DECEMBER 2010                                                                   Download PDF Version

A Speech by Gary Brass


Given at the Lawyers’ Summit in Brussels on 26th November 2010

Good afternoon. I would like to thank Slaughter and May, and James Cripps in particular for inviting me here today. I should warn you in advance that I am about to break all the rules of speech making.

Harold McMillian said that a speech should only include one message; I shall be including more than one. Secondly I was told to include jokes because these are the only things you shall remember. Well there are no jokes, at least none that I am aware of.  And finally one should answer the question. Say no more…

I will restrict my comments to consider briefly four unforeseen consequences for the Fund Management industry in the light of the current investment environment:

  1. 1.Wealth Management as compared with Asset Management.

  2. 2.Fees

  3. 3.Investment advice

  4. 4.The Offshore Funds’ Industry

One of the tabled topics is “Back to the future’ – is traditional investment the new way forward?”

To attempt to respond to that question and to introduce my specific subjects I would like briefly to comment on current markets, developments over the last 30 years (and not just 2008), and consider some lessons for the fund management industry. 

Chart.1:


The chart above shows the evolution of 10 year US Government bond yields over the last 50 years with the grey bars showing periods of recession and confirms that bonds have been an excellent investment over the last 30 years. Yields could still go lower but clearly further material upside is limited.

So, there are only two possible scenarios for the future:

  1. Bonds will either remain expensive as rates remain low, and therefore provide meagre returns to investors from here on (this is a mathematical fact not a forecast); or

  2. Bonds will fall in price as interest rates rise.

The latter will occur if and when economic activity and expectations for inflation pick up. Given this situation, investors must be aware how much bonds could be affected in the latter scenario.

Chart 2:



The chart above represents the long run graph of US 10-year Treasuries since 1798 and shows two things:

Not only are current bond yields indeed unusual but the graph also shows that yields can stay low for a substantial period of time. The time of low rates at the end of the 19th century reflected the period of the industrial revolution and the time from the 1930s to the 1950s encompassed the Great Depression and the Second World War; both long periods of low interest rates followed strong rallies in the bond market and structural economic developments. It seems to me therefore not unreasonable to expect a similar period of low rates arising this time out of a ‘de-leveraging recession’.

The recent recession, which officially ended in the USA in June 2009, was the deepest and longest since the Second World War. Normally one would expect a deep recession to be followed by a strong period of expansion in which rates would recover rapidly, but this recession was different in nature. For most of post war history many governments actually had to restrain their economies from growing too fast and generating inflation. The traditional role of the central bank was to ‘take away the punch bowl just as the party was getting going’.

However, another glance at the first chart will show that we enjoyed longer periods of prosperity and shorter recessions between 1982 and 2007. This stability led to the growth of massive debts and investment in non-productive assets such as housing. This bubble has now burst and we are just left with the debts. Instead of raring to go again, many households and governments are more anxious about reducing their debts and are therefore saving more and spending less. This de-leveraging is a new factor in post war history and the subsequent lack of demand in the West is, at best, leading to a long and slow recovery and, at worst, could lead to the feared ‘double dip’.

The charts put events since the crash of 2008 in perspective. However I believe the crash exposed many weaknesses in the fund management industry as investors recognised perhaps for the first time the paltry equity returns achieved since the turn of the century and are anticipating a long slow recovery. The industry is not alone in this self-exaMination forced by disillusioned and dissatisfied investors, regulators and fiscal authorities.


I will now revert to my chosen topics and the consequences for wealth managers. 


1. Wealth Management as compared with Asset Management

Investors do not easily recognise the distinction. They think they are getting Wealth Management whilst in practice they are being “sold” Asset Management. Wealth Management to be credible has or should have a close alignment of interest with the client. Asset Management focuses on selling services and products (all be it in good faith) but for the benefit of the provider. Hence with Asset Management emphasis and pressure is on employees to generate greater Assets Under Management (AUM), product placing capability and performance fees etc. I accept that in some situations certain managers claim that in Asset Management there is indeed considerable alignment of interest but in reality this is not often the case. For example with hedge funds where Performance Fees crystallise annually and no recovery takes place in subsequence down years.

It is important for investors to seek out managers who share a similar investment philosophy. This results and perhaps explains the recent profusion of specialist managers with relatively low levels of AUM. Investors are increasingly asking whether their advisor is a partner or a counter party.

Jonathan Davis recently wrote in the Financial Times “it is more important to intrust your money to someone WHO’S age, experience and tolerance for risk matches your own”. Whilst I would hope to be able to advise more widely than retirees I do believe a compassionate advisor is essential to determine asset allocation and selection.

