Investment Management Association Of Singapore, 7th Annual Conference, 20 Sep 2005, Grand Copthorne Waterfront Hotel
Remarks by Mr Ong Chong Tee, Deputy Managing Director, MAS
1 Good morning. I am delighted to be here for IMAS' 7th Annual Conference.
2 As some of you may be familiar, the fund management industry in Singapore has seen continuous stellar growth. Over the past 5 years, total assets under management registered strong double-digit percentage increases. In the latest survey, AUM in 2004 grew 23% over the previous year. Industry asset under management in Singapore is now about S$600 billion, with about 70% of that from foreign sources of funds, reflecting the international nature of our financial centre. Today, the industry employs more than 1,100 investment professionals.
3 Yet, market size or the strong industry growth rates do not tell the whole story. Underlying the expansion, the nature and character of the investment management business is rapidly evolving, not just in Singapore but globally. Market conditions are changing. Customer needs are changing. New asset classes and instruments have emerged. To succeed, the investment management industry will need to innovate and adapt to the evolving investment landscape.
4 Estimates of long-term returns from traditional asset classes have been shaved over the last few years. Take developed market equities, for example, and the debate over whether there has been a structural decline in the equity risk premium and equity returns. The total return of the S&P 500 for the last 5 years was the lowest since 1975. The yield on US 10-year Treasuries is close to its lowest level since the early 60's, with global bond markets having witnessed an astounding rally in most of the last 20 years already. So not surprisingly, most projections of future expected returns in traditional asset classes are markedly lower than past performances. I would therefore like to focus on 3 key challenges arising from the prevailing market environment of lower asset class returns.
Challenge 1: Role of the traditional fund manager
5 First, a preference for absolute returns will, I believe, take on greater significance. As returns have fallen and obligations have not, there will be increased pressure on fund owners and sponsors to seek out new avenues of returns. And just beating a benchmark may no longer be satisfactory. There is a school of thought that argues that this is positive for investment management, because there will be greater emphasis placed on generating alpha, as "portable alpha" becomes a new buzz word and alpha strategies develop into new growth areas for fund management firms. There may be some merits to this argument. But there are other schools of thought that challenge the role of the traditional fund manager.
6 The first of these alternative views, is one - at the risk of over-simplification - I will call "Absolute Betas". This postulates that active management adds precious little to overall return. "Absolute Betas" advocates typically subscribe to the theory of efficient markets and hence, the near impossible task of consistently generating alpha returns - since any anomalies and trading opportunities will be quickly priced to fair market levels. Further, there is the view that the absolute sum of all alpha performances (both positive and negative) could very well net off to beta returns if we view betas as a holistic set of market returns. If this is true, then in theory, alpha generation is a zero sum game taken at the broadest possible level.
7 So rather than market timing, "Absolute Betas" proponents choose to focus on constructing the "better" benchmark and then passively manage their funds against this superior benchmark. David Swensen, the CIO of Yale Endowment Fund, (and some of you may have read his new book) is a notable advocate of this view, observing that most managers cannot consistently outperform efficiently priced markets after adjusting for fees, and such mandates are better off indexed. Swensen further recommends that retail investors should stay with index funds, instead of aiming to beat the market. As this school of thought gains traction with some investors, the issue of benchmark construction will become a more important focal point, and can be a manager's comparative advantage to support his client's needs.
8 But putting aside this question of what is a good benchmark, I believe that it would be an erroneous view to discard the promises of alpha, by alluding instances of excess returns to survivorship bias, timing or even luck. The flip-side of the efficient market theory relies on arbitrage agents, whether alpha generators or liquidity providers, functioning properly with information transparency to keep market pricings at the proper equilibrium. This follows from the self-evident observation that markets are perpetually on the move and are rarely if ever in a stable state. The absence of such arbitrage agents that can exploit information and technology quickly would lead to inefficiencies giving rise to alpha opportunities, especially so in less developed markets.
9 In addition, market segmentation will mean differing price sensitivity, and therefore relative value prospects. Not all market participants share the same objectives or risk tolerances. Not all investors will have unfettered access to the complete suite of derivatives instruments, or if they do, could be bound or biased by legislation such as pension asset-liability matching regimes, to favour a given habitat on the yield curve. Where it is harder to find mispriced assets in liquid public markets, there remain possibilities in alternative investments such as emerging markets, real estate, certain commodities and private equity albeit at the risk of constraints due to poorer liquidity.
10 At the other extreme, a second school of thought, would be "Absolute Alphas", Here, the investor and his manager believe that assets should be kept risk-free assets (i.e. no beta risk), and over-layed with long-short hedge fund style management. Absolute alphas question the efficacy of benchmark-investing. Behavioural finance studies, for example, indicate that the use of benchmarks to evaluate short-term quarterly performance tends to draw unhelpful attention on short-term investment performance at the expense of longer-term returns. This can result in a disposition towards higher levels of turnover while discouraging contrarian views. Depending on the specific benchmark, and the instruments available to the fund manager, a further drawback arises from inadvertent constraints on the investment leeway given. So the "absolute alpha" camp says, ditch the benchmark-based investing framework.
