Global themes in asset management Our little rough guide

The value of investments and the income from them can go down as well as up and your clients may get back less than the amount invested. The above document is strictly for information purposes only and should not be considered as an offer, or solicitation, to deal in any of Aberdeen’s investments or funds and does not constitute investment research as defined under EU Directive 2003/125/EC. Aberdeen Asset Managers Limited (“Aberdeen”) does not warrant the accuracy, adequacy or completeness of the information and materials contained in this document and expressly disclaims liability for errors or omissions in such information and materials. Any research or analysis used in the preparation of this document has been procured by Aberdeen for its own use and may have been acted on for its own purpose. The results thus obtained are made available only coincidentally and the information is not guaranteed as to its accuracy. Some of the information in this document may contain projections or other forward looking statements regarding future events or future financial performance of countries, markets or companies. These statements are only predictions and actual events or results may differ materially. The reader must make their own assessment of the relevance, accuracy and adequacy of the information contained in this document and make such independent investigations, as they may consider necessary or appropriate for the purpose of such assessment. Any opinion or estimate contained in this document is made on a general basis and is not to be relied on by the reader as advice. Neither Aberdeen nor any of its employees, associated group companies or agents have given any consideration to nor have they or any of them made any investigation of the investment objectives, financial situation or particular need of the reader, any specific person or group of persons. Accordingly, no warranty whatsoever is given and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of the reader, any person or group of persons acting on any information, opinion or estimate contained in this document. Aberdeen reserves the right to make changes and corrections to any information in this document at any time, without notice. Issued by Aberdeen Asset Managers Limited. Authorised and regulated by the Financial Conduct Authority in the United Kingdom.

Preface “Life is not illogicality; yet it is a trap for logicians. It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait.” G.K. Chesterton This little book follows a trawl of the established published sources of information on our industry and quite a few others as well. Many institutions return each year to publish and cover their views on the asset management industry, the trends the sector faces and the emerging themes. Some themes in particular resonate with Aberdeen’s culture and brand identity and for this our second edition, we have a new chapter on Risk, our eighth chapter, which fills a gap from the first edition. Many giant blockbuster tomes revert each year with fresh content. Of merit is the UBS Investment Annual, which features an overarching insight from LBS professors Dimson and Staunton. This weighty oeuvre sits alongside the legendary annual Barclays Equity Gilt Study as the early year publications. Beyond the investment banks, consultants and market intelligence firms generally dispense their wisdom during the year. It is hard to pick out any specific pieces for praise and clarity of insight; in all there are over 100 public sources of information for this booklet. These have been written, in no particular order, by six banks, four trade bodies, seven investment consultants and accountancy firms, twelve academic institutions, five governmental organisations, and five asset managers, as well as nine journalists. We have listed the links to the sources at the end of each chapter, and are grateful for the insights and intelligence that all these authors have shared to make this little book of themes flourish. After writing, we have summarised each chapter with boxes containing the key arguments or issues, and a second box that defines Aberdeen’s position as we know it on each theme. Piers Currie Group Head of Brand May 2015

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Contents

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Chapter 1: Simplicity

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Chapter 2: Long-termism

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Chapter 3: Transparency

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Chapter 4: Behavioural economics

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Chapter 5: Active management

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Chapter 6: Global convergence

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Chapter 7: Outcomes and solutions

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Chapter 8: Risk

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Index

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Global themes in asset management: our little rough guide

Acknowledgements Our thanks to those who gave us insights on our themes. Of particular mention in editing and contributing to this edition have been Douglas Elliott, Brookings Institution, Julian Marr, Simon Morris, Partner, Cameron McKenna as well as many internal colleagues. Any mistakes are our own. So please help to improve the next edition. [email protected]

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Simplicity

Increasing complexity defines the fund management industry today. The KPMG survey of fund management professionals in July 2008, in a report called “Beyond the Credit Crisis”, revealed that 57 per cent of mainstream fund management firms use derivatives in their portfolios. The figure was even higher within large mainstream fund management firms: nearly one-third of those with assets of at least US$10billion used derivatives to a major extent. Even more fund managers (61 per cent) now manage hedge fund strategies, which in many instances are complex.

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Global themes in asset management: our little rough guide

This KPMG study also found that half of all mainstream fund management firms manage private equity strategies, nearly half manage asset-backed securities, and more than one-third manage collateralised debt obligations (CDOs). Fund managers still believe that with the exception of CDOs, all the above strategies and asset classes will see wider use over the next two years. On the other hand, 70 per cent of the investors who answered the survey say that the credit crisis has reduced their appetite for complex products. Simplicity is making a small come-back. Misplaced maths The disciplines and measures attached to the relatively new craft of analysing investments are not as old as those within mathematics and physics with more certain rules. It is perhaps surprising therefore that the industry attaches so much credence to models and formulae. Mathematician Benoit Mandelbrot in 1964 indicated that “real life economic systems are dominated by the extreme cases. Specifically the outer 5% are as important as the [other 95%] of the data.” This observation by Mandelbrot predates, by many decades, the recent observation of “fat tails” and black swans that charted the disastrous period leading up to 2008 and beyond. Mandelbrot is perhaps best known for his beautiful computer drawings of fractals, which are geometric objects that are self-similar, looking the same at different scales, like the outline of a snowflake. The fractal distributions used to produce these pictures have infinite variants, “which can be a very uncomfortable property for financial analysts, who are used to dealing with a finite measurable variance”. The legendary value investor, Benjamin Graham, speaking to the New York Society of Financial Analysts back in 1958, concluded that “mathematics is ordinarily considered as producing precise and dependable results, but in the stock market the more elaborate and abstruse the mathematics, the more uncertain and speculative are the conclusions we draw therefrom”. Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience and, usually, to give to speculation the deceptive guise of investment. This quotation is sourced from John Bogle’s ‘The Clash of the Cultures: Investment vs. Speculation’, an entire book dedicated to demonstrating the difference between the two.

“ The fear surrounding the misplaced modelling of mathematics and physics has been going for quite some time”

The fear surrounding the misplaced modelling of mathematics and physics has been going for quite some time; however, the more the inventors of products need to model to try and account for elements to do with risk, the more these models get taken as valid renditions of a reality, which is not necessarily one that can be considered true. aberdeen-asset.com

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Erosions of economics of information In an academic article, entitled ’The Epistemology of Economics’, on the importance of simplicity in economic research, the paper explores how the founding precepts have eroded, and examines why. In particular, the tradition of such simplicity was one of the goals set by the fathers of the discipline: Adam Smith; John Stuart Mill; and Jeremy Bentham. Economic theory as applied science can only be done by a severe and quantitative control model. As noted by Robert Nozick, in his views on the functions of instrumental rationality with respect to scientific research, a top central explanation in the sciences: “reduces a difficult problem to an easier set of problems, and uses other heuristics to solve the latter”. Problems of data overloading are also covered in a paper by the US intelligence agency, the CIA. Key findings from the CIA’s research were that once an experienced analyst has the minimum information necessary to make an informed judgment, obtaining additional information generally does not improve the accuracy of his or her estimates. Additional information does, however, lead the analyst to become more confident in their judgment, to the point of overconfidence. Experienced analysts have an imperfect understanding of what information they actually use in making judgments. They are unaware of the extent to which their judgments are determined by a few dominant factors, rather than by the systematic integration of all available information. Analysts actually use much less of the available information than they think they do. Product complexity is rife Product complexity as well as complexity of market behaviour is an area where the investment industry has done too good a job of convincing the public that successful investing is a highly complex endeavour, and that it requires credentials of super-human maths skills. So argues John Goltermann CFA, Partner at Obermeyer Asset Management. Goltermann lists the painful roll call of failed financial products that have been launched in the last few decades, which have had too much complexity and lack of transparency, which in turn led to significant losses. His laundry list includes CDOs, CLOs and CDO2s, as well as Enron, late ‘90s technology stocks, quant funds, Fannie Mae and Freddie Mac, “principal guaranteed” investments and Long Term Capital Management. That is before we consider Lehman, Bear Stearns and the other failed banks. Goltermann’s product objections include structured products, “which instruments are designed by banking firms’ product specialists, who quote nicely bundled, listed over-the-counter securities and the like, options or futures, and slap a huge upfront fee on it”. He says: “if the future does not unfold in the way that benefits the specific product’s design, the investor will be worse off and saddled with an illiquid, costly investment.” He argues that simple is better. He’s not alone: James Saft, CFA, explains that, in his view, complexity, whether it is in a strategy or in a financial product, makes investors vulnerable to being overcharged, to misunderstanding risks, and to being unable to exit positions easily and economically. Unfortunately, complexity, when accompanied by its inevitable handmaiden, the expert, is even more dangerous.

“ Complexity, whether it is in a strategy or in a financial product, makes investors vulnerable to being overcharged”

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Global themes in asset management: our little rough guide

His view is that complexity breeds activity like a swamp breeds mosquitoes, and observes that complex products, by their very nature, tend towards being active products, meaning executing trades more often. This, he says, may or may not benefit the investor, but definitely does create a stream of income for brokers. Derivatives and yet more complexity Doubts about products and strategies employing complexity, especially in the area of derivatives, have been well-voiced, going back to Warren Buffett, who described those contracts as devised by “madmen”, and believed that the trade in derivatives poses a “mega-catastrophic risk” for the economy – and this was as far back as 2003. More recently, writing for BBC News, journalist Michael Robinson pointed out the re-emergence of increasingly opaque investment products in Britain and elsewhere: “complex financial derivatives are once again thriving”. Some fund managers recoil at this, and the giant BT pension fund manager, represented by Saker Nusseibeh, is quoted as saying “we are the only industry that likes complexity”. Somewhat frustrated, he says: “in art or in science, the crowning rule is that the simpler it is the better. It seems we have done exactly the opposite; the more complex a thing is, the better it is perceived to be”. Champions of simplicity In the foreword to his book, ‘Brutal Simplicity of Thought’, Maurice Saatchi cites Winston Churchill as a great believer in simplicity. Churchill liked to quote Blaise Pascal’s letter to a friend that started: “I didn’t have time to write a short letter, so I wrote a long one instead”. Saatchi opines that to achieve simplicity is very hard indeed, and that it requires what Bertrand Russell called “the painful necessity of thought”. Simplicity for Saatchi is more than a discipline; it is also a test. Saatchi is neither the first nor the last writer to look at the fact that we tend to overcomplicate elements in our world to our detriment. The lateral thinker Edward de Bono, in his book ‘Simplicity’ in 2009, explains that complexity means “distracted effort” and simplicity means “focused effort”; he goes on to explain that simplicity is somewhat difficult to achieve. Simplicity is a regulatory imperative of the 21st century for wholesale and retail alike. Complexity underlay many of the wholesale instruments that contributed to the financial crash – neither provider nor purchaser fully grasped their true characteristics. A lack of clarity around overlapping risks and multiple charges continues to harm retail investors who can buy a product they do not need or understand. “Keep it simple” is now more than ever the key to satisfying the regulator. A legal and regulatory perspective by Simon Morris, Partner, Cameron McKenna

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Key points • Simple can be harder than complex: “you have to work hard to get your thinking clean” • Investor revulsion at the global financial crisis has led to a renaissance of simplicity as a business proposition in asset management • Misplaced and complicated mathematical models failed to foresee the crisis • Economics of information, according to one paper, is disorder • CIA reports that additional information at a certain level does not improve accuracy, just overconfidence • Mandelbrot said that calculus in the stock market can be seen as a warning signal of substituting theory for experience • Complexity in investment products can make investors vulnerable to being overcharged or misunderstanding risks • De Bono says the easiest way to be superior is to pretend to understand what others don’t • Casual empiricism reveals that catching a frisbee is not only an activity undertaken by those with a doctorate in physics – an average dog can do it De Bono also explains that there are some very practical reasons why a few people delight in complexity and hate simplicity. He says somewhat waggishly, “if you want to be taken very seriously, then write a very, very complex book – in French if possible; several things then happen”. And he goes on to explain that the small club of people who will enjoy the culture and talk about the book will actually give the assumption that the author is very profound and struggling to express immensely complex thoughts. He disagrees with that in principle. “The easiest way”, he says, “to be superior is to pretend to understand what others cannot understand; for that you need complexity”. Apparently, complex matters provide a position for interpreters of that complexity. Simple matters remove that role. The British regulator FSA would agree, and says; “Complex products are more likely to be mis-sold because they provide a greater opportunity to exploit consumers’ limited knowledge or understanding of risk.” De Bono’s discussion was not about financial services, but to some extent he is pointing out the role of intermediation in building products at a high cost that people who may be unfortunate enough to buy them might not understand. Simplicity, he says, is not to be confused with simplistic; he explains that simplicity before understanding is simplistic, but simplicity after understanding is simple. Over-simplification means carrying simplification to the point where other values are ignored, because it is one of the perils on a journey to try to make things easier for others to understand.

