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The financial markets industry belongs to the most fascinating industry sectors of the world. At the same point in time the financial markets industry is probably one of the fasted evolving areas in both research and production. The speed of change is only comparable to information and gene technology, but there may be more business drivers in our industry.
Although financial markets have already reached a manifoldness and degree of complexity which only 30 years ago probably nobody imagined, an end of the development is still out of sight. Will there be a point of stagnation, any stage which could be evolutionary stable, or is this impossible as we have observed an ongoing revolution?
In the following I would like to focus on a part of the industry, the buy-side. The piece of the industry which is often seen as slower and less sophisticated than the rapidly changing sell-side.
The perception of a slow changing buy-side may due to those famous and antiquated appearing regulations, principles and characteristics like the US Investment Company Act of 1940 and Investment Adviser Act of 1940[1] the even older “prudent man rule”[2] or that most people investments in assets for their retirement.
Nevertheless the asset management industry has also been affected by various and also identical regulations and trends in the recent years like, Sarbanes Oxley Act of 2002 (SOX), T+1 initiative, Basel II, performance presentation standards (PPS), undertaking for collective investment in transferable securities regulations (UCITS). Interesting is that those business drivers on the one hand emerged internally, i.e. out of the industry and on the other hand regulations like UCITS represents external changes. The latter indicate that developments could be revolution.
At the same time we could observe the continuous changes of the investment management industry. We find three generation in the modern investment industry going along with a evolution of sophistication in portfolio management and technology. As typical in an evolutionary framework we outline overlapping generations, i.e. at least two generations coexist.
First Generation “Investment Management Professionals”
Nowadays we see hundreds of large investment managers, but in the 1960s the market have been covered by only a few companies. The emergence of the first generation has been supported by the clash of four events. Similar to current European pension issues, it become more and more apparent that the U.S. retirement system is faced to the thread of being underfunded. The Employee Retirement Income Security Act (ERISA) of 1974, created new positive net investments inflows. By means of the so called “Individual Retirement Account” (IRA) employees saved additional capital for their retirement (until 1998 assets have accumulated to approximately USD 1,800bn Source: BVI). ERISA generally aims at securing the pension accounts against investment and management failures by the “prudent expert rules”.
At the same time, i.e. between 1973 and 1974, the stock markets underperformed, especially relative to the investors expectations and the recent established portfolio theory became used by first skilled investment managers.
To sum up, the environment was perfect for a change and the equilibrium was not evolutionary stable against mutant entrants. These new investment management companies have been characterised small teams of investment professionals who in many cases concentrated on one investment style. Due to their professionalism and strong personalities the new companies grew. In the following years their success were also supported by progress in academia on portfolio theory, resulting application providers like Wilshire and Barra.
Technology is always an industry driver. In terms of technology the first generation was also characterized by point-to-point connections for internal applications and external communication. Electronic external communication was very rarely. The relationship to brokers was often personally. Portfoliomanagers and traders called the broker by phone and waited for faxed confirmations.
A technology which is not scalable. But with an ageing first generation investment companies grew in all dimensions and finally this generation expand to the next.
Second Generation “An Expanding Industry”
The second generation which emerged is characterized by enormous growth. Merrill Lynch and Case,Quirk & Acito named this generation the “Expanding Industry”. According to the Investment Company Institute the investments in funds in US grow from around USD 500bn to USD 7,000bn in the years 1985 to 2000. The small companies of the first generations mutated into complex financial service institutions. The consequences of complexity exhibited in various dimensions. The early band specialized firms became universal in terms of clients (mutual funds and institutional investors), asset classes they invest in, and investment style. Simultaneously the investment process has been enriched by more and more information, especially quantitative portfolio theory. Complex calculations has been enabled by the improved technology available. The technology shift allowed the investment companies to cope with their problems linked to the increase volume and complexity. Straight through processing (STP) emerged as a buss word, which could only be solved via increased usage of technology. All application became connected via a middleware. Middleware has emerged as a set of software services layers that assisted in solving problems specifically associated with heterogeneity and interoperability of different application programs. At its inception, Middleware tackled the replacement of hard-coded point-to-point interfaces that were difficult to maintain and upgrade and presented complications on the insertion of new applications within the infrastructure. Rather than developing and maintaining up to (n-1)/2*n bi-directional point-to-point interfaces to connect n applications with each other only n connections to the middleware bus are necessary. In the first generation of enterprise application integration tools (EAI) the message broker of a middleware (message-orientated) has been used to connect applications (figure 1 below illustrates the difference of the infrastructure of the first and second generation of investment managers).
Next to internal STP, electronic external communication increased, message protocols like FIX and SWIFT become more and more used. This become impressive clear when looking at SWIFT. Via the Society for World Interbank Fund Transfer (SWIFT) which has been founded 1974, 3.4 million messages has been send in its first year of operations 1977. In 2001 more than 1.5 billion have been exchanged with an estimated value of USD 6 trillion per day. Asset manager continued to create departments for execution. Need for connectivity emerged at the traders desks. Electronic exchanges, intermediate brokers, fragmented liquidity required more and more direct and electronic access to pools of liquidity. The whole investment cycle become much faster driven also by investment volume.
