselves faster than their competitors will maintain their leading edge.

Harry says that institutional investment is based on the search for alpha or outperformance, however, active investment managers have long battled against the erosion of alpha as their ideas and processes are taken up by competitors. The best of them are constantly searching for new ideas and new sources of information to maintain their competitive advantage.

The book reveals the insights gained from conversations with 12 professional and academic figures in the global investment industry, including, Dr Stan Beckers, Head of Alpha Management at BGI, Ray Dalio, Chairman and CEO at Bridgewater and Professor Stephen Brown, Professor of Finance at NYU.

It is set against the background of 12 ‘mega trends’ including a more difficult monetary environment, global economic imbalances, increased competition, the separation of reward for skill (alpha) and market exposure (beta), increased interest in the ‘alternatives space’, and growth in socially responsible investing (SRI).

Seven common themes emerged from the interviews, providing investors an insight into what they may expect from the industry in the coming years:

1. Active versus passive - the moving frontier

As more and more of what was once deemed ‘insight’ becomes systemised, pure alpha may become rare.

“However investment technology is changing with great speed, led by cutting-edge hedge funds. There will always be an important role for human judgement. The most successful funds will be those which learn to integrate these machine-based systems with seat-of-the-pants checks and balances that can effectively introduce common sense into the process.” – Stephen Brown, Professor of Finance at NYU.

2. The future of the investment industry - the dual world

While some fund management firms are positioning themselves for the coming decade with a firm focus on alpha returns, others will fall behind.

“The investment business will consist of alpha generators and beta replicators (and firms that do both), and the alpha generators will have very smart people who understand financial engineering and are equipped with fabulous information technology. In other words, the quality of play will increase dramatically.” – Ray Dalio, CEO of Bridgewater.

3. Generalist versus specialist - a place for both

Traditional debate has now moved into hedge fund space with many investors comparing the merits of the ‘fund of fund’ versus the multi-strategy approach.

“One could mount a reasonable case for either the fund of funds or multi-strategy approach to thrive going forward, depending on the marginal cost of acquiring alpha externally or developing it internally.” – Harry Liem.

4. The current environment - concern and hope

As the sub-prime mortgage fallout continues, attitudes to risk are being re-assessed.

On the one hand there is concern.

“The most striking thing about today’s environment is that practically every risky asset looks overpriced. At current levels we believe all of the major sectors of the global equity markets are overpriced, credit spreads are universally too narrow, yield curves give too little premium for duration risk.” – Ben Inker, CEO of Grantham Mayo Van Otterloo.

“Taking risk within specific opportunities while being generally defensive appears the prudent strategy this late in the cycle.” – Jae Park, CEO of Loomis Sayles and Co.

On the other hand there is hope that emerging markets will be able to take over as the engine of the world, at a time when economic growth in the US is slowing down. Economic leadership may pass back to the East.

“The pendulum of history which swung so visibly and decisively towards the West in the past 200 years is now beginning to return at an accelerating pace towards a twenty-first century world dominated by the East, in wealth, population, technology and economic dynamism.” – Robert Lloyd George, Chairman of Lloyd George Management.

5. The hedge fund industry - expecting a shakeout

There is increasing concern among interviewees about the fast growing hedge fund industry.

“As a client recently said: there are about 8,000 planes in the air and 100 good pilots.” – Ray Dalio, CEO of Bridgewater.

“The alpha can in fact be leveraged up, so in that sense, there is unlimited alpha. Many hedge funds operate by using leverage and assuming tail risk which is not captured in the traditional ratios.” – Professor Stephen Brown

6. Ethical Investing - the jury is still out

A common theme is that socially responsible investing is going mainstream. During the past decade investors have mainly been focused on governance, and in recent years the attention is expanding to take in environmental and social aspects. The body of research on whether ethical investing adds value will continue to grow.

“In essence, there are three competing hypotheses. The extra-financial information may be found to be relevant (eco-efficiency and corporate governance matter), irrelevant (have no material impact on performance) or relevant in a negative manner (i.e. there may be a risk premium for investing in sin sectors such as defence and tobacco). To make things confusing, you can actually find academic evidence for all three hypotheses.” – Rob Bauer, SRI expert and Professor of Finance at Maastricht University.

7. Investing: art, science or skill?

Despite all the emphasis on quantitative techniques, at the heart of superior performance lies human insight.

“There is a scientific method to it all, but it is the art that makes us humans indispensable, as we need to process information and be one step ahead of our opponents.” – Jae Park, CEO of Loomis Sayles and Co.

Hat Tip: Mebane Faber