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Global themes in asset management: our little rough guide

Banking is not simple Banking performs badly in a paper called ‘The Global Simplicity Index’ (GSI) which asks whether the global financial crisis would have been less serious if banks had been less complex; they say that if anyone had understood the nature of the structured products they sold, and the network of interdependencies linking the portfolios of the various institutions, then Lehman Brothers would arguably not have failed. This report describes the financial services as one of the most complex industries, and its problems are compounded by geographical diversity having a negative impact, where the two top-performing firms in the banking sector are operating in fewer countries, compared to their poorer-performing rivals. The majority of the global banks are close to passing beyond their complexity tipping-point, and they feel that internal forms of complexity are more harmful than external sources. Internal sources of complexity from their own organisations, design processes and other sources have a bigger impact on external forces, such as regulation and economic turbulence. Organisational complexity is therefore seen as a major factor in terms of adding to the complexity of banks, which have to underpin how we operate in terms of our financial institutions today. Simplicity is a great virtue and one that needs to be considered more in public policy, but it requires careful analysis, because it often needs to be balanced against other objectives. As Albert Einstein wrote, “everything should be made as simple as possible, but no simpler.” Regulating bank capital is an example of this. Take the renewed focus on a simple “leverage ratio”, requiring banks to have equity equal to some minimum percentage of assets. The internationally agreed Basel III capital rules are going to add this ratio as a useful adjunct to more risk sensitive measures. But there are those who call for just using the leverage ratio, despite the problems that arise when differing levels of risk are ignored, as that ratio does. Capital is meant to cover risk and needs to be proportional to the level of that risk; it is no good pretending all assets are equally perilous. Another area where simplicity has great potential to help is in disclosures on most financial products, including mortgages. The key characteristics and their associated risks should fit on one page, in language understandable to average people. Simplicity requires focus and the taking of responsibility. Decide what matters and force those elements to be disclosed; do not try the CYA approach of listing everything, just in case. It is no wonder that almost everyone skips reading those dense disclosures. Public Policy Viewpoint by Douglas Elliott, Brookings Institution Regulation risks complexity too Turning to regulation; in an insightful paper entitled ‘The Dog and the Frisbee’, Andy Haldane, addressing the policymakers at Jackson Hole, Wyoming on 31st August 2012, also pointed to the weakness of too much mathematics, or false mathematics perhaps, to try to account for changing market conditions and investor behaviour. His great piece explains that, were a physicist to write down the catching of a frisbee as an optimal control problem, they would need to understand and apply Newton’s law of gravity; yet, he says, despite this complexity,

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catching a frisbee is remarkably common. Casual empiricism reveals that it is not an activity only undertaken by those with a doctorate in physics, it is a task that an average dog can master; indeed some, such as Border Collies, are better at frisbee-catching than humans. His argument for the secret of the dog’s success is about keeping things simple. Equally, the watchdog’s failure, in terms of trying to understand complexity, has been to create more complexity, when less would be better. He points back to the established corporate finance models of Barrow Dubrow, or Merton-Markowitz frameworks, which fail to admit the uncertainty of human behaviour. Instead, modern macrofinance has been built on an often stringent assumption about the human state of knowledge and cognitive capacity. This constraint means that the regulators, and others, can create problems for themselves. For the physicist Richard Feynman “it is not what we know, but what we do not know which we must always address to avoid major failures, catastrophes and panics”. Despite operating in a small area of the profession, decision-making under uncertainty has begun to attract interest from elsewhere, particularly from behavioural economists. Haldane argues that complex instruments often call for simple decision rules, because these rules are often robust to ignorance, and rules of thumb may prove a better response to dealing with the problems of crisis. Complex models are more likely to be over-fitted, so the extent to which people try to understand what is going on in the world creates a problem for itself at the other end. Haldane concludes that modern finance is complex, perhaps too complex, but the regulation of modern finance is complex too – certainly too “ The regulation of modern complex – and that configuration spells trouble, as one does not fight fire with fire. One does not, finance is complex too” in his view, fight complexity with complexity, because complexity generates uncertainty, not risk, and it requires a regulatory response grounded in simplicity, not in complexity. He concludes that to ask today’s regulators to save investors from tomorrow’s crisis by using yesterday’s toolbox, is to ask a Border Collie to catch a frisbee by first applying Newton’s law of gravity. So the vision, from one of the more enlightened regulators, is that less – and simpler – may signify more. Last words The last words on simplicity that we offer come from one person involved in finance, and one who is not. Steve Jobs talked about simplicity in a Business Week interview in 1998: “That’s been one of my mantras – focus and simplicity. Simple can be harder than complex: you have to work hard to get your thinking clean to make it simple. But it’s worth it in the end because once you get there, you can move mountains.” At a recent CFA conference, behavioural financial guru James Montier of GMO is quoted as saying: “in finance we love to complicate. We love to over-complicate. We rely on complexity to baffle, bamboozle and generally thwart human understanding.” That’s throwing down the gauntlet to keep it simple.

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Aberdeen viewpoint “There’s far too much complexity in financial services today, especially fund management. There’s too much trading, there is too much use of derivatives. What we try to do at Aberdeen is keep it simple and do our work.” Martin Gilbert, CEO, Aberdeen, May 2013 Brand video After a decade in which complexity, over-engineering and a lack of transparency almost led to the downfall of the global banking system, people want financial expertise they can see, that they can understand. People are rightly seeking out skilled practitioners who focus tirelessly on what they do best. So at Aberdeen, asset management is our sole focus. Our approach to achieving performance from our funds is open and straightforward. No black boxes, no short cuts. Simply asset management. As a company – even a big one – we aim to be independent and completely focused on what we do best – without the complex structure and contradictory interests of a major bank or life assurer. We identified, therefore, that what we stand for is ‘No pretence’. Externally we’ve expressed the proposition as ‘Simply asset management’. This is a bold but authentic claim that instantly tells the world what we do (stressing our multi-asset expertise), what we value and what makes us powerfully different as an investment partner. In a world that increasingly favours simplicity and rejects excessive complexity, this is a compelling proposition. Chairman, Roger Cornick, points out, “a brand proposition isn’t something that’s limited to advertising, design or a strapline. To be effective – to be real – it needs to be reflected in everything we do. ‘Simply asset management’ is our global ethos for how we all behave and approach our work. It’s about being open, grounded and straightforward – with each other and our clients. It’s about real focus, and making our solutions as simple and straightforward as they can be without losing the richness that makes them work. Every day, we can all bring ‘Simply asset management’ to life.”

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Sources Munich Personal RePEc Archive, “Epistemology of the economy”, comments from Robert Nozick, Fernando Estrada, University of Colombia http://mpra.ub.uni-muenchen.de/22410/1/MPRA_paper_22410.pdf CIA, “Do you really need more information?” https://www.cia.gov/library/center-for-the-study-of-intelligence/csi-publications/books-andmonographs/psychology-of-intelligence-analysis/art8.html BBC, “Experts warn of hidden danger of complex investments” (5 July 2011) http://www.bbc.co.uk/news/business-13961625 William Wright, “A crisis of culture and complexity in investment banking” (June 28, 2013) tFT, “The future of investing, academics predict more complexity” Maik Rodewald (11 October 2009) http://www.ft.com/cms/s/0/f5806350-b4fa-11de-8b17-00144feab49a.html “Complexity in retail investment products and services”, Huntswood http://www.huntswood.com/advisory/advisory-documents/complex-retail-investment-products.pdf “Avoiding Complexity as a Bankable Strategy”. John Goltermann, CPA, CFA, Obermeyer Asset Management (January 2011) http://www.obermeyerasset.com/site/article/avoiding-complexity-as-a-bankable-strategy/ “Transparency, simplicity and honesty is urgently needed in investment”, Blue and Green (February 7, 2013) http://blueandgreentomorrow.com/features/transparency-simplicity-honesty-investment/ “In praise of simplicity”, James Saft (May 24, 2012) http://blogs.reuters.com/james-saft/2012/05/24/in-praise-of-simplicity-jame-saft/ “Some Reflections on the Immutable Role of Investment Firm Culture”, Jan Squires, DBA, CFA; CFA Institute (May 2012) http://blogs.cfainstitute.org/investor/2012/05/18/investment-management-culture-wars/

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Long-termism

Concerns about short-termism in markets, government thinking and corporate behaviour have increased following the global financial crisis of 2008. Levels of uncertainty surrounding investor and corporate behaviour have led to a raft of initiatives from governments, business leaders and academics examining what to do about the issue of short-termism.

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The struggle has been to try to understand and produce perfect, or improved, mechanisms to reduce short-termism and its associated evils. But few are without blame in the cycle: shareholders, customers and government leaders are all increasingly short-termist, irrespective of the social and other costs. “Short-termism and US Capital Markets” is a paper by the Aspen Institute in the U.S. covering the issue and the serious consequences they see for both investors and society at large. This report refers to research by JP Morgan indicating that a focus on quarterly earnings in US companies in order to show short-term profits is leading public companies to defer spending on marketing research, product design and prototype development and this reduction in investment is causing problems.

“ The rise of new types of trading shareholders, such as hedge funds and private equity firms, has added a heightened short-term focus into markets”

The situation is exacerbated by the shrinking public company CEO tenure, another indicator of short-term thinking, and changes to the fundamental nature of shareholders. The rise of new types of trading shareholders, such as hedge funds and private equity firms, has added a heightened short-term focus into markets, and put pressures on companies to be responsive to this type of shareholder.

The puzzle within – casino culture Looking more widely, the conundrum of short-termism is addressed in a paper by Kent Greenfield. ‘The Puzzle of Short-termism’ explores the strange paradox of what happens when short-termism takes root. The financial crisis of 2008 brought into sharp relief the economic costs of short-term management, and among the competing theories of the cause of financial collapse – the over-dependence on derivatives, the overuse of leverage, the culture of greed and entitlement in the financial industry, to name just a few – is the focus on short-termism. This is an omnipresent narrative thread according to Mr Greenfield. The addiction to leverage, derivatives and greed that caused the market to become a casino would only have been possible, he argues, in a business culture where short-term gains are prioritised over long-term costs. So, despite some naysayers, the problem of short-termism, he says, is very real. Shareholders now hold their stocks for less than a year on average, and even less for small companies. Institutional investors have been said to be particularly bad on this front, acting “more as traders seeking short-term gain”, and managers admit that they make decisions that harm a company in the long term in order to meet short-term earnings expectations. The paper goes on to explore the difficulties that arise from the short-term view, including the research and development cuts, as mentioned, but also the use of accounting adjustments, either legal or illegal, to accelerate recognition of revenue and to delay recognition of expenses, is inflating current earnings. This creates a level of concern as to the credibility and worth of the financials that have been put forward.

