Bubbles or Banyan trees The Asset Management Dilemma

ValueNotes White Paper By Adhik Sathe and Jaslene Bawa

February 2010

BUBBLES OR BANYAN TREES THE ASSET MANAGEMENT DILEMMA

Asset management as we know it is changing. While there is general consensus regarding the evolution of investment management, there is significant divergence of opinion on the long term trends. This white paper analyzes some key global trends in investor appetite as well as evolving shifts in asset management. We conclude that timely and credible intelligence is vital to differentiate between bubbles and banyan-tree saplings.
1

Commercial considerations no longer the sole investment criteria

Increasingly, investors are behaving in ways that are not consistent with the commonly acknowledged risk/return principles. Investors, at both the retail as well as the institutional level are looking closely at where the funds are being placed and how they are managed. Competition for customer funds is intensifying and asset allocation is turning out to be a key differentiator. Needless to say, fund management companies are aligning their product strategies with investor preferences. Three key changes in the global investment environment influencing fund management are: Increasing relevance of responsible investing, Increased influence of faith (religion) in investment activity and Newer / emerging investment areas The factors driving growth in investment products which fall under the above-mentioned categories reflect a mix of socio-political trends - corporate governance, awareness of societal obligations, heightened concerns around environment and climate change challenges, innovations in technology and processes, advances in product structures and evolving regulation around all these areas. Investor interest in the three areas above has been significant enough to warrant introduction of investment funds focused on these aspects.

1.1

Responsible Investing

Increased investor interest in aligning investment goals with the larger interests of society has given rise to Socially Responsible Investing (SRI). This refers to an investment strategy which aims to increase financial return through investments which either positively impact society or those which do not engage in activities socially/morally/ethically harmful to society. The terms SRI, ethical investing socially conscious investing responsible investing are often used inter-changeably, though there are differences in their stock pick strategies. The other sub-sets of this kind of investing include Green-themes, ESG (Environmental, Social,
1

Banyan refers to giant trees which sometimes cover several hectares and are said to contain medicinal properties as well. They have extremely strong roots, are very difficult to uproot and these trees are considered sacred by many cultures.

White paper | February 2010 | Bubbles or Banyan trees - The Asset Management Dilemma

and Governance), Climate change, CSR (Corporate Social Responsibility), Carbon emission trading, Microfinance-based and the like. While specific strategies will differ across fund managers, the investment rules which are most often applied are as below, Not investing in companies which engage in the production or sale of products linked to substance-addiction in society examples include gambling, alcoholic drinks, tobacco and its variants. Increasing investment exposure to companies which are actively pursuing sustainability initiatives, either through their product strategies or through inculcating sustainability measures in their daily operations. Investing in companies whose businesses and technologies focus on goods and services that mitigate the environmental impacts of commerce, including such areas as alternative energy and energy efficiency, water treatment and pollution control, and waste technology and resource management. Increasing exposure to companies which practice good corporate governance and ethical workplace practices. Fund management companies have been quick to sense the growing

Consideration of environmental, social and governance issues in investment decision making is growing rapidly and is now considered by investors responsible for about $US13 trillion of investment capital, as reflected by their commitment to the UN Principles for Responsible Investment. Of particular interest for investors are the business risks around climate change, with $US55 trillion of investor capital represented in the Carbon Disclose Project calling on 5,500 companies around the globe to disclose these climate-related business risks - Nick Edgerton, Sustainable Alpha Team, AMP Capital Investors.

awareness and appetite among retail as well as institutional investors for these investments, and have been launching appropriate products. Net inflows into SRI type of funds are proof enough of investor willingness. According to data compiled for Responsible Investor by Lipper Feri (the investment data group on Europe's mutual fund markets) in July 2009, SRI fund sales were holding up well in European countries and increased in comparison to their

mainstream peers during the economic crisis. Some indicators of SRI success given below, Fund sizes are growing According to the latest statistics released by the Investment Management Association(IMA), the trade body for UK's asset management industry, total SRI Funds FUM in UK increased by 22% Q-o-Q to reach 5.5bn (US$9.1bn) in Q3 2009 and increased by 13% Y-o-Y. According to Swiss private bank Sarasin, its assets under management (AUM) or advisory in SRI investments in 2009 total US$30bn, up ten-fold from US$3bn five years ago.