11 But yet, to rely completely on alphas can be disappointing. After several years of outstanding double-digit returns, the CSFB/Tremont Hedge Fund index underperformed the MSCI World Index in 2004. Year-to-date reports indicate that results in the first half of 2005 are lackluster, notwithstanding some variation depending on the specialty sector. This is attributed to the large number of new hedge fund players collectively managing an estimated US$1trillion, chasing after a finite set of opportunities. Thus, relative value bets are quickly re-priced - in other words, the very feature of efficient markets at work. This might explain why the wheel of investment styles appears to have come full circle with the return of long-only investment funds under hedge fund brand names. Or as a Financial Times leader puts it, "Going back to beta suggests trouble generating alpha".
12 In my view, it is unwise for an investor to focus exclusively on alpha or on beta. A mix of both alphas and betas can lift the portfolio to a higher level of efficiency. By this argument, there is still a role for the traditional fund manager, who actively manages off a broad benchmark. The benchmark offers clarity around which a market risk and return can be factored into the portfolio optimization process when deciding on the strategic asset allocation. Active management can add another layer of return that is relatively uncorrelated with the return of the benchmark. And it is still dual reach for alpha and beta, that the MAS actively manage our own reserves with our fund manager partners. The benchmarks that we use are subject to regular strategic reviews, as are our strategic asset allocations. These benchmarks may be modified from commonly accepted ones, to reflect our views of market structure and future expected returns and volatilities. We would then overlay investment leeway around that to take advantage of a fund manager's skills, and the firm's technology and research capabilities.
Challenge 2: Effects of Financial Innovation
13 The second challenge for investment managers, arising from the low yield environment, is the emergence of a slew of new, sophisticated yield-enhancing products. Structuring teams in investment houses have come up with derivatives on credit defaults, credit spreads, equity default, volatility and dividend swaps, and so on.
14 In itself, financial innovation benefits investment managers, allowing them to widen the opportunity sets and to capture arbitrage potential across markets where there were previously constraints; and to do so in the most risk-efficient or cost efficient manner. Credit default swaps for instance has enabled the unbundling of interest rate and credit risk, while its development into a tranched market offers more refined options to investors according to their risk and yield appetite.
15 But financial innovation poses challenges to fund managers too. Firstly, for a fund manager to invest in a product, he must ensure that he has the ability to value, manage, settle and account for these products. These can be quite complex as the recent regulatory attention of the settlement backlogs of credit derivatives showed. Secondly, even if a fund manager chooses to stay away from these products, he still needs to understand the effects these can have on traditional or underlying assets in terms of price dynamics and transmission channels. Estimates of valuation and risk, based on past experiences, will have to be calibrated to take into account these effects.
16 Again, the credit market is a good example. The growth in credit derivatives over the last few years has been astounding. I am told that in Europe, more bonds are now issued into CDOs than directly to end-investors. This structural change has affected valuation of corporate bonds, with credit spreads reaching and staying at historically low levels. In the words of Greenspan, it is in "a protracted period of low risk premiums". On the flip side, it has also introduced a higher level of uncertainty.
17 In early May, the credit downgrade of GM and Ford triggered reverberations throughout the credit world. The mechanism for transmission was traced to the unwinding of so-called correlation trades - complex trades involving going long on the equity tranche of CDOs and going short the mezzanine tranche. Thus, even managers that do not carry out these correlation trades needed to understand them to manage their credit portfolios effectively.
18 So I have highlighted 2 challenges so far, finding its role: (a) finding your role within the alpha versus beta spectrum; and (b) adapting to the slew of new products. But there is a third related challenge or implication. As clients of asset managers themselves become more sophisticated and more demanding in this low-yield environment, there will be greater attention on manager skills, manager styles, as well as internal investment process, and corporate and risk management systems. A 'black box' brand name that says "trust me to deliver the performance" will not suffice. There will also be a lot of scrutiny on performance fees and transaction costs. Asset management firms will have to devote more resources to managing client relationships and client expectations.
19 Borrowing from MAS' own experience with reserve managers, our relationships have developed from one of essentially purchasing a service - to one of forging a partnership. We do not rely on past performance alone, as a predictor for future performance. The people and process aspects feature equally high, if not higher, in our evaluation criteria. And these are not done merely at appointment but as a regular process of dialogues and reviews.
20 The manager's internal process must include a clearly articulated investment philosophy behind its track record, and supported by a robust risk management culture.
21 The quality of the investment teams that we work with in our various investment mandates are critical. The expertise and experience should preferably go beyond a single key person. Fund managers, more so than ever, will need to compete for skills against other peers, with a perceived shortage of good people with that investment or research acumen exacerbated by the proliferation of many new hedge fund players. It is important for the industry as a whole, and in Singapore's case for an industry association such as IMAS, to also take the lead in talent development and skills upgrading. I am happy to note that IMAS has participated last month, in the launch of the IBF Financial Sector Seminar Series to the academic institutions, to profile the career opportunities in the financial sector and in fund management. Individually, industry practitioners like yourself can also take the lead in both ensuring continuing professional education also to build the supply pipeline through internships and taking on fresh graduates. On our part, the MAS has a number of schemes that can help defray the costs of training staff, as well as build up research capabilities - and I would encourage all of you to tap this.
On this note, I wish you all a fruitful exchange of views and insights during this conference.