2. Fees

The Fund Management industry is not alone in seeing pressure on fees. This legal audience will be familiar with this development as are the accountancy firms who are faced with increasing fixed price competitive tendering and consultancy firms dependent on government contracts. Many of you will also have recently read that the Chinese achieved substantial reduction in IPO investment banking fees. Furthermore one is aware of pressure on managers to reduce performance fees particularly where undrawn commitments and leverage has been a considerable factor in boosting managers’ income.

I believe traditional fees for fund management services will increasingly be under the spotlight. Leading investment houses are already seeing reductions from a traditional ad valorem 1% per annum on portfolio valuations and managers are endeavouring to reduce “the total expense ratio”. However I think this has much further to go. I envisage a time when fixed fee arrangements will be common (i.e. fees not subject to market fluctuations and subjective valuations of illiquid or unlisted investments). Furthermore performance fees that only crystallise on redemption should become the norm.

For avoidance of doubt it seems to me difficult to claim that an investment portfolio of a £100m requires more work than for £10m. Why therefore should there be up to a 90% fee differential. In my previous life we advised a charity for almost 20 years during which time the assets tripled after all payments to beneficiaries. Our fee was fixed and reviewed from time to time. Our role was that of an advisor and together with the trustees from time to time we made investment changes. Our role was akin to that of a non-executive director and as such it seemed appropriate to charge a fixed annual fee based initially on a modest percentage of AUM but then remaining fixed for some time. I am sympathetic to charging a time related initial fee to encompass the rigorous process of establishing the requirements of a new client. This inevitably takes time and should be properly remunerated and differentiated from on-going care and maintenance.

3. Investment advice

I agree with Jonathan Davis and his advice referred to earlier. An advisor should only advise along the lines what he does for himself. I hear you say “easier said than done” but investment managers have a House philosophy or as someone said to me the other day a “DNA” which should fit easily with the investors’ philosophy. In my early days when I invested in individual securities I would quip that “one should judge one’s broker by the company he keeps on his screen”. I haven’t changed my mind.

At Consulta we had a mantra “performance takes time”. Not only is this true but initially at least resonates with investors. However it is so soon forgotten in the maelstrom of media hype, Bloomberg screens and CNBC which all contribute to destabilise the client and transform him like a child’s toy to become a short term trader of securities. No longer is he an investor, he becomes a speculator and engages in a different business.

Decisions to invest in securities or funds are hopefully taken with a medium to a long-term time horizon in mind. For example the almost universal current theme of “blue-chip global dividend paying shares” is based on value and yield over a period of years, not months and certainly not days. True wealth preservation and creation requires time whether in respect of a business or investment portfolio. Warren Buffett reminds us that an equity investment is a share in a business. Businesses often require generations to create success. Similarly investments in art, property, timber and wine all currently fashionable usually require decades to mature.

One should not be persuaded to treat stocks and bonds any differently. Liquidity can be an investor’s best friend or worst enemy. Liquidity should be regarded as providing optionality, to buy more on weakness and to sell on extraordinary strength or to exit when circumstances are deemed to have changed. However illiquidity can also be beneficial and would have protected investors in many hedge funds after the collapse of LTCM and two years ago after Lehman Brothers’ demise. I think I am in a minority of one who approved of the Hong Kong stock exchange closing during the Asian crisis if only to protect the lay investor. Performance does truly take time and investors should not be unduly influenced by the liquidity provided by our sophisticated markets.

A few additional lessons learnt from recent years

  1. Risk is not necessarily a reflection of historic volatility: traditional risk measures did not show true risk. Historical data is helpful but history does not repeat itself. Clients clearly did not understand risk and often neither did the managers;

  2. 3 standard deviation moves happen more often than history would lead us to believe;

  3. Structured products (often comprising zero coupon bonds, options and credit risk) can be beneficial but only where the investor designs the position and the product. This is an appropriate use of the derivative markets. An investor should not necessarily buy a product offered by a provider.


4. The Offshore Funds Industry

It seems to me that there were two simple reasons for the growth in offshore funds. historically both were based on legally side stepping or avoiding domestic tax and regulatory jurisdiction and as we know are under considerable pressure. The taxation advantages including fiscal neutrality are increasingly limited as transparency and ‘look-through’ become the norm. As this conference acknowledges the increasing funds’ regulations make offshore registration and administration an additional burden on structure. There will however be a continuing role for administrative excellence and price competitive offshore administration but the services will have to be of the highest standards. The days of multiple nameplates on non-descript buildings in offshore centres are in my view limited and will become redundant.

In closing I believe the Wealth Management industry has a further opportunity if not a requirement to restore customer faith after a traumatic decade for investors.


GMB 26/11/2010

 

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