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Kay and Cox reviews in the UK Two important initiatives have emerged recently on a governmental level in the UK; one is the Kay Review of 2012, which examined the efficiencies of the equity markets as they stand today. The second is a report entitled ‘Overcoming Short-termism Within British Business’ by Sir George Cox, which was commissioned by the Labour Party and published in February 2013. Sir George’s analysis confirmed that short-termism constrains the ambition of UK business, holding back its development and inhibiting economic growth, and comes up with a number of recommendations as to how to improve the situation, such as addressing how equity markets function, including tapering taxes and especially capital gains tax. The villains of the piece are not restricted to the private sector, however, and the short-term focus of any government is highlighted as a problem, as politicians need to renew their positions every five years by trying to be re-admitted to Parliament. The asset managers represented in the Cox conversation do point out that their responsibilities are different from the board of directors and other company executives. As shareholders, fund managers have a stewardship responsibility to the client; sometimes fulfilling that responsibility will involve engagement with companies, but at other times it will necessitate selling or reducing a shareholding if they cannot protect clients’ interest through engagement. That, argue the asset managers, should not be seen as a dereliction of duty but a fulfilment of it. There is a subtle but important distinction, explains one investor, between what boards of directors and company secretaries may desire, and what shareholders want and need. A valid asset management perspective may therefore be to divest rather than to carry on holding for the longer term. Another dynamic at play is the competitive pressure on fund managers to deliver short-term performance. An academic paper called ‘Fund Managers’ Contracts and Financial Markets’ Short-termism’ (Sebastian Pouget), which was produced in July 2012, deals with the issue of long and short-term strategies. In its introduction the report quotes a Socially Responsible Investment (SRI) fund manager as saying “the big difficulty is a lot of the reputational issues and environmental issues play out over a very long period of time, and if the market is not looking at you, you can sit there for a very long time on your high horse, saying this company is a disaster – it shouldn’t be trusted - and you can lose your investors an awful lot of money”. Myopic shareholders In ‘Can Executive Compensation Reform Cure Short-termism?’ authors Gregg D Polsky and Andrew C W Lund discuss the validity of executive compensation reform as a way to encourage senior managers to adopt a longer-term perspective. Their view on short-termism is that there is a tendency for public companies to overweight short-term results relative to long-term consequences when they are making decisions. This can result in a number of significant “ short-termism could just social costs.

be the result of myopic

To elaborate on an earlier point, short-termism shareholder preferences could just be the result of myopic shareholder preferences for current results, which leads to for current results” systemic over-discounting of long-term opportunities and costs. In one argument then, short-termism is a result of ever-increasing disclosure and transparency and quarterly reporting cycles, which encourages short-term aberdeen-asset.com

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behaviour, because investors cannot easily assess the long-term consequences of decisions. So they might tend to focus unduly on short-term consequences, which are easier to assess and understand. The debate around long and short term has moved from the analysts’ desks to the regulators’ committees as policymakers have come to understand that short term decisions can cause long term damage. Just two examples show how this concern is applied in practice – asset managers are now expected to set their charges to ensure they are consistent with offering a long term solution to their retail customers, so challenging the old front-end loaded model. Second, remuneration structures are now required to reflect long term performance, rightly aligning financial incentives with customer interests. A legal and regulatory perspective by Simon Morris, Partner, Cameron McKenna Shorter tenure of CEOs It is worth exploring the shortening tenure of CEOs in further detail as short-termism could be the result of poorly designed executive pay options. However, chief executives, in their defence, are actually seeing higher levels of job insecurity than previously. Polsky and Lund’s paper reveals some empirical studies from Professor Steven Kaplan and Bernadette Minton, who found that “from 1998 through 2005, CEOs from a sample of large companies expected a 17.4 per cent annual turnover rate, which translates into an average CEO tenure of less than six years”. This is consistent with a 2010 Wall Street Journal study, which found that the typical CEO of an S&P 500 firm had served in that capacity for only 6.6 years. CEO turnover, then, is significantly related to share price performance, which brings the problem full circle. However, once a firm is compelled to boost current earnings, executives in competing firms may have to follow suit as well. This is a situation where one bad apple could possibly spoil the rest of the bunch. This may be the best rationale for Chuck Prince’s famous explanation of big banks’ behaviour in the run-up to the recent crisis: “As long as the music is playing, you’ve got to get up and dance.” Consequences of short-termism The effects on investor returns are also quite high. Transaction costs aggravate the problem and increase the costs to shareholders, and so the long-term net effect of short-term thinking on investor returns is, therefore, often negative.

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Key points • A culture of greed and entitlement in financial services has encouraged short-termism • There is a gap left by banks and governments as a result of deleveraging • Equity markets now involve trading volumes of high speeds and vast sums • All participants have been found wanting: myopic shareholders, traders, hedge funds and governments • Executive pay should be longer-term in structure, argue most reformers • Asset managers’ primary duty is to the client’s needs first – even before engagement with companies • Public companies overweight short-term results relative to long-term consequences • CEO tenure has shortened to less than six years • Only 3 per cent of small businesses use equity finance, whereas 55 per cent use credit cards • Human beings are by nature short-term, as the marshmallow test shows • Long-term infrastructure needs may be met by asset managers, but they are constrained • The emerging middle classes have a huge appetite for protein and water; the public and private sectors will need to work better together Professor John Kay’s conclusion is that the equity markets have now effectively become a zero-sum game, operated by traders, and one insight into this comes from US psychologist Walter Mischel, who has studied the drivers of short-term behaviourism. The marshmallow test and human behaviour Mischel is famous for his work on the ‘marshmallow test’, in which young children are offered the choice of one marshmallow now, or two after a short wait. Mischel conducted follow-up studies of this famous analysis of the behaviour of children 20 years later, and found that the reactions of the children to the marshmallow test were a good predictor of both scholastic achievement and future behavioural problems. In short, those who were able to delay gratification tended to do better in later life. The reactions to the marshmallow test illustrate the two common manifestations of the natural human tendency towards short-termism. One is excessive discounting of the future in favour of the present; and the second is that there is an innate bias towards action – it is difficult for small children to sit, even for a few minutes, without actually doing something. So, for Kay, this suggests the desire for short-term thinking is innate to the human conditions, and so must, in some way be regulated if it cannot be improved. aberdeen-asset.com

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So it is in our very nature Kay’s main emphasis is to try to illustrate that most shareholders and investors are only operating and trading for short-term interest, rather than for the longer term. For his part, Jack Gray, co-director of asset allocation at GMO, in a presentation from September 2007 called ’Avoiding short-termism in investment decision-making’, argues strongly that you have to make five steps to long-termism – not least of which is avoiding falling foul of “aggression’s law of investing”, which is “comforting short-term, urgent drivel drives out discomforting, long-term important information”. Standing above all this is the observation of the 17th century philosopher and mathematician Blaise Pascal that “All man’s miseries derive from being unable to sit quietly in a room alone”.

“ All man’s miseries derive from being unable to sit quietly in a room alone”

The Cox report seeks to identify ways in which to incentivise longer-term shareholding. One again relates to taxation - perhaps introducing more tax relief - but there is also the fact that equity markets now involve the trading of large volumes of equities and stocks at high speeds.

In the process they have become largely secondary markets, without actually providing much assistance to the primary investment for which they were originally intended. There is nothing wrong with the justifiable objectives, but they’re collectively the participants in this type of equity market casino, and not adding anything that is particularly offering value. There is nothing wrong with this in itself, as such, but, taken collectively, the markets have become a kind of casino that is not actually offering anything of value. Fighting the natural human tendency to focus on the short term is one of the hardest jobs policymakers face. It appears to be easiest when there is a clear societal consensus about the steps to be taken or when the elite has such a consensus and is in a position to carry it through over long periods. Such a consensus is perhaps easiest to achieve when there is a great disparity between a nation’s starting position and its desired goal. This is true for most of the Asian success stories, but also for Germany after the Second World War. Unfortunately, we do not have this benefit in most of the advanced economies today, with the partial exception of Germany, which seems quite sure of its approach. Perhaps the best we can hope for in America and in most of Europe is the re-emergence of a consensus about the path ahead. There is more hope, however, in another area - dealing with longer-term infrastructure needs. There is a growing consensus about developing public-private partnerships that allow governments to target areas of investment, with the private sector players and markets providing the funding. There is much still to be done to work out the optimal patterns of cooperation, but real progress has been made. The U.S. is considering a national infrastructure bank that may help in this regard. Public Policy Viewpoint by Douglas Elliott, Brookings Institution

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Global themes in asset management: our little rough guide

Returning again to taxation, the tax distortions that can favour debt over equity disenfranchise those groups that might be able to use capital in more efficient ways. Under the present tax system, Sir George Cox points out, interest is tax-deductible, whereas returns on equity are not, and this encourages raising finance by way of debt rather than equity. This is not unique to the UK, he points out, and the extent of the bias and adverse consequences were assessed by the IMF in 2011. Its conclusion was that more could be done to make the tax status of these different forms of investing more equal. The issue remains especially problematic for smaller UK companies which significantly underuse external equity funding. Cox points out that only 3 per cent of small businesses use equity finance, whereas 55 per cent use credit cards. These smaller businesses often need significant capital injections to achieve their potential, and may often be deemed inappropriate for bank finance alone, due to their innovative nature. Governments are short-termist, but long-term financing needs exist Governments are, by their nature, short-term in outlook, something that is neatly illustrated by the striking example in the Cox report concerning the question of airport capacity in the South East of England. This is a subject that the government turns over every five years, with the electorate equally short-term in their thinking, or at least that appears to be the assumption. It thus becomes very difficult for arguments to be made around infrastructure and other longer-term developments, and so there is a failure to construct globally competitive infrastructure, which is a significant problem facing the UK. In March 2013 the European Commission published its Green Paper on long-term financing in the European community while the Investment Management Association’s (IMA) 2013 annual review looked into what asset managers could do to broaden the long-term finance debate both in the UK and in Continental Europe. Firms interviewed by the IMA (now renamed The Investment Association) generally saw long-term finance as having a wide range of meanings, but identified three particular areas of focus: long-termist behaviour, emphasising engagement in corporate finance, stewardship and socially responsible behaviour; long-term finance revision, such as direct lending to business; and long-term financing projects. However, despite significant willingness to get involved in different forms of market-based finance, there appeared to be little client demand in areas, for example, to do with infrastructure. In the gap left behind by the banks, there are reservations as to what potentially could go wrong, including serious concerns about any attempt to rebalance “ Asset managers need to their primary duty towards the clients with that of serving the interest of the wider UK economy. work on a longer-term Returns were also a cause of uncertainty, while the liquidity of infrastructure projects was, in many cases, seen to be an obstacle. There were also concerns over skill-sets and, in particular, continued security of investment across political cycles. Asset managers need to work on a longer-term basis than the five years of the UK’s political cycle.

basis than the five years of the UK’s political cycle”

