Take a blank sheet of paper to fund management

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How would you design a fund management business for the future, if you had a blank sheet of paper today?

I was talking to a leading industry figure yesterday about what was wrong with the fund management industry and why I’d like to redesign it, when he asked me “… so what does your vision for the fund management business of the future look like?”.  With a blank sheet of paper, how would I design a fund management business for the future? This was only the second time anyone had ever asked me a question like this. The first was David Jacob, just before I joined Henderson to help him restructure the fixed income team.

In a sentence if I was building a fund management business today for the future I would  design it around the investment outcomes that clients need. I have never written this down before but after yesterday’s conversation I felt inspired to share my thoughts on the future of fund management and invite other perspectives on it.

Back to the future

When David and I designed and built the fixed income business at Henderson, we focused on getting buy in from our clients and their advisers for our overall vision and our new investment strategy group (that did risk budgeting and asset allocation). Firstly, this better met their needs. Secondly, it meant that once they were comfortable with that they would give us discretion to manage their risk across different underlying asset classes, capabilities and products subject to their risk budget and overall guidelines. Finally, it made it much easier to develop and launch new products that were run out of that team/process.

Today I would start in the same place, but with greater audacity. I have seen too many fund management companies build around asset classes and regional equity silos. This is not in the clients’ best interests and it makes no sense for the future. Clients want outcomes – they want their capital preserved, they want to draw a predictable level of income, they want to beat inflation over the long term, etc. The demand for LDI, hedge funds, absolute return, diversified growth, fiduciary management, global income, inflation protection demonstrates this shift.

Ignore the label

Frankly, clients couldn’t (and shouldn’t) care about asset classes, regions, styles, etc. Asset class labels are not a very helpful way of managing a portfolio; and definitely not a useful way of designing a fund management business.  Yet most are split into independent asset class silos with a clear grading of importance based on the fees they can charge clients. Hedge funds and private equity sit at the top of the pile, followed by property, credit and then government bonds, LDI, solutions, or passive funds at the bottom. “Hedge funds” (“private equity” and “bonds” for that matter) is a deceptive label that can represent a myriad of different capabilities, styles, liquidity and risk profiles.

If what clients want is an outcome or an ultimate goal their starting point should be: where am I today; where do I want to get to and by when; how much risk am I willing to take (what’s return volatility would be uncomfortable and what’s my maximum drawdown); and what cashflow (or liquidity) do I need along the way. This is true for a pension fund, an individual investor, a family office, a sovereign wealth fund, in short, anyone.

An ‘outcomes’ hub

I would build my ideal fund management business around the clients’ needs and therefore around a central risk management, risk budgeting and allocation team. This can’t be a committee of the great and the good, it can’t be just one star manager, and it can’t really be larger than 4-5 people. Each person must bring some distinct perspective and therefore value to the group but clear decision making accountability is critical.

Specialist spokes

Around this hub I would have a series of specialist capabilities (spokes) with 3 critical elements, as follows:

1. I wouldn’t try and be all things to all people. So many fund management businesses have way too many specialist capabilities, many of which consistently deliver pedestrian benchmark performance at best. The key to success in any business is to focus on your areas of differentiation and opportunity. Most CEO’s I’ve met are very proud and want to manufacture everything in house. They wouldn’t dream of investing in a competitors fund even if it’s better. I would not manufacture everything in house. I would outsource any asset that is liquid and commoditized to an external (passive/scale) manager – regional and global large cap equities, government bonds, commodities, etc.

2. I would build my internal capabilities around areas of what I call ‘structural competitive advantage’. When we built our fixed income team, we hired analysts that could straddle high yield and high grade by industry, as well as physical and synthetic credit. Later we merged our developed and emerging market rates teams.  We should have merged our high yield and loans teams. We were looking at building a team/product that invested across property debt and CMBS. In addition, today I would build specialist teams that invest across a company’s capital structure (equity, convertibles, loans, private debt and public debt and derivatives); the same is true for a property and an infrastructure project’s capital structure. I would also have teams that have skills in various less liquid risk premia including commercial real estate debt, infrastructure debt, maybe even corporate lending, social housing, insurance linked securities too.

