Friday, August 16, 2013

Investing in a Debt-Fuelled World?

In June, Principal Global Investors released the fifth annual asset management research report, Investing in a Debt-Fuelled World, presenting critical findings on how the current ultra-low interest rate environment and aging populations are changing the landscape of the asset management industry.

The executive summary provides the key findings and highlights:
Principal Global Investors is pleased to sponsor the fifth annual asset management research report, authored by Professor Amin Rajan of CREATE-Research. The report, entitled Investing in a Debt-Fuelled World , presents critical findings and addresses how the current ultra-low interest rate environment and aging populations are driving investors to personalize risk — changing the landscape of the asset management industry.

The critical findings of this report focus on the implications of policy action in both the U.S. and Europe and how it will transform investor expectations and behavior. The effects of repeated rounds of unprecedented quantitative easing and the resulting financial repression will accelerate the closure of Defined Benefit (DB) plans and drive the evolution of defined contribution (DC) products over the next decade.

The asset management industry will need to redefine how it works. New, forward-looking products need to be developed. Innovations will be more solutions-based,with alpha being a question of exceeding clients’ needs rather than the market. This transformation will require stronger trusted advisor relationships between asset managers and clients.

By partnering closely with its clients to understand their needs and developing customized solutions for them, Principal Global Investors has been making significant progress — a distinct advantage of their multi-boutique strategy.

  • 62% of survey respondents expect markets to be driven by unprecedented quantitative easing
  • The realities of an aging demographic will push investors to personalize risk by targeting specific investment outcomes to meet their needs
  • 63% of asset managers and 56% of pension fund respondents expect these factors will accelerate the closure of DB plans, thus rewriting the pension promise
  • Over two-thirds of respondents wanted asset managers to prioritize a deeper understanding of the debt dynamic and its risks and opportunities
  • 49% of respondents said they would prefer an integrated solution to asset allocation, manager selection and investment options
  • A shift from DB plans to DC plans that combine the best of today’s plans with new innovations will mark the need for personalization of risk
  • Today, DC plans hold 43% of global pension assets. By the end of this decade, this share will exceed 60%
  • The transition has prompted asset allocation strategies to evolve with a shift to real assets. This is the biggest single change from the 2012 CREATE report
Eight important themes emerged from the research survey:
  1. A catch-22 will characterise the dynamics of deleveraging
  2. The 2008 crisis and ultra-low interest rates have been the final straw for pension plans
  3. New diversification is targeting a multiplicity of goals in the DB space
  4. Personalization of risk is ushering in a new era of solutions alpha
  5. The next wave of innovation in the DC market will be its most ambitious yet
  6. Equities, credit, and real estate will remain very attractive
  7. Loss aversion in the West and search for high yield in the East will characterize mass market investing
  8. Asset managers have to decouple marketing from thought leadership if they are to go from distant vendors to trusted advisors
Principal Global Investors encourages you to read the full report, Investing in a Debt-Fuelled World. This important research reveals over 700 industry peers’ views and insights into the most topical asset management questions in today’s investment markets.

The full report is available at
I encourage my readers to take the time to go over the entire report as it provides an in-depth discussion on all eight of the key themes outlined above. I also encourage you to read a comment by Jim McCaughan, CEO of Principal Global Investors, on the road ahead -- what markets are positioned for over the next five years.

I can't predict what will happen over the next three to five years. The critical theme for me remains whether the forces of inflation win out over those of deflation.  I share the same concerns of St. Louis Fed President James Bullard, namely, the Fed could increase the risk that the U.S. economy suffers a damaging bout of deflation if it tapers its bond buying too aggressively. 

But QE isn't a panacea. Soaring stock markets are great for the prosperous few but the restless many are still waiting for a sustained pickup in real economic activity. Unless we see a sustained and vigorous pickup in job creation in the U.S. and Europe, there remains a real risk that the world will enter a protracted deflationary cycle, especially if China slows down markedly.

And given that most governments are in austerity mode, the pressure is on central banks to keep pumping liquidity into the financial system, increasing the risk of an inflationary or deflationary cycle down the road (you can make a strong case for both scenarios).

So what are global pension funds doing to address the uncertainty that lies ahead? They are allocating more to alternative investments like hedge funds, private equity, real estate and investing in "newer" asset classes like infrastructure and timberland. The key remains diversification away from public markets and focusing on long-term results.

Of course, the approach pension funds take varies. I had a discussion this morning with a senior U.S. pension fund manager who lamented about how the boards of U.S. public pension plans rely on their external consultants for investment decisions. "They do this for liability reasons," he explained. 
He told me that the consulting model is "all about volume," which is why the bulk of the money keeps going to the same brand name alternative investment managers. "The consultants are thinking of how many clients they can service using relationships with a handful of funds, not what is necessarily in the best interest of the pension plan. This means a lot of good managers with $300 million or less of assets under management are being overlooked."

There are many problems with the governance of U.S. public pension plans, compensation being one of the biggest hurdles. By contrast, Canada's top ten got the governance and compensation right. They're increasingly managing assets internally and co-investing with top external managers, lowering costs significantly and achieving better long-term results. This approach will help them navigate through this challenging investment landscape.

Below, the FT's John Authers talks to Jim McCaughan, CEO of Principal Global Investors, about how pension funds are placing money in new asset classes. Again, take the time to read the entire report. I don't agree with everything in this report but it provides a thorough discussion on the challenges that lie ahead and how institutions are preparing for them.