Yale School of Management

International Center for Finance

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Asset Management: A fiduciary responsibility for a social need

What we all need is a portfolio that delivers an outcome that perfectly matches our individual future goals and needs. Once this is achieved, some of the existential financial questions about alpha, beta, passive, active, premium, factors, efficiency, and behavior may become naturally less important.

March 31, 2016

Thiago Palaia, an Executive MBA student, class of 2016, shares his article below discussing the importance of the Asset Management Industry to society and the transformation already in course needed to allow investment companies to provide better solutions to their clients. The transformation started as a response not only to clients’ needs, but also to society as a whole and its future social needs. It is a complex and exhausting long term agenda based on some important pillars: increase client financial literacy, bridge the gap between academics and practitioners, develop portfolio solution expertise, redesign organizational structure and engage with the main stakeholders of the asset management ecosystem (clients, regulators, academia and other investment managers).

The article discusses the relevant research and improvements that have contributed to the implementation of Modern Portfolio Theory (MPT). The truth is that, for the last decades, academics and practitioners focused much more on sophisticated, quantitative tools to implement MPT (risk and return estimation, optimization models, etc.) and much less on dealing with less tangible, but still extremely relevant issues observed in the Asset Management industry ecosystem. The understanding of client’s unique and intertemporal goals and behavior requires much more than quantitative models. It touches challenging subjects like client literacy, financial advice, principal agent issues, regulatory constraints, tax and finally one of the most well-known and at the same time complex financial risks – inflation.

The solution to this complex problem – provide better solutions to clients with clear gains to society and future generations – might be less linked to quantitative sophistication and more linked to humility and simplicity. Asset Managers will need to recognize that: 1) the proper usage of international diversification along with better understanding of clients’ needs and behaviors is still an important gap; 2) global investment knowledge and solutions expertise are complex skills to build, acquire and retain and therefore might require long term partnerships with academia and other investment managers in order to make this process truly effective not only to individuals, but society overall.

The Growing Demand for Solutions

What brings us back to the existential questions is the fact that academia and practitioners have not found this “magic” portfolio yet, or the perfect version of it. Modern Portfolio Theory (MPT) arrived at the capital-weighted world wealth portfolio as a singular solution, but only in the context of very strange assumptions, such as complete tradability of assets, and other factors that ignore the specific needs of investment clients.

Practitioners still have to break down the problem into little pieces which are already well defined in financial theory (alpha, beta, style factors, etc.), apply the Model Portfolio Theory investment process and expect that the risk and return estimates combined with an optimization model result in a portfolio that, at least, reduces the problem.

In a recent paper, the Legacy of Modern Portfolio Theory, the authors (Harry Markowitz, Frank Fabozzi and Francis Gupa) well remind us that the theory underlying MPT is an investment process where the optimization model is just one of the components of the process, but not the process itself as many people would think.

The article discusses the relevant research and improvements that have contributed to the implementation of MPT. The truth is that, for the last decades, academics and practitioners focused much more on sophisticated, quantitative tools to implement MPT (risk and return estimation, optimization models, etc.) and much less on dealing with less tangible, but still extremely relevant issues observed in the Asset Management industry ecosystem.

  • There is no such thing as a unique solution or portfolio. The “Portfolio Problem” cannot be generalized because every single client (individual or corporation) has its unique intertemporal needs and goals.
  • Clients usually cannot clearly define their intertemporal needs and goals. Research shows that low levels of financial literacy and financial advice is often the reason behind many of the investment mistakes explained by rational and behavioral theories.
  • Regulatory, tax and principal agent issues are relevant constraints to the development of better portfolio solutions and can transfer large amounts of liability matching risks to the final investors.
  • Inflation is an important and complex variable. “It is not a well-defined or singular concept and cannot be hedged in the classical sense. All we know is that we are scared of it and that we should try to do something”

Portfolio solutions expand the traditional Asset Allocation role, so far focused on developing quantitative tools to better implement MPT. It connects the Asset Management ecosystem to MPT and fosters higher levels of financial literacy and better understanding of individual client’s liabilities, principal agent problems and inflation.

The Need for Global Diversification

The home bias phenomenon has been extensively documented in the last 30 years. However, there is no definitive conclusion on the real reasons why investors hold a disproportionately larger share of their wealth in domestic portfolios.

In very simple terms, the global equity market capitalization is composed by 45% in US Equities and 55% in International Equities. The CAPM would suggest that US investors have to invest 55% abroad and non-US investors should invest 45% in the US (abroad from their local markets perspective). Still, most investors invest largely at home, and in international finance this is known as the empirical phenomenon of “home bias.”