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In areas such as social housing, asset managers felt they could “make a difference if the industry and government help each other”. Property is very interesting, because it is seemingly the only asset class that is not global, one interviewee told the IMA. People “still buy domestic property as their number one choice”, so as a potential new asset class, real assets in the space of property and infrastructure development might be a new way for fund managers to take advantage of the difficulties they are now experiencing in a climate of low returns and high volatility in markets. The last word on sustainability In a closing section in UBS’s ’Investing in 2013 and beyond’, Sir David King, scientific advisor to the firm, points out the need for change with regard to future requirements for fuel and water. “One gallon of petrol can shift a carefully driven aircraft carrier just twelve inches”, Sir David points out. At $150 a barrel, the cost becomes prohibitive, which is quite a challenge for military and political planners. Elsewhere the Chairman of Nestlé is quoted as saying that “water is today the choke point in economic growth”. China’s annual consumption of meat has risen from 8 million tonnes in 1978 to 71 million tonnes today. Meat production consumes extraordinary amounts of water, taking around 14,000 litres to produce one kilo of grain-fed beef, according to UBS. So in addition to needing to find long-term solutions for infrastructure and development, a long-term vision of how to meet rising appetites of the emerging middle classes, and the need of military might for fuel, are other issues to ponder for the future. Decisions and actions, Sir David concludes, will need to evolve through the strength of public and private sector examples of sustainable, futureproof actions. Aberdeen view Unless you need your money back soon, you should think long-term and avoid getting caught up in the daily noise of markets. This is for two reasons: first, it makes sense to align your own investment time horizon with that of the companies in which you invest. You will find that all good companies and even some bad ones have a long-term perspective. If a company builds a factory, for example, it expects to generate returns from it for at least yen years, as you should from its shares. The second reason is that short-term price movements are most inconsequential as they are largely about temporary loss (and gain) of capital. What you should be worried about is permanent loss of capital, and this is all about assessing a company’s long-term business prospects. Investing for the long term sounds like a very simple and easy strategy but you would be surprised by how few actually adopt it. In today’s fast-paced environment, the desire for instant gratification runs through to investment-return expectations as well. The temptation to react to short-term news flow is huge. And yet short-term price movements are mostly inconsequential as they are largely about temporary loss (and gain) of capital. In our opinion shorter-term trading and over-exuberant attempts at market timing are fraught with danger meaning that bouts of often painful volatility should be weathered in order to reap longer-term rewards. Aberdeen Asset Management Ten Golden Rules of Equity Investing

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Sources “Short-termism and US Capital Markets: a Compelling Case for Change”, The Aspen Institute Business & Society Program, (2010) http://www.aspeninstitute.org/sites/default/files/content/images/Compelling%20Case%20 for%20Change_August2010.pdf “The Puzzle of Short-termism”, Kent Greenfield, Boston College Law School http://lawdigitalcommons.bc.edu/lsfp/375/ Kay Review 2012: “UK Equity Markets and long-term decision making”, Professor John Kay http://www.bis.gov.uk/assets/biscore/business-law/ docs/k/12-917-kay-review-of-equity-markets-final-report.pdf “Overcoming short-termism within British Business”, Sir George Cox, (February 2013) http://www.mbsportal.bl.uk/taster/subjareas/accfinecon/labour/144083overcomingshorttermi sm13.pdf “Can Executive Compensation Reform Cure Short-Termism?” Authors Gregg D Polsky and Andrew C W Lund (March 2013) http://www.brookings.edu/~/media/Research/Files/Papers/2013/3/18%20executive%20 compensation%20polsky%20lund/Issues%20in%20GS%2058%20Mar%202013%20 polsky%20lund.pdf “Fund managers’ contracts and financial markets’ short-termism” (July 2012) http://sebastienpouget.com/wp-content/uploads/2009/07/ShortTermism.pdf The Stanford marshmallow experiment (Wikipedia) http://en.wikipedia.org/wiki/Stanford_marshmallow_experiment “Avoiding Short-Termism in Investment Decision-Making”, Jack Gray, GMO (September 2007) http://www.cfasociety.org/southafrica/Downloads/Gray%20-%20Longtermism.pdf Investment Management Association Annual Survey 2013 http://www.investmentfunds.org.uk/research/ima-annual-industry-survey/ “Investing in 2013”, UBS (November 2012) http://bit.ly/1cKmcZj

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Transparency

Concerns following the global financial crisis in 2007/2008 have centred on the subject of transparency in many guises. This has included transparency of financial products. Namely those incorporating mortgage-backed securities that led to the crisis, with neither investors nor credit agencies understanding what was being sold across the world.

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Global themes in asset management: our little rough guide

Then there were concerns about the transparency of governance down to the transparency of sales processes and more recently, issues relating to pricing. Accompanying these anxieties are wider matters related to risk - both unexpected factors and those that they would see in terms of market volatility. Even our largest financial institutions, including central banks, have been caught. Transparency is described in somewhat long-winded terms by Wikipedia as “a general quality implemented by a set of policies, practices and procedures that allow citizens to have accessibility, usability, understandability, informativeness and auditability of information and process held by centres of authority (society or organisations)”. According to the US’s Center for Association Leadership in 2010, transparency is now a hot topic because “President Obama uses it a little bit…also technology has made things so much more transparent”. So says Quint Studer, a US business leader in healthcare. The British regulator, the Financial Conduct Authority (FCA), describes transparency more simply as being “about disclosing relevant information in a way that can be clearly understood”. In the UK regulator’s Financial Risk Outlook 2013, the word transparency is most often raised with respect to distribution, disclosure and consumer protection. Complexity obscures Under conflicts of interest in financial transactions, transparency issues related to poor disclosure in highly intermediated channels make “the final transaction complex”. According to the FCA, “increasingly complex charging structures (driven in part by pressure on firms from declining markets and changing consumer behaviours) have generated important new revenue streams for many firms. In some cases, these have also been accompanied by lower levels of transparency on products and pricing. In addition, disclosures on fees and charges for long-term investment products, such as pension and long-term savings products, can mislead consumers on the lifetime costs of the product.” A recent Boston Consulting Group report covered the issue in the context of investor frustration with volatility and poor returns over the last 10 years leading to an increased interest in the whole area of transparency. This is picked up by the Investment Management Association (IMA) Annual 2013, which actually covers the pressures affecting changing client needs, and the need to build client trust for the future. They say that asset management firms and their clients face a complex combination of regulatory changes, uncertain market conditions and evolving public policy environments. Whether looking at the institutional market in general, the emerging DC market in particular, or traditional retail fund markets, the need to focus more specifically on client outcomes is intensifying. Within this category, the IMA looks at the area of building client trust. They say that building an emphasis on better client communication is at the heart of actions that should be taken by asset management firms, but other areas, such as internal monitoring and operating culture, are also being looked at.

“ Investor frustration with volatility and poor returns over the last 10 years has led to an increased interest in the whole area of transparency” aberdeen-asset.com

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Client communications In the area of client communication, the IMA argues across institutional and retail platforms. For institutional clients, the changes in client communication are concerned with making sure that clients are informed on every step of the investment journey. In some cases, the communication for firms has developed hand-in-hand with increased client scrutiny. A number of organisations stated to the IMA that clients across the institutional spectrum now ask for more details and bespoke information more frequently. One quotation goes: “We have moved forward in a softer way, and our whole emphasis is on partnership and how to be more engaging and transparent. A lot of this is easier to do institutionally, but we’re also trying to make it more accessible on the retail side.” With respect to the specific approaches to client communication itself, the IMA highlights the quality of information, charges and costs – both explaining how much things are really costing to the underlying client, and moving beyond product, which is really about communication strategies expanding their focus increasingly beyond product information into education on personal investing, market behaviour and related areas of investor interest.

Key points • Poor investment returns over the last ten years have led to increased interest in transparency • Sarbanes-Oxley: revelations of financial irregularities have promoted investors to scrutinise financial information more aggressively • FCA describes transparency as disclosing relevant information in a way that can be clearly understood • IMA finds its members are asked for more details and bespoke information more frequently • Investors say they want more openness, clarity and understanding • UBS thinks distribution teams are changing: no longer just selling a product, but higher technical skills and investment knowledge • Technology is accelerating the expected pace of corporate reporting

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Global themes in asset management: our little rough guide

Other trust-building measures the IMA addresses are to do with operating culture. A number of firms have undertaken wholesale reviews of their values and culture, resulting in greater emphasis on partnership and on the firms’ role as problem-solvers, rather than purely product manufacturers. This includes various forms of product checking. In a separate report, public relations firm “ People would like a Lansons undertook a communications survey with investors about asset managers, exploring genuine conversation with what it was that investors wanted to see more of in terms of transparency and their their asset managers” communications. Some of the results were quite surprising. Investors across the UK, US and Germany answered that they want more openness, clarity and understanding. There is a plea for greater straightforwardness, for a way of reducing complexity in the whole fund management system, and also a certain amount of cynicism from the UK, saying that relying on investor apathy is not a good business model, and that people would like to have a genuine conversation with their asset managers about how their money is actually being handled. Common complaints Arguably, this is quite a retail/wholesale request in terms of openness, but there are a series of common complaints across different countries around the world. What clients want in terms of communications can vary by country and by region, but a lot of the findings are based on different ways to put a narrative across, and being able to make what asset managers are doing more understandable for investors. The Wall Street Journal (WSJ), in an article on building trust in asset management, explains that transparency is all about explaining the risk in portfolios to clients. This article covers the desire for firms to be more upfront with clients regarding the risk to their portfolios, such as the probability of a shortfall in a down market. Asset managers can really build trust. Transparency regarding fees can also put investors more at ease. In addition, transparency is a favourite theme in asset selection, giving a boost to simple products “ The future is likely to be such as ETFs and index funds. One of the shorter-term horizons” commentators in the WSJ article says that the opportunities don’t lie in complex instruments, whose value or risk may be nearly impossible to discern, but in recognising long-term trends, such as rising food demand in China. Here, the appeal of transparency is about understanding the clarity of the product. EFAMA, the European trade association of asset management groups, undertook a survey in September 2012 to explore what the industry can do to encourage long-term savings. In a presentation by Bernard Delbecque, the survey findings revealed that there is not much being done because of a lack of trust and that, actually, the fall in savings of financial assets of the European population is primarily driven not only by market risk but also by a lack of trust in the participants operating in the sector. There’s much that could be done to try to improve that as a particular liability. aberdeen-asset.com

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Transparency may be the most promised and least practiced virtue in public policy! You would not have search for long to find a leader who does not call for complete transparency; yet look how hard it is to know what is actually going on, and why, based on the information that is actually revealed. Obamacare is the latest example. Sadly, this is not just true of the public sector; look at all the problems with private firms that only reveal problems when it is unavoidable. Transparency is particularly important for those managing other people’s money, whether asset managers or leaders of publicly traded companies. The key to transparency is the sincere belief of those in charge that they owe it to their stakeholders to give an honest and clear account of the situation. Warren Buffett is perhaps the epitome of transparency among CEOs. It is probably no coincidence that he is also so successful. If you do not evade responsibility or hide unpleasant truths, then you are also more likely to notice and correct your mistakes, one of the keys to success as an investor or a corporate leader. Public policy needs to encourage accounting and legal standards that incentivize clear thinking, straight talk, and the taking of responsibility. Our overly legalistic standards do not come close to achieving those goals, instead encouraging long disclosure full of jargon that obscures the key points. Public Policy Viewpoint by Douglas Elliott, Brookings Institution Evolving fund managers In an interesting report from in October 2012 on the evolution of the asset manager, UBS Asset Management addressed two areas with respect to lack of transparency causing malaise. One was from the academic uncertainties which have emerged about the assumptions behind the capital asset pricing model (CAPM) and modern portfolio theory (MPT). These two models have looked increasingly unrealistic, which is also causing concern to investors who, in turn, have short time horizons and an increased aversion to risk. This creates quite a cocktail for the changing face of asset management, where the future is likely to be shorter-term horizons, an acceptance that perhaps investors are no longer always rational profit-maximising agents (assuming that they ever were!), and flexible, continually updated views on valuation, volatility and correlation. Furthermore, distribution teams will need to no longer focus solely on selling a product, which may be just a one-off part of an overall investment package the client needs. They will need to be able to develop high levels of technical skills and investment knowledge, so that they are able to talk to their clients in the future. The UBS report is stringently interested in Dr Theory meeting Mr Practice, where behavioural finance is actually blossoming into a fertile area of academic research which can shed light on the irrationality of investors. Ultimately, the hope is that this research will result in the introduction of more levels of understanding and transparency when markets and products fail to perform as investors expect.