These are areas of structural competitive advantage because we live in a specialised world where most fund managers and analysts miss the dislocations, mispricing and opportunities that exist along the intersections.  A lot of these fall between the gaps of two adjacent specialists/teams that don’t talk to each other, don’t share insights and use different tools, approaches and buying criteria. More importantly this is not easy changes for most fund management businesses to make as they are structured along these specialist lines with each team having different levels of compensation, each fiercely competitive and each thinking they are better than the other.

3. My specialist teams must offer flexibility rather than holding the business hostage. Too many CEOs become hostage to their specialist teams/stars that have usually grown too large to risk them walking out (client loyalty is with the manager rather than they company). On top of that, once you have invested in a specialist capability, within a broader multi-asset/strategy portfolio, there are lots of barriers to taking your money out (especially if that underlying capability relies on your allocation). If you manufacture specialist teams in house they must have stand alone clients and be credible/saleable on their own too.

However, you don’t have to own/run a capability to be able to use it (given the headaches involved this should be preferable).  I would invest in, take a stake in, have a distribution agreement with and/or build an alliance with a whole host of fledgling, specialist investment boutiques built around exceptional minds with specialist skills, knowledge and insight into a particular market, asset, tool or technique. Many of these are crying out for support, distribution, alliance and capital.

Re-working distribution

This brings me onto distribution. Having a well oiled, connected and regarded distribution capability is fundamental to fund management success. Most fund management groups have separate retail, wholesale, institutional, property, private equity and hedge fund sales and marketing teams that are independent, earn different levels of compensation, have different sales incentives, are very competitive and share nothing. This might have made sense in the past but it absolutely does not make sense for the future. Retail IFAs and platforms are rapidly institutionalising; institutional investors buy retail and hedge fund products; property and private equity investors are buying debt products; and the rapidly growing DC market straddles retail and institutional approaches.

My salespeople would be trusted advisers, more like consultants and problem solvers, than sales people. They would absolutely align themselves with the type of client/investor they are responsible for (so channel specialisation still has some role to play). They must be able to listen and draw out client’s unarticulated needs, they must understand markets and be able to offer advice/assistance to help their clients reach their overall strategic goals.  As part of that they will naturally be able to offer internal outcome-oriented products, specialist underlying capabilities (whether manufactured internally or by a partner, or competitor) and even co-design new products. Either way they client will always see them, will always take their call and will always be willing to meet them because they see them as serving their needs & helping them achieve their goals.

Top 5 outcome-oriented flagship products

My top 5 outcome-oriented flagship products would be: inflation protection, inflation plus/real return, multi asset target return, all weather and global diversified income. These underlying capabilities should be offered in different regions, to different sales channels and at different targets (RPI+2%, Cash +4%, 6% income, etc.).  To really leverage an investment capability (given the bulk of your costs are the fund management manufacturing) I would want to offer the same underlying skills/risk premia into different channels and markets, even packaged into different funds or wrappers. This requires co-ordination amongst sales channels to understand what an investment capability/skill/risk premia can offer their clients, and how it needs to be packaged to meet their needs. From this comes a product development strategy. However, most fund managers don’t do things this way.

Seeding new products

Seeding new product is difficult and they need to be launched and run at critical mass for at least 3-5 years before any sales team would sell it widely. Any new product must be launched with internal seed money, manager/employee co-investment and at least one client seed investor.  Also to launch a new product you should have to shut down an old/out-of-date product at the same time (even if it is profitable). The discipline of this is critical as too many fund managers have too many funds, and can never close them down because they are all marginally profitable. However, they miss the fact that this long tail of capabilities eat up a huge amount of resource, add to operational complexity, distract you endlessly and weigh down a business.

Performance

Clearly none of this design and structure matters if you are not able to deliver investment performance consistently, within reasonable risk parameters, to help your clients reach their goals. Having said that, performance itself is not enough to make a successful fund management business. It is critical that clients are educated to measure performance and monitor portfolios over a long enough time horizon.  Delivering relevant, timely and pertinent reporting digitally, in writing, by video and face-to-face with helpful milestones highlighted along the way should make this easier to achieve than ever before. Moreover, this approach might also minimise the reporting burden and short-term measurement impact on the fund manager too.

Which brings us onto the subject of hiring the right people, the best talent and the brightest investment minds to deliver the best investment performance. Do you just throw a lot of money at them? Do you go out of your way to accommodate their individual demands? Now that’s whole different subject for another day.

This is just my gut feel and a bit of ramble.

How would you design your ideal fund management business for the future, with a blank sheet of paper?  I’d love to hear your thoughts on this.

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