There are some important considerations when applying the CAPM to assess or understand the home bias.

Firstly, the CAPM is a positive asset pricing theory. It takes the insights from the Mean Variance Efficient Portfolio (MVE) theory and asks: “What if everyone behaves this way?” However, this is eventually an imperfect assumption since there are many reasons why investors would not behave equally, for instance, due to different liabilities, different levels of financial literacy, different ways of processing information (behavioral bias) and different tax and regulatory constraints.

Secondly, the CAPM and the MVE are “absolute wealth” centric models. In reality, investors’ concern is primarily about matching their future liabilities and not just growing their wealth in a diversified way. Therefore, one should be more careful about claiming the benefits of diversification under absolute wealth models like the CAPM and MVE.

For the average investor, his future needs and goals are linked, to some degree, to the country where he will spend his life. After all, why would an investor with local liabilities need to invest or diversify globally?

It is useful at this point to briefly mention some important historical facts of the finance theory.

Harry Markowitz was primarily concerned about the diversification of risky assets, the risky portfolio. Different from the CAPM, the MPT is a normative theory since it describes a standard norm to build a portfolio.

In 1958, James Tobin added the concept of combining the optimized risky portfolio with risk-free assets according to the investor risk preference. This process is known as Two Fund Separation (separates risky assets from the risk-free asset) and is determined through the tangency between the investor risk preference curve and the Capital Asset Allocation Line (CAL).

Although the Two Fund Separation was the first attempt to include some sort of investor preference to the MPT process (in this case a risk preference), it was still primarily an absolute wealth centric model.

Only in 1973, Merton proposed a dynamic, intertemporal and relative centric model which resulted in the Three Fund Separation Model: risky portfolio, risk-free asset and liability portfolio (or a proxy of it that would vary across different types of investors).

Since then, there have been many studies about liability-relative investing (e.g., Leibowitz 1984 and Sharpe-Tint 1990). Academics and practitioners have been using implementations of the Three Fund Separation model, but still focusing on investors with very clear and well-defined liabilities like pension funds and corporations, for example.

Nonetheless, most of the simplification of the pension funds and corporations liability portfolios simply shift the risk to the final individuals. Therefore, the problem is not completely solved at this level and could generate long-term deadweight losses to society in general.

The truth is that academia and the Asset Management industry are in their early stages of understanding how this framework could be implemented for individuals.

The complexity of the problem involves making individuals aware of their unique liabilities, making them capable of communicating it to their financial agents, reconciling the problem with behavioral finance (i.e., Prospect Theory) and defining the liability proxy portfolio.

There are just a few recent studies that discuss eventual solutions for individual investors. Das et. al (2010), Anssen-Kramer and Boender (2013) and Merton (2014) are very good references, but unfortunately not perfect or definitive.

Besides the complex factors mentioned above which are yet far from being resolved, there is another important and critical element of this problem: how to define and hedge the inflation premium embedded in the liability portfolio?

The definition of inflation for individuals carries the same complex characteristics as the liability portfolio: hard to individualize, dynamic and intertemporal. 

Also, inflation is not a perfectly hedgeable risk:  

  • There are many sources of inflation which are linked to different financial and economic environments, for instance, inflation can arise from demand or supply, and that changes its nature and eventual ways to hedge it.
  • The magnitude and speed of inflation depends on how the government and monetary authority manage capital flows, currency regime and monetary policy.
  • Inflation varies across investors and their respective future needs and goals. It is dynamic, intertemporal and impossible to completely and perfectly hedge.
  • Inflation premium differs from most of the other risk premiums. It is persistent, much less volatile, but significant when compounded for many decades.

The solution to this problem might be less linked to quantitative sophistication and more linked to humility, simplicity and the acknowledgement that the best hedge for inflation tends to be a well-diversified global portfolio composed with assets that responds well to different sources of inflation like equities, real assets, commodities, TIPs, etc.

Because of the different sources of inflation described above, it should not be the role of a single asset to specifically hedge inflation, but this could be achieved through an entire portfolio aiming to capture inflation in a diversified manner.

It is clearer now to understand why to diversify across different inflation sensitive assets, but why global?

Cliff Asness, CEO of AQR, explains this very well in his paper “International Diversification Works (Eventually)”:

“What drives the difference between the short and long-term benefits of diversification? One hypothesis is that short-term market downturns are, at least partly, about panics and broad-based selling frenzies. Long-term results, however, tend to be more about economic performance.”