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The relatively new technology component of to transparency is reflected in a report by PwC that talks about transparency in corporate reporting. The report explains that companies face increased pressure to provide higher quality information faster and more efficiently, as this is required by the US Public Company Accounting Reform and Investor Protection Act, known as Sarbanes-Oxley. “Revelations of corporate financial irregularities have prompted investors and analysts to scrutinise financial information more aggressively, and penalise companies that delay or restate earnings.” They recommend that quoted corporates improve their regulatory close periods and reporting cycles. Corporate transparency Within corporations, organisational transparency is becoming the management watchword, and this is reflected in internal communications. Quint Studer, the author of a business book called ‘Straight A Leadership; Alignment Action Accountability’ explains, “people need to know what is going on in organisations, because it is not like we don’t have communication systems. It’s just at times we don’t have good communications systems.” The risks of doing nothing are that somebody else becomes the message point, somebody else positions it. “Once that person positions it, then you’re starting to play reactive leadership instead of proactive leadership.” Studer argues that in a transparent organisation “every employee knows what the specific goals are within the organisation and how they’re being measured – for example a very transparent scorecard or dashboard.” He is dismissive of immature organisations; “if you don’t share the information, they’re going to find out anyway. If it is negative or positive, you may as well let them know beforehand.” Certain institutions once deemed inscrutable are now exposed to the disinfectant of the transparency principle. The International Monetary Fund has a factsheet called ‘Transparency in monetary and financial policies’ which explains that central bankers were once notorious for being inscrutable, as reflected in Alan Greenspan’s famous quip that “if you understood what I just said, you must not have heard me correctly.” However, many of today’s central bankers have begun to prize clarity in explaining their objectives to the public. Limits to transparency Not all thinkers believe transparency is a limitless good, and some argue that the balance between transparency and openness needs to be carefully marshalled. Transparency is a popular concept in management circles, and thrust into everyday lives with disclosures and leaks, such as that of US intelligence information. In a thoughtful paper, James Heskett, Baker Foundation Professor at Harvard Business School, cites the extreme position of Kapil Sopory who observed that “excess of everything is bad.” Just where people draw the line on “ To trust transparency alone to information is hotly debated, with engender trust in management some academics saying that only data should be shared, rather than and co-operation is a pipe dream.” information among employees/ colleagues. Others differ, with one asking “how can you expect people to implement the strategy if they don’t know what it is?” Culturally, not all staff are comfortable with a high-transparency environment; it makes some aberdeen-asset.com

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people uncomfortable, although this is increasingly a generational issue. Younger people assume that much of what they do will become public knowledge, regardless of any efforts to keep it secret. Tom Dolembo from Harvard Business School gets the last word in this debate, saying that “if the company culture operates better within the founder’s vision of transparency, all well and good, be transparent. But to trust transparency alone to engender trust in management and co-operation is a pipe dream.” “What you see is what you get” only works when you can see it in the first place. Hidden charges, hidden features and hidden risks have been the target of financial services regulators for many years. Regulators worldwide are now invigorating this policy with two fresh initiatives. The first is to recognise the role of wholesale providers in the creation of complexity that is transmitted to retail investors unable to identify the problem, let alone deal with it. Second, there is renewed focus on firms’ operating structures because an opaque operating structure can be used to hide a host of risks and accumulated liabilities. Transparency is a renewed regulatory focus, and achieving this is now more necessary than ever. A legal and regulatory perspective by Simon Morris, Partner, Cameron McKenna Silos are a worry In an engaging piece on information silos, Marcelo Cote, a senior associate at SECOR Inc. in Montreal, penned ‘A matter of trust and respect’ for CA Magazine, in which he highlights the perils of the silo effect. Generally, he says, silos are an offshoot of decentralised management. “Ambitious managers, responding to the objectives asked of them, pull those reporting to them along in their quest.” As a result, he sees the department’s interest taking precedence over the wellbeing of the organisation as a whole. “Silos are a perversion of the decentralised management concept,” he argues. “The CEO may have set demanding objectives, and given managers the authority and means to achieve them. One manager may be instructed to increase sales, another to reduce costs, and a third to keep a tight rein on finances.” The results, he says, are not hard to predict. “Lieutenants concentrate on their personal objectives and disregard those of the whole...they convey the message that achieving their department’s goals is paramount, and other departments can take care of themselves.” He concludes that silos reduce efficiency: “If silos cannot be eliminated, they should be traded away”. It is not a coincidence that economic and financial crashes are always followed by a call for greater transparency. In the void of functioning market systems, openness helps to restore confidence, and counter classic market ills such as moral hazard, asymmetric information and principal-agent problems. No guarantees However, transparency should not be considered a silver bullet. This is neatly explained in a speech by Donald Kohn, member of the Financial Policy Committee at the Bank of England, in September 2011.

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He points out that risks will come from different directions over time. “Adapting transparency to shifting risks will be a substantial challenge,” he says. Transparency in his view should just be a subset of information used for risk management by firms. But data overload adds layers of complexity. The upshot is that, while transparency is essential to supporting a productive economy and stable financial landscape, being well informed and in possession of all the relevant information does not automatically translate to an ability to process and contextualise it. Therefore, the real challenge should be the quest for optimal transparency, recognising that in times of crisis the required level will be higher. Aberdeen position on transparency The fourth golden rule of Aberdeen’s small book on equity investment is entitled ‘Understand what you are buying’. Hugh Young, Aberdeen’s Group Head of Equities, says that if there is something about a business that does not make sense, “walk away”. This common-sense approach to transparency is somewhat defined by its opposite, namely to be wary of processes and businesses that are opaque. The pragmatic investor’s answer to a lack of transparency is avoidance, and this is characterised by the Aberdeen investment process. Aberdeen champions the clarity of its investment portfolios. Indeed we say that “clients understand our process and portfolios because they are transparent.” The firm predominantly takes a long-only, active approach to investment, which is characterised by high conviction investments, in the case of equities, being held for the longer term. Transparency is also a vital component of good corporate governance and stewardship. Our website explains that “a review of the corporate governance practices of a potential investee company is part of the initial screening process, and an investment will only be made after meeting with the management team. After investing in a company, regular meetings are held with management to discuss strategic, operational and governance matters. Engagement is therefore embedded in the Aberdeen investment process, which is reinforced with all voting decisions being taken by the Group’s investment managers.” Aberdeen is committed to adopting best practice for its own corporate governance policies. The Group is also committed to exercising responsible ownership with a conviction that companies adopting best practices in corporate governance will be more successful in their core activities and deliver enhanced returns to shareholders. Internally, the ethos of transparency forms part of Aberdeen’s values. We explain on our website with respect to teamwork: “from our beginning we have valued a culture of openness, mutual dependency and collective purpose. We organise our fund managers in teams, so every one of them has a voice. And by following investment processes that are clear, systematic and where all information is shared, we think this leads to better outcomes than if a star fund manager were in charge. We strongly believe that the combination of experienced hands and fresh minds invigorates our thinking and can lead to better performance.”

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Sources The Wall Street Journal, “To grow we must accept some risk” (July 2013), Catherine Bolgar http://online.wsj.com/ad/article/assetmanagement-risk International Monetary Fund, “Transparency in Monetary and Financial Policies” (March 2013) http://www.imf.org/external/np/exr/facts/mtransp.htm Deloitte, “Financial Stability and Transparency – Consistent Objectives?” (June 2012) http://www.financedublin.com/sponsors/article.php?i=279 PwC, “How to achieve more timely, accurate and transparent reporting through a smarter close” http://www.pwc.com/en_US/us/advisory-services/assets/transparent_reporting.pdf Associations Now, “Using Transparency to Drive Organizational Success” (November 2010). Kristin Clarke http://www.asaecenter.org/Resources/ANowDetail.cfm?ItemNumber=53097 Wikipedia, “Transparency (social)” (August 2013) http://en.wikipedia.org/wiki/Transparency_%28social%29 Harvard Business School, “What Are the Limits of Transparency?” (July 2013), James Heskett http://hbswk.hbs.edu/item/7297.html SECOR Inc., “A matter of trust and respect” (March 2002), Marcel Côté http://www.camagazine.com/archives/print-edition/2002/march/columns/camagazine23400.aspx The Wall Street Journal, “Global financial crisis spurs evolution in the asset management industry” (August 2012), Catherine Bolgar http://online.wsj.com/ad/article/assetmanagement-crisis Investment Management Association, “Annual survey: asset management in the UK 2012-2013” (August 2013), Jonathan Lipkin, Andrea Pechová, Graham Taylor, Chris Bryant, Adrian Hood http://www.google.co.uk/url?sa=t&rct=j&q=&esrc=s&frm=1&source=web&cd=1&cad=rja&uac t=8&ved=0CCQQFjAA&url=http%3A%2F%2Fwww.theinvestmentassociation.org%2Fassets% 2Ffiles%2Fresearch%2F2013%2F20130806-IMA2012-2013AMS.pdf&ei=9JBMVf36HaW27ga3 14HwBQ&usg=AFQjCNHvywQhMMk0m5HttcvrzhQlE5K80g&bvm=bv.92765956,d.ZGU PwC, “US Asset Management: Strategic Imperatives for Asset Managers” (May 2013) http://www.pwc.com/en_US/us/asset-management/investment-management/publications/ assets/pwc-stratgic-imperatives-asset-managers.pdf

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Merrill Lynch Wealth Management, “Outlook 2031” (July 2013) http://www.financedublin.com/sponsors/article.php?i=279 UBS, “Evolution of the asset manager”, (October 2012) http://www.static-ubs.com/global/en/asset_management/gis/current_perspectives/_jcr_ content/par/teaserbox_3/teaser_10.824663487.file/dGV4dD0vY29udGVudC9kYW0vd WJzL2dsb2JhbC9hc3NldF9tYW5hZ2VtZW50L2dpcy9Fdm9sdXRpb24tb2Ytd GhlLWFzc2V0LW1hbmFnZXIucGRm/Evolution-of-the-asset-manager.pdf Lansons Communications, “Communication priorities for asset managers in 2013” (March 2013) http://www.lansons.com

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Behavioural economics

With the effects of the global financial crisis still resonating in markets around the world, many of the belief systems of classic economics and portfolio theory have found themselves challenged. The central tenets of modern portfolio theory and beliefs in rational markets have been found wanting. Rising slowly to replace many of these beliefs is a new social science, namely that of behavioural economics.