Figure 1: Illustration of point-to-point connection versus integration via middleware/message broker
Although new technologies and new applications have been introduced, inefficiencies has not vanished in all parts of the complex organizations. As will be illustrated below the companies even over invested, which causes new inefficiencies. But the bull markets hid these. Basic index comparison demonstrate that from 1982 to 1999 the S&P produced an average annual return of nearly 20%. This positive performance has changed dramatically in the following years.
It’s been four years since the capital markets have turned in a positive performance. In the recent month (spring 2004) we have seen an upswing. The financial markets industry agree, that’s the unique similarity with 1999. In 2004, after a 3 to 4 years of dramatic cost cuttings, scandals, and layoffs the securities industry is an entirely different business. In terms of technology and automation, we are more dependent then ever on them. There is clearly a third new generation.
Third Generation “Heterogeneous and Advanced Sophistication”
The second generation was driven by expanding the business through “external events”. The third generation is characterised by an increase of sophistication in all areas. The basis has been laid in the previous generation.
General observations:
All has become faster, especially in internal and external processes. The development has been supported by improvements and adoption in technology and trading possibilities. The challenging competitive markets, opportunities for growth are much more infrequent and clients are significantly more sophisticated. In terms of education there is a new generation of asset managers as well, the share of young talents having already investigated the Capital Asset Pricing Model (CAPM), structured products, and all sorts of option pricing models at the university. These standard knowledge of quantitative “tools” (this does not imply that it has not been known and not used in the previous generations) goes along with the expanding success of hedge funds and demand for capital guaranteed investment strategies and transparent investment workflows.
These observations give indications of the drivers, but the crucial changes and drivers has not become obvious. The companies during the second generation reached an enormous complexity, the number of employees have grown, all sorts of applications and research have been bought, but the without any doubt most crucial process the investment decision process has not been adapted adequately to the new environment. The investment committee decisions have either been dominated by the most senior professional, i.e. the process was dictatorial without sufficient involvement of the young talents, or everything (talents and information sources) has been included, but companies developed a complicated long lasting consensus building process.
As already mentioned above the bull market hid inefficiencies, as they provided little motivation and reasons to change the behaviour and processes. There was no action to rationalize applications and technologies. But similar to the emergence of the first generation, the recent bearish years have made this inefficiencies apparent, the asset management industry rapidly mutated and the third generation appeared.
Efficiency, skill and quality are the key characteristics of the third generation, which is well in line with the by the industry itself identified requirements of their clients (see Figure 2, results form recent research of Barra).
(Number if respondents), 5 point scale from 1 “Not important” to 5 “very important”
Figure 2: Interview (in 2003) of 62 CIO and other senior decision makers of leading investment mangers in European and the US, here importance of attributes to their institutional clients, Source Barra.
An impressive example of the impact of exchanges are Exchange Traded Funds (ETF). As Deborah Fuhr explained in her article “Exchange Traded Funds: A global Overview, year-end 2002”. ETFs are already used for
- equitise cash flows,
- effective asset allocation,
- reducing portfolio risk,
- switching between sectors
- hedge a sector or country
ETFs could be excellent suited for fund of funds. Currently index tracking (mutual) funds create often a higher performance, which makes it difficult or even impossible. Gary L. Gastineau pointed out a potential solution in the Journal of Portfolio Management Winter 2004. He proved that the “problem can be solved simply by requiring authorized participants to commit to creating or redeeming by 2:30 p.m. on any day they wish to create or redeem” , as this asymmetric information between portfolio manager and investor is the reason for the relative underperformance.
Before concluding I would like to bring hedge funds in the context of evolution. Hedge funds could be described as a more advanced stage of active management. Hedge funds may be the reason why we believe sell and buy side become more and more similar. Which cannot be denied completely as many hedge fund managers has a history as a prop-trader.
In hedge funds we even see the evolution of the investment industry in a micro cosmos. We can frequently see how within a few years a hedge fund emerged, expanded and dies. Moreover the success of a investment style varies extremely (see Figure 3). Thus a single hedge funds have a higher probability to survive when they can deliver all kinds of hedge finds strategies, similar to the second generation.
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Figure 3: Performance of Hedge fund strategies.
Conclusion
Many divers of the industry have been identified, some of them are external like technology, legislations others are internal like poor performing market and investment styles. Thus the question “Revolution or Evolution” is justified. The drivers behind the most radical changes, first and third generation, is primarily the market performance. Minor divers are external events, which would justify in interpretation in terms of a revolution.
The crucial impact of internal drivers let me concluding that the industry could be described in terms of evolution. Thus we have to fear that there may be a stage of stagnation, far down the road but there with now way out. From my personal point of view only exchanges could provide an environment for a real revolution of the buy side. They are in a position to provide products which revolutionise the industry. But even if this would not happen, technology, academia and investment styles will influence the industry. In 20 years time we will see that the current environment has been a key defining period, and we look back as we look back today.
[1] The Securities Act of 1933 and Securities Exchange Act 1934 may be more important.
[2] The "prudent man rule" is going back to a verdict, Harvard versus Amory in 1830.
[3] Embedded alpha is the opportunity to enhance investment returns by managing such factors as trading costs, slow decision-making, and unintended risk exposures (as defined by Merrill Lynch and Case, Quirk & Acito).
