Crippled by the crisis

The funds management sector has been hit hard by the financial crisis. But don't expect things to go back to the way they were if the downturn abates – the impact on managers is likely to be long-lasting.

The global financial crisis has ravaged the funds management sector. While the markets may be showing some signs of life, the impact on the managers may not be a temporary phenomenon.
The crisis has shut off inflows and swollen outflows. For some, like the hedge fund sector, the impact on business models that promised investor liquidity they couldn’t deliver under the pressure of the crisis has been extremely destructive.

A paper issued by investment consultants Watson Wyatt (advisors to the Future Fund in this market) produces a gloomy outlook for the industry, forecasting considerable changes and continuing pressures.

The firm says that 2008 earnings for asset managers were down about 10 per cent to 15 per cent. This year the starting point is for revenues between 30 per cent and 50 per cent lower than 2008, with earnings experiencing even greater declines.

That is a quite nasty outlook for an industry that grew dramatically on the back of the long-term boom in equity markets and, in this market, the mandated stream of compulsory superannuation contributions. The ad valorem basis on which fees are structured made that a very lucrative and highly leveraged gravy train for managers during the good times – and reverses the leverage in the downturn.

Even if the current rebound in markets were to continue, the impact of the financial crisis isn’t going to recede quickly. Investors, particularly the large superannuation funds, have been scarred and have learned from the experience.

Even without assistant treasurer Chris Bowen’s campaign for lower fees, the big funds will be conscious that while they can’t control markets they can control costs. They have also been reminded that while equities might produce good returns during sharemarket booms they carry latent and substantial risk.

Watson Wyatt believes the investment managers will respond to the changed conditions by cutting costs (people) and by consolidating. On the client side, it believes there will be greater diversification of managers within mandates, a push for lower fees and different fee structures and a structural shift in the mix of active and passive managers.

One lesson learned from the crisis is that while a lot of managers, particularly hedge fund managers, promised to deliver ‘alpha', or returns above those delivered simply by the markets’ performance, through their superior investing, very few actually delivered that alpha under the pressure of the crisis. Equally, promises of uncorrelated performance generally haven’t been met – the ebbing tide of markets stranded most investment strategies.

So, the funds are likely to be more discriminating about their investment managers, have a greater proportion of the lower-cost market-tracking index or passive funds, and seek to screw down the fees charged by the smaller number of larger managers they will deal with.

They are also likely to have less appetite for risk, even in recovering markets, which would reduce the flow of funds into equity mandates and shift it towards fixed interest and cash and other lower-cost options.

In this market we’ve already seen the big industry funds starting to cull the number of mandates they’ve awarded to make their funds easier and more efficient to manage and perhaps to give themselves greater leverage to negotiate with the smaller number of managers they retain.

Watson Wyatt’s Australian head of investment strategy, Tim Unger, believes hedge funds, and more particularly the funds of funds-style aggregators of hedge funds, face particular problems because of their performance, the availability of leverage, the liquidity issues that have led to investor funds being ‘locked up’ and the Madoff scandal.

One could argue that the liquidity issues – the inability of funds invested in underlying assets that are themselves illiquid to deliver liquidity to investors when they most require it – has damaged, not just hedge funds, but most of the alternative asset classes.

Unger also believes there will be a continuing role for boutique investment managers, but that they are likely to be fewer, larger and better capitalised.

The likely rationalisation of the sector and more aggressive, or at least assertive, stance of the gatekeepers of the funds – apart from creating pressure for a large-scale restructuring of the sector and the shift Watson Wyatt sees towards more passive exposures (and probably a significant shift in risk appetites) – could create an opportunity for funds to change the structure of the fees they pay managers.

Why should the sector operate on ad valorem fees? It doesn’t cost that much more to manage $5 billion as it does to manage $1 billion. Why not a combination of fixed fees and a percentage? Why not a lower base fee and performance fees for excess returns delivered, not on an annual basis, but in the medium to longer term?

The funds management sector has grown explosively in tandem with the explosive growth in the superannuation system created by the introduction of the superannuation guarantee in 1992.

The global financial crisis appears likely to be a very visible, and perhaps traumatic, punctuation point in its hitherto expansionary history.

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