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The erosion of confidence in conventional portfolio management theory caused by the Long Term Capital Management hedge fund disaster in 1997 was nothing compared with the damage wrought by the global financial crisis. In 2008, expectations of uncorrelated assets were confounded as all boats sank. As a recent blog by financial researcher Joshua Sharf explains: “Since finance is one of the intersections of math and men, Long Term Capital Management represents the failure of both”. Sharf cites two books written on the LTCM story, ‘Inventing Money’, whose author Nicholas Dunbar emphasises the mathematics while, by contrast Roger Lowenstein’s, When Genius Failed’ emphasises the men. Sharf explains: “LTCM based its strategy on Modern Portfolio Theory. MPT is an essentially Brownian motion – random motion with normally-distributed action – applied to financial markets. It produced the famed Black-Scholes equation, now used statutorily for pricing options. The problem is, they forgot the fine print.” Normal mathematics in abnormal times Sharf points to the assumptions that misled such smart people: “The normal distribution curve is one simplifying assumption. Another is that returns in different markets are uncorrelated; that is, what one does has no effect on the others. Another is that markets are always liquid – they trade at the smallest tick, and unlike the Hotel California, you can actually leave any time you want.” Behaviouralists worry that human beings confuse correlation with causality, and in recent cases of extreme market events many of the accepted investment formulae quickly began to melt. The ’Value at Risk’ (VaR) thesis calculated how much an investor might be expected to lose in the worst month out of any 20 or 100, say. But the model is oversimplified and the calculation of short-horizon VaR can be misleading for customised or exotic products that cannot be liquidated within the assumed time horizon. Questioning the validity of modern portfolio theory (MPT) could have serious consequences for fund managers. Critics have observed that Sharpe’s “Capital Asset Pricing Model” (CAPM) and the Modigliani-Miller theorem were written during periods of extreme market stability. MPT was written in 1959, and Modigliani-Miller’s papers during the early 1960s. During the great bull market runs MPT seemed to perform well, but in current market conditions its cracks are truly showing. The volatility approach in MPT and Sharpe’s model values downside volatility and upward moves equally. But such an approach is flawed in the current market environment and any student of “loss aversion” will know that such neutrality fails a common sense test. Getting real and down to earth The authors of a thought paper for Europe Arab Bank in January 2009 conclude: “What we have observed over the last five years, whether it is managed on the basis of fundamental factors, momentum, arbitrage or any other rationale, is that everything tends to end up on the same side of the trade at the same time. Believers in portfolio theory are convinced that alternative investments are somehow negatively correlated with basic equities for instance. During 200708 they have learnt the hard way that this is simply not true. Bonds, equities, commodities and currencies aren’t asset classes in their own right.”

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The policy suggestions from this team involve becoming distinctly local and grounded: “Our suggestion is that the paradigm shift in financial economics should be a reversion to ‘traditional’ markets. Not only does diversifying across asset classes and geographical regions not spread risk, we have seen how in a bear market it amplifies risk. The clear lesson from “ everything tends to end up the crisis is to ‘know one’s risk’, and that is on the same side of the trade best served by concentrating on assets and sectors that one is familiar with. Diversifying at the same time” in the name of the MPT will only erode value.” Behavioural economics is a breakthrough in economics that has serious implications for public policy. One implication is that macroprudential policy is important; this is the policy area falling between monetary policy and traditional safety and soundness regulation of financial institutions. It focuses on the risks to the financial system as a whole, many of which are created or exacerbated by systematic problems of human behaviour in markets and at financial institutions. For example, there are strong institutional biases towards participation in asset bubbles. Failure to join in cuts one’s income and can lead to job loss, while there is a good chance of avoiding being fired after the bust as long as one is camouflaged by a large enough crowd. Central banks and financial regulators need to step in to counteract the tendency towards excessive risk by requiring higher safety margins and other elements of conservatism when the risks of bubbles are at their highest. Behavioural economics also suggests more detailed ideas about how to design disclosure and other regulatory policies in order to encourage sound decisions by the humans involved. It even shows that voluntary participation in long-term savings through occupational pensions can be improved simply by making it the default, with an easy opt-out, instead of requiring an opt-in, even when the opt-in was extremely easy. As the field becomes more developed, it will undoubtedly make many contributions to improve public policy. Public Policy Viewpoint by Douglas Elliott, Brookings Institution Cartesians bite back Peng Cheng of Dimensional Fund Advisers contended in 2012, on addressing the issue of whether MPT failed in the global financial crisis that: “diversification in fact did not fail at the security level and the basic asset class (stocks, bonds, cash) level. However, the increasing globalisation of economic activity and capital markets has made stock markets around the world much more highly correlated, reducing the benefits of diversification across these markets, especially during periods of crisis.” Peng also explained that many hedge funds have embedded beta risk in them, so the diversification benefits of blending them with other asset classes is limited, especially as high fees erode the alpha. He offers another mathematical model (the Truncated Levy Flight [TLF] distribution) to account for “higher moments” of skew.

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This proposal prompted CFA-registered blogger David Merkel to say “we have to give up these academic approaches to asset allocation. None of them work – it doesn’t matter whether you have two or four parameters – the parameters are not stable, and can’t be stable.” For defenders of the maths, this is recidivist talk. Merkel, an investment professional with a strong eye on risk, understands that investor behaviours affect asset prices. “There are two matters affecting any investment: the underlying behaviour of the asset in terms of its relative value, and behaviour of those who hold the investment, their perception of relative value, and their need for liquidity,” he argues. “To give an absurd example, think of Bernie Madoff. The actual value of the assets never did anything. But parties owning interests in Madoff’s ‘fund’ needed to raise liquidity when the public equity markets plunged in 2008, which led to the insolvency.” The New Economics Foundation, an independent think tank, has produced a paper, ‘Behavioural Economics: seven principles for policymakers’ that summarises what it terms “alternative” thinking in economics as a briefing pack for policymakers. It explains that “the standard (neoclassical) economic analysis assumes that humans are rational and behave in a way to maximise their individual self-interest. While this ‘rational man’ assumption yields a powerful tool for analysis, it has many shortfalls.” Behavioural economics undercuts these assumptions to reveal how we really are. The authors’ seven principles may be summarised as: other people’s behaviour influences on our own; habits are important; people want to do the “right thing”; self-expectation; loss aversion; poor computation; and needing to feel involved. Warren Buffett once said he’d be a bum on the street with a tin if markets were always efficient. The standard neoclassical model assumes an extraordinary expectation of rationality– that people carry out a full rational analysis of all their available options when making decisions. This is not what we do, of course; we often just copy the actions of other people. In neoclassical economics the assumption is made that, given their particular preferences, people act rationally “ we often just copy the to maximise their utility (utility broadly means happiness or satisfaction). actions of other people” “Doing something out of habit, for example, choosing my normal coffee in the usual-sized jar when shopping, is outside of neoclassical theory, in which I would do a full analysis of all the available coffee/jar-size/price options,” notes the New Economics Foundation paper. Doing the “right thing” seems to bypass traditional economics altogether, which has no place for altruism in its model and also would disregard the role of commitments and promises as irrelevant unless they are backed by sanctions. And although risk preferences are covered by traditional theory, the idea of loss aversion is not well explained. The paper also points out Nobel Prize-winning behavioural economist Daniel Kahneman, who says people use “rules of thumb” in making calculations, whereas a neoclassical economist would assume that people act rationally and logically as well as having all the necessary information at their fingertips.

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What other kind of finance? Behavioural finance is a relatively new discipline. Writing in 1999, economist Richard Thaler argued that “behavioural finance is no longer as controversial a subject as it once was. As financial economists become accustomed to thinking about the role of human behaviour in driving stock prices, people will look back at the articles published in the past 15 years and wonder what the fuss was about. I predict that, in the not-too-distant future, the term “behavioural finance” will be correctly viewed as a redundant phrase. What other kind of finance is there?” In his paper, Thaler goes on to list evidence that should worry advocates of efficient market theory. One element involves volume of stock turnover, with Thaler saying: “Standard models of asset markets predict that participants will trade very little. The reason is that in a world where everyone knows that traders are rational (I know that you are rational, you know that I am rational, and I know that you know that I am rational), if I am offering to buy some shares of IBM Corporation and you are offering to sell them, I have to wonder what information you have that I do not.” But in the real world, people have liquidity and rebalancing needs. There is also volatility. But since 1981, Thaler points out, aggregate stock prices appear to move much more than can be justified by changes in intrinsic value, and stocks and bonds are more volatile than advocates of the rational efficient market would predict. Dividends and the equity premium puzzle have also added to the confusion, although the latter has in recent times not shown quite as much of a premium as expected. In many important ways, says Thaler, real financial markets do not resemble the ones we would imagine if we only read finance textbooks.

“ stocks and bonds are more volatile than advocates of the rational efficient market would predict”

Once the realm of the first year undergraduate, behavioural economics is now receiving top level attention from the regulators, with the UK’s FCA publishing its first paper on this topic only a few months ago. The reason is clear – you cannot protect consumers before you understand what drives them. By digging beneath the surface the regulators are giving out some important signals. First, disclosure is not enough – people don’t read it and in any case probably don’t understand it. Second, firms can play the market, exploiting inbuilt assumptions and prejudices. Third, inertia dominates too many decisions, such as sticking with the same bank for the whole of your life. In seeking to challenge these features the regulators are trumpeting the fact that they are, post crash, seeking to overturn the way the retail market has operated and create a new normal of firms competing to offer customers the services the regulators think they need. A legal and regulatory perspective by Simon Morris, Partner, Cameron McKenna

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Value investing matters In 2000, Christopher H. Browne, a value fund manager, gave an impassioned speech to Columbia Business School. “A whole body of academic work formed the foundation upon which generations of students at the country’s major business schools were taught about Modern Portfolio Theory, Efficient Market Theory and Beta,” he began. “In our humble opinion, this was a classic example of garbage-in-garbage-out. One could have just as easily manipulated the data to show that corporations with blue covers on their annual reports performed better than corporations with green covers on their annual reports.” Browne explains in behavioural terms why value investors have a harder time than fund managers who follow growth strategies. The latter approach, he believes, panders to the human need for immediate gratification, while the value investor has to wait longer to see their results. He also believes that institutional behaviours can act as a bias and distort, saying: “I am also of the opinion that the institutionally prescribed definitions of value and growth are flawed”. Consultants using data from sources such as Barra have divided the universe of all stocks into either value or growth. Managers of either style must then take care to construct their portfolios from their style universe, or risk losing the account because of committing the sin of “style drift”. This institutional bias can leave many value managers with a list of large industrial companies – cyclical stocks, whose heydays of growth and high returns on capital are long past. “My brother, Will,” Browne explains, “calls them the ‘hospice patients of corporate America’.” Working the loser’s game One of the early proponents of a behavioural attitude to investing was Charles D. Ellis, whose 1975 book ‘The Loser’s Game’ examines the fascinating premise that investment management is not a winner’s game but a loser’s game. Ellis quotes a study of the crucial two differences in playing strategy by Dr Ramo, who observed that tennis is not one game, but two, one played by gifted professionals, the other by amateurs. In expert tennis the outcome is determined by the winner, who seldom makes mistakes. In amateur tennis the victor gets the higher score because the loser is losing even more points. The loser in effect defeats himself.