White paper | February 2010 | Bubbles or Banyan trees - The Asset Management Dilemma

According to Global Trends in Sustainable Energy Investment 2009, released by the UN Environment Programme's (UNEP), an estimated US$155bn was invested in 2008 in clean energy (more than a four-fold increase since 2004) companies and projects worldwide, not including large hydro projects. Out of this $117bn of investment went into renewable energy projects from geothermal and wind to solar and bio-fuels. UNEP estimates that between 2009 and 2011 a minimum of $750bn is needed to finance sustainable economic recovery by investing in the greening of five key sectors of the global economy: buildings, energy, transport, agriculture and water. Investment Performance has held up The Australian SRI median manager has posted out-performance of the S&P/ASX 200 over one, two, three and five years to 30 June 2008. These findings are consistent with studies from AMP Capital Investors and run in parallel with a range of other international studies on the impact of analyzing social and environmental factors that point to the long term competitive nature of SRI funds. A recent report published by Thomson Reuters shows that SRI may fare better than the average mutual fund. Performance of 160 funds selected from the Social Investment Forum (SIF), indicated that throughout 2009, SRIs regularly outpaced benchmark funds, often by significant margins. Growth prospects appear bright With the SRI investing trend catching up, the global investment market has also witnessed a rise in the number of products launched and indexes tracking them. Estimates suggest that over 90 global investment fund houses have launched some variety of SRI funds. Robeco Group and Booz & Company conducted a study in 2009 on the current Responsible Investing (RI) market and its future potential. The study expects the RI market to become mainstream within asset management industry by 2015, reaching between 15%-20% of total global AUM (US$ 26.5 trillion), from the current ~7% of current AUM. Launch and popularity of aligned Indexes and fund houses A key indicator of the penetration of these funds has been the growth in and popularity of
For investors, the energy race requires a fundamental rethinking of how to frame asset allocation in the context of a resource-constrained world. To do that, we must refocus the investment prism away from narrow verticals like carbon or clean technology and towards a more holistic framework built on maximising the return from natural capital. - Aditya Doshi, Beetle Capital, A natural capital asset manager

SRI/sustainability indices. Many of the major stock markets have established SRI or sustainability indices that track companies in the relevant areas. Some of the most popular sustainability indices are the Dow Jones Sustainability

White paper | February 2010 | Bubbles or Banyan trees - The Asset Management Dilemma

Index (DJSI), the FTSE4Good Index, and the DAX global Sarasin Sustainability Index. There are fund houses being set up, which exclusively focus on niche areas in these sectors. For instance, UK-based Beetle Capital Partners, a natural capital asset management platform proposes an investment framework built around the concept of natural capital, the combination of the worlds renewable and non-renewable resources.

1.2

Faith based investing

Religious doctrines are increasing their sphere of influence, affecting not only investment choices, but capital allocation criteria as well. Faith-based funds are sometimes considered a subset of SRI funds. There are funds that invest according to Islamic, Catholic, Jewish, Hindu and Buddhist values, among others. According to Morningstar, faith-based offerings have gained traction since 2000 and currently represent more than half the total of all SRI funds. Undoubtedly, the largest chunk of the faith-based investing market comprises of Islamic funds in fact, it may not be out of place to state that growth in Islamic funds has been a key driver in itself for the larger category of faith funds. The number of Islamic funds in the market has seen a steady increase, as have the AUM. According to an Ernst & Young report on Islamic funds and investments, from an estimated 200 funds in 2003, the number of such funds were a little short of 700 in early 2009. The AUM has also grown from US$20bn in 2003 to touch US$44bn in 2009. The number of indices tracking Islamic funds has also increased over the years. Dow Jones, S&P, MSCI and FTSE have all successfully launched Islamic indices. Apart from Islamic funds, the fund management market has seen significant interest in Catholic Mutual Funds, Dharma funds (which target Hindu investors), Methodist funds and Jewish funds. Dharma Investment Group and Dow Jones Indexes launched the Dow Jones Dharma indices that assess company performance in accordance with dharmic (Hinduism and Buddhism) values and principles.

The alternative asset class has new members

The search for newer investment areas has gained prominence as wealth management takes on a more holistic approach and diversifying into newer/alternative areas gains traction. A couple of newer areas which appear to be gaining traction now are property derivatives and asset-based lending.

1.3

Property Derivatives

If allocation to property was a risk mitigation measure last decade, hedging risk within the various property types is what is new. Property derivatives have been attracting substantial interest since the early 2000s. Investors use property derivatives to,

White paper | February 2010 | Bubbles or Banyan trees - The Asset Management Dilemma

Hedge their portfolio from potential dips in property prices Mitigate their investment allocation risk - reduce sectoral exposure by investing in diverse asset classes with the overall exposure to real estate Currently, the UK and US are the most prominent markets, with well developed property indices on the stock exchange. At present, the property derivatives are based on property indices (Commercial and Residential) and sub-indices that are traded on stock exchanges. Large portions of the deals are carried out in the over-the-counter (OTC) market. In the UK, approximately 90% of the commercial property derivatives market deals are based on the IPD (Investment Property Databank) index. IPD also manages property indices in other countries including Japan, Australia and several countries in Western Europe. The annual trading volumes on IPD indices in the UK increased from 850m in 2005 to 7.2bn in 2007. Property derivatives as a market has picked up steam owing to extensive spread of investment portfolios of investors. Until recently, there was no fund in this category. However the appetite for property derivatives is picking up. The inProp UK Commercial Property Fund will launch in first-quarter 2010, investing in swaps which are cleared as futures on Eurex's property derivatives exchange.

