The investment world has changed dramatically since the 2008 financial crisis, and the landscape is set for more change. According to TheCityUK estimates, the global investment industry has a total of US$80 trillion in assets, of which pension funds have US$30 trillion. Any shift in the composition of pension fund and retail assets will result in a dramatic change in the global investment landscape, products, fund flows, and asset valuations. What investment professionals must do is always look to the future: when the world changes, and when it turns against current strategies. This article will try to uncover some of the developing themes that result from changing investment behaviour and their implications for the investment landscape.

KEY THEMES

Competitive landscape: The tightening grip of stronger industry players, such as Canadian banks, has put the independent manager’s margins under pressure. This has resulted in consolidation and is expected to result in an increase in industry concentration.

Government regulations: Governments are expected to be a big force in the investment landscape in the foreseeable future. While the financial services sector has faced significant regulatory changes over the past decade, the pace of change has accelerated rapidly in the wake of the financial crisis. The focus of regulatory efforts has shifted from the likes of Undertakings for the Collective Investment of Transferable Securities (“UCITS”) and Markets in Financial Instruments Directive (“MiFID”) to addressing systemic vulnerabilities, improving market transparency, and enhancing investor protection through the Alternative Investment Fund Managers Directive (“AIFMD”), UCITS V, Basel III, and Solvency II.

Changing demographics: The composition and distribution of global demographics is rapidly changing. Aging population, greater economic equality across genders, a growing middle class, and wider income inequality will increasingly influence investment decisions. This may be further exacerbated by an increase in the number of retirees in the economies of North America and Europe who depend on income from savings.

Impact of social media: The use of social media as an information tool has been eclipsing older investment media such as newspapers. Sites like Yahoo Finance, Seeking Alpha, and Motley Fool have increased their traffic over last five years, and new investment chatter media (e.g., StockTwits) are multiplying. This may morph into a structured form of information arbitrage, where trending topics and unstructured noise are meaningful information tools outside of traditional sell-side research. Peer-to-peer advice software such as TradeKing also has the potential to undercut traditional investment advisors.

Fee pressure: Post 2008, the focus has been on reducing investment fees. Canada has lagged the rest of developed world in this regard, as it has the highest management expense ratios for equity funds and asset allocation funds and the second highest fees for fixed income funds (source: Morningstar). Hedge funds may also be under pressure to reduce their fees by reducing hurdle rates and traditional 20 percent performance fees.

Liquidity of alternatives and derivatives: The main components of future growth in managed money will be Asian high net worth, ultra-high net worth, family offices, and personal wealth, along with public and corporate pension funds in the developed world. This should increase demand for assets such as real estate, hedge fund strategies, private equity, liquid alternative assets, real estate investment trusts, infrastructure companies, and beta replicators. This may also increase the liquidity of futures and derivatives that are used in the implementation of beta-timing strategies.

Yield hunt: This environment of persistent low yields and interest rates will mean that investors are searching for income. This may increase the demand for income funds, despite stretched valuations.

Emerging markets wealth: A significant increase in total investable wealth from emerging markets could offset any negative interest rate effect in the coming three to five years. If that wealth is invested in equity markets, we could see a secular decrease in the discount of emerging markets equity multiples relative to the developed world.

WHAT’S GOING TO CHANGE?

The biggest conundrum by far remains how to earn equity-like returns with a bond-like volatility in the changing investment environment. The investment trends outlined above are affecting the structure of the investment world. A few major implications are:

Increase in defined contribution plans: The pension space has been shifting to defined contribution (“DC”) plans over last few years. Still, there were twice as many registered defined benefit (“DB”) pension plans than DC plans in 2012 (source: Statistics Canada). DB pension plans outperformed DC plans in last three years, and 2013 was a banner year for DB plans. The crisis of 2008, which stressed pension balance sheets by creating large solvency deficits, has triggered a move towards DC and hybrid structures. Also, after fiduciary litigation in the post-2008 period, there is pressure to provide more-sophisticated investment options (the likes of which caused DB plans’ outperformance) to DC plan participants. There is an increased stress on optimization of portfolio returns and risks based on alternative strategies.

Risk mitigation strategies: These products are based on indices and lease rates, and dividends are used to pay for tail-risk protection. Some of this can be achieved through diversified beta, multi-asset funds, equity market neutral funds, balanced funds (e.g., 60:40), risk parity, and minimum volatility products. More widespread adoption of such products may result in substantial fund flow into derivative markets.

Liquid hedge funds: Hedge funds are increasingly being structured in the U.S. under the Investment Company Act of 1940 funds rule (mutual hedge funds) and under UCITS in Europe. Because of this changing regulatory landscape and the growing potential market in high net worth and private wealth, liquid alternatives are needed. These products may need to avoid certain illiquid strategies such as distressed securities, special situations, mortgage securities, and event-driven and long-biased strategies. At the same time, strategies might be based more on relatively liquid global macro, long/short equity, and managed futures strategies. With a few exceptions, the performance of these products may be lower compared to the Hedge Fund Research, Inc. indices.

Absolute return strategies: Global absolute return strategies emerged in the U.K. after the 2008 crisis, and by 2013 had gathered assets of GBP11.7 billion (December 2013). Some of these strategies include market beta strategies (high-yield credit, Russian equity, Korean equity, etc.), directional strategies (U.S. forward start duration, long U.S. versus Canadian, long equity volatility, European swaption steepener) and relative value strategies (relative variance income, U.S. tech stocks versus small cap, Hang Seng versus S&P volatility, and financial sector versus broad credit). Pension funds’ need for cash and the retail investor’s preference for liquidity may result in new, income-focused absolute return strategies.

Income: absolute return strategies: Most of the absolute return strategies target returns of LIBOR plus seven to eight percent. However, smaller pension plans have not been able to benefit from these yield strategies. New absolute return products offering LIBOR or inflation plus four to five percent are needed in order to help smaller pension plans in North America.

Changing mutual fund investment flows: The U.S. mutual fund industry, at US$15 trillion in assets under management, is the largest managed asset component of global managed money. Fund flow data from it showed a net inflow in 2013. There was a strong inflow into equity mutual funds after strong equity market performance and an outflow from bond funds. This trend may accelerate with the probability of an interest rate hike.

Risk segmentation and separation of alpha and beta: Some new products may segment and slice returns and risk even further and add to alpha and beta separation. This may result in investment products based on multi-asset strategies and derivative overlays.

Active versus passive strategies and ETFs: One third of active money in the year 2000 had shifted to passive strategies by the end of 2013. Exchange-traded funds (“ETFs”) will keep expanding in new asset classes and strategies due to lower fees, higher liquidity, and retail access, despite the blow-up of some of the more complicated ETFs. Bifurcation of policy ETFs may be complemented by alpha-only ETFs.

Decline in yield of real assets: In their pursuit of higher returns, institutional asset managers may deploy capital in illiquid assets such as infrastructure, real estate, private equity, and private debt. However, overcrowding of institutional money may cause a decline in the yield of real assets.