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Key points • Neoclassical economic analysis assumes humans are rational and behave to maximise their individual self-interest • The relatively young academic theories around portfolio management have been found lacking after a succession of bubbles and crashes • “Value at risk” models broke when applied to exotic products that could not be liquidated easily • The parameters of academic approaches are not stable: Sharpe ratios, standard deviation and PE ratios as isolated measures are flawed • Efficient market theory is discredited as it depends on expectations of rationality that do not work in practice • The Capital Asset Pricing Model is poor • Behavioural finance sees investors as both rational and quasi-rational • “The extremes of human emotion prevent the stock market from spending much time in a rational state of fair valuation” • Diversification proved to be unsuccessful in the global financial crisis • Behavioural finance may not cure our biases, but it makes us more aware Ellis sees the investment management arena as one which shifted from institutions striving to win by outperforming the market in the 1960s to a loser’s game where the investor is up against institutions who, with their resources, are the giant professionals. The only way to beat the market is to exploit other investors’ mistakes. Defining the enemy as within – in Pogo’s old lament, “we have met the enemy and it’s us” – Ellis lists the internal demons that affect all investors; we are impatient, optimistic, proud and emotional. This, Ellis argues, is what makes us such suckers for the emotionally unstable “Mr Market” and his attention-getting tricks, as opposed to “Mr Value” who does all the important work. In a foreword to ‘Behavioural Investing’ by behavioural finance guru James Montier, John Maudlin says “even as what were once considered the foundations of finance (the efficient market hypothesis, CAPM, and modern portfolio theory) being questioned and even blamed for much of the “ we are hard-wired for are problems of the markets, many of us are looking to the new world of behavioural finance for answers to our the short-term” investment conundrums”. Montier reinforces the view, established by legendary value investor Benjamin Graham, that the investor’s worst enemy is likely to be himself. Elsewhere Montier has written of two powerful drivers that neuroscientists have found about human behaviour. One is that we are hard-wired for the short-term – the

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chance of short-term gains is very attractive, and appeals to the emotional centres of the brain. The second is that our brains are wired so that we want to be part of a herd. There is a pain attached to social exclusion, such as betting against everyone else, which is felt in the same part of the body as physical pain. The only defence seems to be to build an awareness of our behaviour, understand it and then adapt so that we exhibit self-control. Embraced by the regulator The FCA issued an occasional paper in April 2013 that embraces the use of behavioural economics in the context of consumer protection. After citing reasons why behavioural biases were likely to occur in retail financial markets, the FCA concluded that most consumers find financial products complex; many decisions require the assessing of risk and uncertainty as well as trade-offs between the present and the future; many financial decisions are emotional; and learning about financial products can be difficult.

“ The FCA believes more behaviour-based knowledge can enhance an investor’s “toolkit”

The FCA believes more behaviour-based knowledge can enhance an investor’s “toolkit”, adding: “Firms play a crucial role in shaping consumer choices through product design, marketing and the sales process. Much consumer detriment arises as firms design and sell products that benefit from consumers not overcoming mistakes or, at times, exacerbating mistakes.”

The regulator goes on to suggest “firms may also play the opposite role, and actively use behavioural insights to help individuals to engage with financial services and make better choices by designing products that consumers are more likely to understand, and using marketing and selling tactics that do not trigger or exacerbate biases”. And it concludes by offering a challenge for good: “Or firms might help people interact with the firm through channels that offer a better consumer experience or are cheaper to use. Whether such practices are feasible and sustainable, however, depends on the nature of the bias and competition and, ultimately, whether debiasing is in the best interests of the firm.” The last word Montier perhaps put it best when he observed – “CAPM is in actual fact Completely Redundant Asset Pricing (CRAP)”. For his part, Charlie Munger said in April 1994: “I have a name for people who went to the extreme efficient market theory, which is ‘bonkers’. It was an intellectually consistent theory that enabled them to do pretty mathematics. So I understand its seductiveness to people with large mathematical gifts. It just had a difficulty in that the fundamental assumption did not tie properly to reality.” In a seminal annual report in 2008, the Dundee Corporation’s CEO Ned Goodman expressed the shortfalls of the conventional approach to asset management, arguing that investment has not kept up with cutting-edge intellectual developments: “While the science of irrational behaviour is quickly growing up, conventional wisdom still provides investment advice based on very outdated, bogus ideas of sensible sane people and rational stock markets,” he continued.

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“The extremes of human emotion prevent the stock market from spending much time in a rational state of fair valuation. The stock market has multiple personalities: extreme state of happiness to severe depression. The stock market rarely behaves in an average manner.” As recently as 2004, the creators of the CAPM, Eugene Fama and Kenneth R. French, wrote: “The attraction of CAPM is that it offers powerful and intuitively-pleasing predictions about how to measure risk and the relation between expected return and risk. Unfortunately, the empirical record of the model is poor – poor enough to invalidate the way it is used in applications.” Aberdeen position on behavioural economics “The efficient-market hypothesis is nonsense. Markets are driven by humans, humans are irrational, thus markets are irrational.” Hugh Young, Aberdeen Asset Management Opponents of efficient market hypothesis point to Warren Buffett and other investors who have consistently beaten the market by finding irrational prices within the overall market. Aberdeen’s investment philosophy is grounded on scepticism, strong teamwork and a recognition that human beings are flawed. Aberdeen does not believe that markets are efficient. In many ways the arguments of neo-classicists and behavioural economists are not dissimilar to the great philosophical tensions between Cartesians and Empiricists in the eighteenth century. Aberdeen’s natural bias, like Locke and Hume, is towards observation and seeking evidence, finding the more abstruse mathematical and cold logic of Descartes harder to follow. Aberdeen is predominantly a fundamental investor, and an intuitive supporter of behavioural finance. Fundamental investors do a lot of analysis to attempt to find what they think is the best price for an asset – not that fundamental investors always believe in mean reversion or efficient markets. Fundamental investing works for bonds, equities and other asset classes; an investor can, for example, perform fundamental analysis on a bond’s value by looking at economic factors, such as interest rates and the overall state of the economy, and information about the bond issuer, such as potential changes in credit ratings. For assessing stocks, this method uses revenues, earnings, future growth, return on equity, profit margins and other data to determine a company’s underlying value and potential for future growth. Aberdeen has some sympathy with the view that overdriven mathematical definitions of risk can fail to see the point. As Ned Goodman in the Dundee 2008 annual report says: “Consultants have taken market efficiency to a religion. It is from that religion that we have index benchmarks, risk calculated by volatility (beta), indexing of portfolios. Clearly as the last 10 years in the market has ended, the religion of efficient stock markets is more broadly recognised than those of us who agree with the Buffett-Munger agnosticism towards that ‘bonkers’ theory.”

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Sources “Applying behavioural economics at the Financial Conduct Authority” (April 2013) http://www.fca.org.uk/static/documents/occasional-papers/occasional-paper-1.pdf “New Economics Foundation: Behavioural economics: seven principles for policy-makers” http://www.neweconomics.org/page/-/files/Behavioural_Economics.pdf “The End of Behavioral Finance”, Richard H. Thaler (1999) http://www.google.co.uk/url?sa=t&rct=j&q=&esrc=s&frm=1&source=web&cd=3&cad=rja&uac t=8&ved=0CCwQFjAC&url=http%3A%2F%2Flegacy.earlham.edu%2F~lautzma%2Findex_files %2FCapital%2FPart%25202%2FBF_Thaler_FAJ_1999.pdf&ei=kJFMVcnUIObB7gbUrIDgDQ&us g=AFQjCNEtNv91QCx2CiHiqgct_SBWYoY3jA&bvm=bv.92765956,d.ZGU “Value investing and behavioral finance”, Christopher H. Browne (November 2000) http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Christopher%20Browne/ Value%20Investing%20and%20Behavioral%20Finance%20-%20Chris%20Browne%20to%20 Colubia%20Business%20School.pdf “Why Sharpe ratios are less useful than you may think”, Greg B. Davies, Barclays (August 2013) http://www.investmentphilosophy.com/latest/blog/why-sharpe-ratios-are-less-useful-thanyou-may-think “Are financial markets efficient?”, Andrei Shleifer, Clarendon Lectures in Economics (2000) http://www.amazon.co.uk/Inefficient-Markets-Introduction-Behavioral-Clarendon/ dp/0198292279/ref=sr_1_1?s=books&ie=UTF8&qid=1337780402&sr=1-1#reader_0198292279 “Winning the Loser’s Game”, Charles D. Ellis (1975) http://www.amazon.com/Winning-Losers-Game-Strategies-Successful/dp/0070220107/ ref=tmm_hrd_swatch_0?_encoding=UTF8&sr=&qid=#reader_0070220107 “The little book of behavioral investing: how not to be your own worst enemy”, James Montier (2010) http://www.amazon.co.uk/Little-Book-Behavioral-Investing-Profits/dp/0470686022/ref=sr_1_1 ?s=books&ie=UTF8&qid=1378394491&sr=1-1 “Behavioural Investing”, James Montier http://www.amazon.co.uk/Behavioural-Investing-Practitioners-Applying-Finance/ dp/0470516704/ref=sr_1_3?s=books&ie=UTF8&qid=1378394491&sr=13#reader_0470516704 “Why Smart People Make Big Money Mistakes”, Gary Belsky and Thomas Gilovich (1999) http://www.amazon.co.uk/Smart-People-Money-Mistakes-Correct/dp/0684859386/ref=sr_1_1 ?s=books&ie=UTF8&qid=1378395605&sr=1-1&keywords=why+smart+people+make+big+mon ey+mistakes aberdeen-asset.com

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“Modern Portfolio Theory and the Myth of Diversification”, Europe Arab Bank (January 2009) http://www.worldcommercereview.com/publications/article_pdf/79 “Modern Portfolio Theory: Bruised, Broken, Misunderstood, Misapplied?”, Samuel Lum, CFA; CFA Institute (October 2012) http://blogs.cfainstitute.org/investor/2012/10/18/modern-portfolio-theory-bruised-brokenmisunderstood-or-misapplied/ “On alternative investments”, David Merkel, The Aleph Blog http://alephblog.com/ “Another good debunking of the efficient market theory”, Ned Goodman http://www.valueinvestingworld.com/2010/04/another-good-debunking-of-efficient.html Dundee Corporation Annual Report (2008) http://www.dundeecorp.com/pdf/71525_pressr1.pdf

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Active Management

The stresses of a low-return world are challenging the established investment doctrines of money managers, regulators and investors alike -not least traditional active managers. The 2013 report produced by Professor Amin Rajan of CREATE, entitled ‘Investing In A Debt-Fuelled World’, has a quotation which explains that investors just want to be compensated for taking risk; “They don’t care about alpha and beta”. This highlights the mounting frustration, with the 2000s now being remembered as a “lost decade”, when risk failed to generate return, and traditional equity/bond investing came under closer scrutiny and increasing doubt.

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Equity risk premium, mean reversion debunked That report’s malaise is reflected by a number of other recent sell-side and consultancyorientated discussion papers on the role of active management and whether the industry is able to respond to what investors and clients will want in the future. The Barclays Equity Gilt Study in early 2013, along with the Boston Consulting Group‘s 2013 study of the investment management industry, leads with a welcome for the recent rally in equity markets. Barclays revisit, in their first chapter, their previous year’s analysis of investment returns to account for the huge (roughly 20 per cent) rally in global equities that has occurred since then. “This performance can be attributed at least in part to the reduction in negative tail risks left over from the last crisis,” notes the report. With lower volatility having already been priced in, equity returns over the next five years are also expected to be lower – in the 3-4 per cent range – than we had been anticipating previously and well below historic norms.” The theme of expected lower returns from equities may be found elsewhere. The weighty Credit Suisse Global Investment Returns Annual 2013 addresses the conundrum affecting the major asset classes of equities and bonds, without pulling its punches as to whether the cult of equity is dead. LBS academics Dimson, Marsh and Staunton spare no home truths in debunking the sacred cows of “equity risk premium” and “mean reversion”, both held as defining arguments for investing in equity markets rather than bonds. They explain: “Until a decade ago, it was widely believed that the annualised equity premium relative to bills was over 6 per cent. This was strongly influenced by the Ibbotson Associates Yearbook. In early 2000, this showed a historical US equity premium of 6.25 per cent for the period 1926–99. Ibbotson’s US statistics appeared in numerous textbooks and were applied worldwide to the future as well as the past. It is now clear that this figure is too high as an estimate of the prospective equity premium.” Low returns squeeze institutional margins This theme is taken up by journalist John Authers of the Financial Times, who looks at the conundrum that contemporary stocks, meaning shares, are expensive; and yet bonds are also expensive. “What should an investor try to do, given that both asset classes look expensive compared to where they were historically?” is how Authers poses a question that is adding to pressures on both the institutional and retail segments of the asset management industry. Defined benefit schemes of pension funds need to achieve higher returns in order to meet their 100 per cent target of being fully funded. This, in turn, results in institutions firing active managers and moving money to cheaper passive managers.

