What crucial trends are driving the industry?
I would organize them into four main areas:
(1) Regulation by supervisory institutions, which give a bigger attention on risk management and buffers (for insurers, pension funds, banks etc), which makes a more active approach and therefore the delivering of added value (alpha) more difficult for asset managers.
(2) A push to reduce costs, which lead to more passive mandates and also a good scrutiny whether performance fees, or higher than usual fees, are warranted by the added value delivered by the strategy. This is also driven by a pressure not to allow excessive rewards for asset managers (from a social responsibility angle).
(3) A greater attention for the asset allocation decisions, also driven by distinction of fundamental factors underlying investment strategies, which are targeted more and more through index products. Moreover, this is driven by what seems like a bigger need for asset allocation decisions in the current volatile economic environment, which is driven by monetary policies that are extreme and business cycles that seem to have shortened in duration. This results in a faster rotation between asset classes, sectors and factors. The effects seem to have been aggravated by geopolitical divides (Western World, Russia, China and the Middle East).
(4) Last but not least, a greater attention for socially responsible investing – which started by the more altruistic investors – but also big pension funds in Netherlands, Norway, etc., and therefore asset managers are paying more and more attention to this new criteria. See for example how much attention the financial sector is paying to the climate conference in Paris. Socially responsible investing in its implementation is also changing, it is not only about excluding the biggest polluters, the most social unjust companies or the biggest contributors in the weapon industry, but more and more the focus is directed at investments and companies that make the biggest impact on a better, more social and more climate aware world.
All four trends have an influence on one another.
What market segments will experience the most growth and why?
In response to more regulation and the push to reduce costs, passive investing is gaining more and more ground, as it seems to be the most easy, and most advocated solution. But not all passive investment products are the same. For example, do they really invest in all the constituents of the index, or do they only replicate the behavior of the index, by using derivatives? Do these latter products deliver what they promise to do under all market circumstances? And taking a step further back, are index returns really what the investor want, in all market turbulence and with all side effects?
On the other hand the increased regulation has led to stellar growth in risk management and its techniques. Sometimes you see it stifle an investment organization, and in a number of cases it is clear that past performance (alpha) will be impossible to replicate in the future due to these measures. It has also led to inefficiencies and higher costs in investment management organizations. Despite the necessity of risk management it is good to keep an open mind to these possible misallocations in investment management organizations that institutional investors hire.
The question ‘what type of market returns the investor wants’, together with the greater rotation, has given greater attention to asset allocation decisions, which have to be based on a thoroughly researched and dedicated process. That has lead to new solutions in the market space. One of the most prominent of them are the factor based investment strategies, for example, low volatility shares – which provide more or less the same longer term return as a broader selection of equities but with less volatility in the returns. These strategies get crowded at the moment and it is questionable if they will continue to the deliver the qualities that they used to in the past. New strategies and combinations will be developed again.
As mentioned before, taking social and environmental effects of the investment decisions into account also has a big influence, and might turn out to be a counterbalance against the trend towards more passive investment, because the moral decision about the social and environmental effects and the possible positive impact on society of a certain investment decision (inclusive finance, green investing etc.) will differ among all type of investors, consider e.g. institutional investors and their different client bases. So every investor will have his own investable universe and his own allocation, also driven by other goals than risk and reward, e.g. the aim to be CO2 neutral.
This will ask for new investment solutions and has to become an integral part of the investment process.
What are the key challenges?
Coping with regulation and the ever-changing world of extreme monetary policies are the most urgent day-to-day challenges:
The first challenge is more directed at the organizational set-up. More culturally this has driven investment organizations and institutional investors to operate more in an internal direction instead of an external one, but this has to turn around again. Are the right people in the key decision making areas ready for such a turn around? One could also question whether or not the right measures have been taken. Will other measures be necessary (as well), and what are we to think of a split between commercial and investment banking?
The second challenge is more content wise, which investment manager is able to play in on the big and fast changing economic environment and use it as a source of added value. What kind of processes, and therefore products, will survive long-term? Or will a new big financial crisis, either because of further geopolitical division or of financial instability in the system, throw all investors back to square one: the drawing table of the investment process.
Another key challenge is how to combine these two challenges, in itself already a handful, with a stronger need for social responsible investing. Will the investment universe that results from the moral standards of the client(s) give enough room to maneuver to the investment manager to deliver returns at a financially responsible risk?
All this is needed, with a continuous demand for lower fees. A hard task it will be for the consultant to play in all four quadrants.