1.4

Asset-based Lending

Asset based lending has evolved over the recent years and is gaining prominence as a mainstream financing option. The credit crisis which was largely responsible for the nowreceding recession has constrained banks ability to lend, especially considering the current pressures on capital adequacy norms, and might increase further after the new Basel norms come into effect.. This has highlighted the need for an alternative source of capital for middle market companies.

Seismic shifts are affecting the investment management landscape

Apart from being influenced by changing investment appetite, fund management is also undergoing other changes that challenge current business models. A few important ones are highlighted below, Fund distribution is changing In most countries, investment fund distribution is dominated by intermediary channels - either IFAs or banks. Regulatory and investor pressures are driving down intermediary remuneration, and global trends indicate a shift from asset-based to feebased remuneration structures. The trend in remuneration structure has impacted distribution dynamics significantly enough, so that intermediary channels find it more rewarding to sell other financial

White paper | February 2010 | Bubbles or Banyan trees - The Asset Management Dilemma

products. Therefore, there is immense pressure on asset managers to find ways to motivate distribution channels. The pressure on intermediary fees has also been partly responsible for the move towards open architecture. Open architecture enables investors to pick and choose funds from a wide selection, including third-party products not directly owned or affiliated with the immediate intermediary channel. Open architecture decreases the instances of product pushing as it reduces the dependence on intermediary channels, providing a level playing field for new fund managers to compete effectively. Alpha/beta separation has come to stay Investors are seeking higher alphas at different levels of beta and the increased competition for funds has meant that funds need to differentiate their offerings in order to attract the discerning investor. There is continuing pressure on fund managers to provide cheap beta and true alpha and consequently the separation between alpha and beta is getting wider. Going forward, Investors are increasingly likely to pay less for beta and only true alpha generators are expected to command premium fees. A direct result of the search for cheap beta has been the growth of Exchange Traded Funds (ETFs), which provide investors with one of the cheapest and simplest ways to capture beta returns. Current worldwide AUM of ~2,000 ETFs traded on 40 exchanges across the globe is estimated close to a trillion dollars. Fund performance measures are changing. Fund performance is typically based on relative benchmarks. However, this still does not represent a true picture to the investor who is unsure if he would have been better off in a fund with a different style or asset allocation. This has given rise to what have come to be known as outcome driven funds, where the performance promised is measured in absolute terms. Outcome-oriented funds include liability-driven investment (LDI) mandates, capitalprotected funds, regular-income funds, inflation-protected funds and target-date funds. Investor interest in outcome-oriented funds is expected to increase on account of the relative predictability of performance. Outcome-driven strategies such as LDI are expected to increase especially in the management of pensions, given the introduction of norms around mark-to-market accounting and funding level requirements. Excessive focus on benchmarks had earlier resulted in product proliferation. A focus on outcome based investing could lead to rationalisation of product suites in fund management houses.

White paper | February 2010 | Bubbles or Banyan trees - The Asset Management Dilemma

The Bubble and the Banyan Tree

Investment managers are not completely deviating from commercial considerations. They are using finer customer segmentation and perhaps more client analytics to find niches that have not been served adequately. This analytical approach is leading to a variety of new products. No doubt, to meet the growing investor demand for newer and innovative products/ investment areas, it is imperative that fund managers are aware of evolving investor appetite, competitive landscape, investment strategies, product demand, market opportunities, regulatory shifts, distribution and intermediary trends and enabling technology. It is vital for asset management companies to spot trends before or as they emerge so as to gain and retain competitive advantage. However, not all trends and forecasts actualize. The SRI funds for instance, had many naysayers initially, but today, are undoubtedly among the most resolute fund types for an investor. Going back in history, we could do well to deliberate on much hyped trends which fizzled out in the end CDOs and complex opaque structured instruments being the most recent of them all.

So, how are fund managers to know the bubbles to avoid and the banyan saplings to nurture?
We believe that the continued evolution of the fund management industry reinforces the need for credible and timely research and competitive intelligence. Fund managers who weave research and intelligence into their operational strategies will find themselves at an advantage as they are able to leverage research-driven insights proactively to spot and address evolving market needs. Objectivity of the research is of prime importance if true demand has to be un-covered. As a corollary, credible third party research providers, play a crucial role in enabling decision-making at asset management companies.

White paper | February 2010 | Bubbles or Banyan trees - The Asset Management Dilemma

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White paper | February 2010 | Bubbles or Banyan trees - The Asset Management Dilemma