There are two important concepts that we can learn from the statement above:

  • “In the short-term, markets tend to crash together, thus diversification does not really help investors exactly when they need it the most. That is a wrong assessment. The benefits of diversification should be examined over long-term holding periods”.
  • Since diversification is a long-term strategy and economic performance is the key factor that turns it into a “de facto” free lunch in finance, diversifying across the global economy sounds intuitive. The recent performance of emerging markets shows how global diversification can mitigate the risk of being caught off guard in long-term periods of disconnection between economic growth, financial market performance, headline inflation and shadow inflation.

Manager Selection: A Framework for Long Term Partnership Models

One important trend in the Asset Management industry has been increasing M&A and growing strategic partnerships between large institutional clients and global asset managers. The main reason behind that is twofold:

  • Recognition that global diversification is necessary
  • Recognition that global expertise is a complex skill to build, acquire and retain.

Traditional Fund of Funds have been developing their manager selection process, which normally includes quantitative and qualitative screenings and several due diligence meetings and analysis (investment, operational, risk, compliance etc.).

However, selecting fewer long term partners brings to the table different risks and benefits to both sides. This requires deeper analysis on important aspects of the internal context (organizational design and competitive advantage strategy) of the two firms that goes beyond the traditional investment and risk management selection process.

One of the most important trends in the asset management industry has been large institutional clients, sovereign wealth and local asset managers partnering with renowned and experienced global managers looking not only for well managed global strategies but also for general knowledge transfer about global market investing and competitive strategy alignment.

In summary, having the best investment strategy, best talent, best risk management and best operational infrastructure process and system is no longer enough.

Actually, traditional fund of funds businesses also look for asset managers with sustainable excellence in managing money; there is nothing new here.

However, a good analogy could be boyfriend-girlfriend versus a husband-wife relationship. There is no doubt that the “due diligence” process done in the latter is different, not really better or worse, but different.

We concluded that a manager selection framework for a long term partnership model should be similar to the solid and well established one implemented by traditional fund of funds, but, with an extra layer of analysis that would allow us to understand how efficiently the investment manager’s organizational design enables its long term competitive advantage strategy.

This layer is called ARC framework (Architecture, Routines and Culture). ARC is a well-known framework used by consultants and investment banks to analyze a company’s organizational design and competitive advantage for re-organization, valuation and even acquisition or merger purposes. 

The ARC framework is an important tool that helps to ensure that talent, structure, routines (process) and culture are aligned and will enable the company to achieve its competitive advantage strategy even when everyone in the firm fully internalizes its goals.

There are two important issues in an Asset Management company that can be better understood when following the ARC framework: coordination and incentives.

After all, companies are made up of ways of doing things (coordination) and the rewards for making things (incentives).

Well implemented ARC frameworks allow coordination and incentive to function efficiently and are becoming increasingly relevant in the value added in the asset management industry.

  • Coordination Problem: balance the gains from specialization versus integration. Usually in a Portfolio Management company, talented portfolio managers are hired and incentivized to deliver out-performance (alpha). However, a great part of the success of the business also depends on how information is shared within functional areas and within the company. 

    The way the organizational structure is defined strongly impacts the way people and areas will acquire, process and share information. Many years ago, the asset management industry was based on “star” managers that for some divine reason could generate alpha for many years in a row. Sources of alpha either from risk, investor constraint or behavioral finance are becoming increasingly rare and the “information” management model is becoming more effective than the “star” management model. 

    Also clients are increasingly looking for investment managers that have a sustainable value proposition and a solid and convincing succession plan. The “star manager” model, for instance, has a clear disadvantage in long term partnerships.
     
  • Incentive Problem: one of the most important elements when defining the structure of an organization is how people are incentivized, how the company deals with hidden information (where superiors don’t have all the information possessed by those who make the decisions) and hidden action (how much effort and what actions the unit or people have taken and how that drove failure or success). 

    The main conclusion is that selecting a long term partner without carefully going through an ARC framework to understand how the company deals with the coordination and incentive problems could dangerous. The long term sustainability of investment management excellence carries meaningful weight in the partnership model. 

    The ARC becomes also an effective tool to verify organizational design (architecture, incentives, routines, culture) and competitive strategy alignment between the two partners. The compatibility of design, beliefs and goals is another important critical success factor for a durable and long term strategic relationship.
About the author

Paulo Palaia

EMBA candidate, Class of 2016

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