Thursday, February 7, 2013

Slicing Up the Institutional Investment Pie

Slicing Up the Institutional Investment Pie

Institutional money management used to be a growth business.  Throughout the 1980s and 1990s, defined benefit plans, 401(K)s, and endowments were ladling out increasing amounts of capital to money managers.  Today, the game is much more difficult.  While new money still flows into retirement plans, universities, and foundations, a lot more money is also flowing out to pay benefits and meet operating expenses.  Since the pie is no longer expanding, the business has become a question of market share.  We’re going to go around the investment table, and see who’s getting a bigger or smaller slice of the pie.

The clearest winners are emerging market managers, who charge a premium over most other equity managers.  Investors have been committing increasing amounts of capital to markets where the underlying growth rate is greater than the recession-bound economies of the West.  While the economic and political risks of these markets are quite high, the lure of growth has attracted all sorts of institutional investors to China, India, Brazil, and host of other Asian, Latin American, and African markets. 

Marketing Off-site (2008)

Many types of hedge funds have also enjoyed a larger slice of the pie.  This is largely the result of public pension plans feeding on hedging funds instead of traditional investment products.  Endowments and foundations, which have much greater experience with hedge funds, have tempered their appetite a tad.  In some cases, the motivation is to find new sources of capital appreciation, but often hedge fund mandates are undertaken to better managing risks.  This is another area enjoying higher fees than traditional institutional money management.

Private equity is also expanding its waistline.  The biggest winners appear to be the large branded buy out firms.  Smaller firms and venture capital managers seem to spend eons trying to raise a few hundred million dollars, while the big boys capture billions of dollars.  Investors are praying that these commitments, along side emerging markets, will boost their returns.

With investment grade fixed income sporting negligible yields, emerging market debt and high yield managers are also enjoying a bigger slice of the pie.  All sorts of institutional investors require current income, and risky credits are the enticement.  Eventually, this trend will provide renewed opportunities for distressed managers. Institutional investors always pour too much money into emerging market debt and high yield bonds, leading to problems in a number of the countries or companies.  When investors panic, distressed managers swoop in to buy bonds cheaply.

So who is on a diet?  The fund of funds business is losing share in both the hedge fund and private equity areas.  Investors have discovered that paying a manager a fee to manage a collection of hedge funds or private equity funds is too expensive.  Moreover, investors think they can do a better job of picking managers themselves.  They’re going to save some money, but they’re not going to do a better job than the fund of funds managers.

Active equity managers have seen their slice of the pie shrink for over a decade.  US equity managers have borne the brunt of this trend in the last decade.  More and more investors have made the sensible decision to index this portion of their portfolios. As a result, active equity managers have lost a significant portion of their clients.  International investing in the developed markets of Europe and Asia also drew capital away from US managers.  This bet, however, hasn’t worked out so well.

The plain vanilla bond manager is bearing the brunt of the shifts to other asset classes.  With US treasury and investment grade corporate yields at extremely low levels, investors are looking elsewhere for income, as I discussed previously.  As a result, these managers will be fighting for a sliver of the pie in the next few years.

What should money management firms be doing in this environment?  If you’re on the winning side at the moment because you manage high yield, a large buy out fund, or another sought after slice of the pie, reinvest in research and development.  These trends aren’t going to last, and you’re going to need new products in a few years time.  If you are on the losing end, and you took all your profits out of the business over the years, instead of trying to address new opportunities, you’ll soon be eating at the children’s table.

What will actually happen?  The winning firms will get greedy and pull too much money out of their businesses.  Eventually their products will falter, but they the senior executives won’t care because their riches will be safely out of the business.  The losing firms will linger for a long time as the margins in money management are more than sufficient to keep the key folks in a life style to which they’ve grown accustomed.  Eventually, their firms will fade away.

As for the clients, not much is going to change.  Their portfolios will enjoy slightly higher gross performance, but the net returns won’t be much different from the last several years.  However, the promise of higher returns may be enough to postpone making the hard decisions about lowering spending and benefit payments.

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