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Active management – key points • The “great moderation” encouraged excessive risk-taking in many asset classes, and financial instability • The “great rotation” from low-returning bonds to equities and other investments is unlikely to be a smooth process • Equity markets, like bonds, are now challenged after delivering lower returns in the last decade; investors are focused on risk, no longer just on growth • Future returns from equities are likely to be substantively lower than historic norms, say Barclays, Credit Suisse and UBS • Optimistic premises such as the “equity risk premium” and “mean reversion” have been debunked by leading academics (as has the “efficient markets hypothesis”) • Most active managers continue to underperform their indices; this and cost pressures have led to the growth of “cheaper”, passive investing • Active managers point to the outperformance of those with high active share, high alpha and concentrated or unconstrained portfolios, especially in an environment of low returns and volatility, such as now • DB pension funds are diversifying quickly away from active equity management to passive – and even into other higher-risk vehicles, including alternatives and derivatives • “High alpha” strategies are likely to succeed, but few managers have the skill • Investors increasingly seek “alpha outcomes”, not just “alpha” One fund manager interviewed by CREATE explained that, “for every five active mandates that come up for renewal, three end up in passives, or exchange traded funds”. This affects the dynamic of the role of active management and a switch to cheap beta – or passive funds. However, institutions are also taking on more risk to compensate for expected lower returns from both asset classes. This involves packaging new forms of finance, involving leverage, shorting and derivatives, notwithstanding the serious problems that emerged in late 2008 surrounding such instruments.

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How active fell from grace Before considering what has happened to active management since the late ‘90s, a useful academic paper from 1995 by Mr I. Walter of INSEAD, entitled ‘The Global Asset Management Industry, Competitive Structure, Conduct and Performance’, reminds us that the rise of the ETF and passive industry resulted from periods of disappointment with the underperformance of equity funds in the late ‘80s and early ‘90s. His paper says that over the 1987 to 1996 period “no more than 26 per cent of equity mutual funds beat the S&P 500 index during four different time intervals. In all, 197 funds underperformed the index fund and only 49 outperformed the index over the 11-year period covered.” This resulted in considerable dissatisfaction amongst investor groups, and the paper explains that the arrival of other reputational disasters during the decade, such as personal trading ahead of fund purchases by Fidelity Investments, the Putnam scandal and the Morgan Grenfell trading scandal, all damaged the reputation of asset managers, over and beyond their fund underperformance. The global financial crisis reinforced this desire for research to show that many asset managers actually failed to deliver enough alpha to beat their benchmarks, after deducting fees. The Wall Street Journal did an analysis and interviewed Sean Davis, Professor of Finance at the University of North Florida, finding that most asset managers continue to underperform their relative benchmarks. The report to the CFA, entitled ‘Investment Management after the Global Financial Crisis’, says that pension funds are struggling with their requirements to pay out pension benefits, despite low interest rates and low returns. So Dr Davis says that active managed funds are not going away, but they will have to work harder to justify the value that they are providing, suggesting that perhaps other ways of actively modelling risk in portfolios, and more solutions-orientated recommendations, will take their place. So relative return alphas will only be achievable in some instances. In defence of active Over the past decade, few thought leadership pieces and academic papers have been presented in defence of active management. One notable exception has been Professor Martijn Cremers, formerly of Yale, who has written extensively on his calculation of “active share” as a measure of what good active management should be all about.

“ active managers of Critics of the passives claims that 85 per cent of all mutual funds underperform point out that this concentrated portfolios unfairly puts all non-passive investments in the persistently outperform same bucket. These funds will include a vast number of so-called “closet” index funds, which may have indices” been so defined by their very purpose. Scott Vincent’s strong article, ‘Is portfolio theory harming your portfolio?’ (2011) challenges the definition of risk offered by modern portfolio theory (typically tracking error). He reasserts that active managers with concentrated portfolios persistently outperform indices. 46

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This view is reinforced in a paper by South African fund managers Coronation Fund Management called ‘The Active v Passive Debate’ (April 2013, Kirshni Totaram). Not only do they also debunk the underperforming universe, they explain that “active managers add the greatest value in low-return environments, outperforming the index in both down months and range-trading periods. The only time that truly active managers are left behind is in raging bull markets, which we believe makes intuitive sense. Coronation also points out that one of the inherent disadvantages of indexation is “the investor will always be buying assets that are going up, and hence potentially overpriced, and selling assets that are under-priced – the antithesis of active management. History tells this story extremely well in terms of how much value investors have lost as a result of blindly investing in just the biggest stocks in the index.” Vincent is more vocal in his criticism; “While Markowitz’s theory has serious issues when applied to real life, Sharpe’s CAPM is in even worse shape. CAPM is built on the back of Markowitz’s theory so it starts with all of the baggage and incorrect assumptions and then adds more... Their mathematics, as well as the precise nature of their output, gives us a sense of comfort which is critical in deploying large sums of money. While some argue that a system which works 99 per cent of the time is good enough, these are the same people who would sell you a burglar alarm that works perfectly well until a would-be-criminal approaches your home. What good is a system that breaks down only when you most need it?” Bonds’ 30 year run is closing The “great rotation” was a term coined by Bank of America (BofA) Merrill Lynch in its research note from October 2012 titled ‘The Bonds Era Ends’. In the piece, the authors laid out the case for why bond investors are likely to be rotating cash into the stock market. John Bilton, an investment strategist at BofA, said “Equities will become more attractive because they are geared to growth and offer returns that investors simply cannot get from their bond portfolios”. However, there are many caveats to the speed of this trend, and the returns that could be derived. An unexpected slowdown in the US, Europe’s on-going debt crisis, adverse economic developments in China or any other surprises could lead investors to seek the relative safety of sovereign bonds as they did mid-2013. That the secular bull run in bonds is ending is however also echoed by UBS in their October 2012 report, saying that, along with the end of “the great moderation” (a period of stable growth which arguably led to greater financial risk taking), there would have to be new ways of establishing asset allocation across vehicles. BofA Merrill Lynch, in a recent report entitled ‘A Transforming World’, looks more deeply into the movements into stocks from bonds, which should offer opportunities for active managers. 2013 market highs have underlined what has become obvious to many, they say, that at least some investors are bolstering their stock portfolios. They see that the shift back to stocks has been described variously as a great rotation, or rebalancing, in which investors move away from the conservative, bond-heavy asset allocations favoured since the financial crisis, and are now devoting a higher percentage of their assets to equities. However, it is also seen that there is a structural underweight remaining, when it comes to the proportion of bonds that remain in investors’ portfolios.

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The role of “high alpha” UBS, in another report looking at the evolution “No real returns on equities, of the fund manager, in October 2012, explains the back story of why the events of since the peak of the the 1990s affected what is happening today. dot-com bubble in 2000, The lack of real returns on equities, since the peak of the dot-com bubble in 2000, have have undermined faith in undermined faith in the equity risk premium, the equity risk premium” for decades one of the central tenets of asset management, and that has combined with the secular bull run in bonds approaching its natural limit, which meant that there would be a reappraisal by asset managers as to how they actually managed money. Ultimately, it comes down to: if one is going to be an active manager, it is increasingly important to be genuinely very high alpha. It sometimes seems that every good idea must be carried to its extreme, where it ceases to be a good idea. The dot-com bubble, a recognition of the transformative effects of new information technology, is one example. It appears that another is the realization that much active management in the past was a waste of money and that passive strategies can sharply reduce the expense load. Many active managers have risen to the challenge by developing a better value proposition while some forms of passive management have developed their own vices. A key public policy challenge is how to encourage a sufficient level of smart, active management. Markets are a very efficient way to allocate resources in a society, but they require participants to make active choices in order to generate the right pricing signals. If too many investors resign from the fight, relying on prices driven by a dwindling band of active managers, these signals will become unreliable. Unfortunately, public policy is generally working in the opposite direction at the moment, with many calls to reduce “speculation” via a Financial Transactions Tax or limits on trading speed or short selling or the use of dark pools and other market structures designed to reduce the penalty to active management. Many banking “reforms”, such as the Volcker Rule, will also harm market liquidity and therefore increase the penalty for active managers. The most critical step we can take is probably to recognize the importance of efficiently working markets and to try to avoid undue limitations or handicaps on the markets. Public Policy Viewpoint by Douglas Elliott, Brookings Institution

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This “high alpha” theme is expressed in a report by management consultants Casey Quirk, which says that there is no role for expensive beta in the active management suite; it is getting compressed, in terms of pricing, margins are being compressed by pension funds looking for cheaper, more passive options in that area, and increasingly there is no interest in expensive beta not offering performance. This report, ‘The Complete Firm 2013: Competing for the 21st Century Investor’, explains that, “between 1988 and 2000, fuelled by bull markets and global equities, the average global 60/40 balanced portfolio grew 10 per cent, compounded annually”. It continues, “However, since 2000, as interest rates tumbled to historic lows in major economies and stock markets, a similar portfolio has only appreciated 5 per cent, compounded annually, and also has had higher volatility. The mighty tailwind that they said propelled industry growth for much of its modern history is now spluttering.” This means, in their minds, that the high alpha active management offer has a chance of a good future, offering a relatively uncorrelated high-tracking error, and is often designed for sheer outperformance in a low-growth environment. This elusive, uncorrelated alpha will still attract most of the client’s fee budget, and therefore represents, in their view, the industry’s most substantial revenue opportunity. Alpha working harder, but are “outcomes” the new alpha? The theme has been continued by consultants McKinsey, whose 2013 annual survey on the asset management industry says “outcomes are the new alpha; the driver of demographic change and other forces at play in the industry are resulting in a demand for net flows only coming in to passive alternatives and to solutions orientated business” on an aggregated basis. They see that net flows have been stagnant across the industry, but are now highly concentrated into passive solutions and alternatives and, as a result, for retail and institutional clients there has been a shift by retail and institutional clients away from high octane performance, in favour of what they see as more assured outcome-orientated investing, and this theme is picked up by a number of different reports published in 2013. The past is not the future Adding to investor angst is persistently high volatility and on-going financial turmoil. This level of volatility and concern about outcomes for a changing demographic have led to a number of reports addressing what will be the future of asset managers and active asset management. The LBS team argue that any hope for a return to the 1990s model for stock market growth is delusional. They conclude in the Credit Suisse ‘Global Investment Returns Yearbook 2013’, “The high equity returns of the second half of the 20th century were not normal; nor were the high bond returns of the last 30 years; and nor was the high real interest rate since 1980. While these periods may have conditioned our expectations, they were exceptional.” However, in its 2013 ‘Equity Gilt Study’, Barclays believes returns on equities are likely to beat those on cash and bonds, both of which they expect to be negative in inflation-adjusted terms. “The continuation of extraordinarily easy monetary policy should keep nominal returns on cash negligible, and the eventual normalization of monetary policy is expected to render returns on bonds even lower than cash.” So, to summarise, active management is here to stay, but it has to earn its keep as a

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“high alpha” business. It is under pressure from other forms of investment available to both the defined benefits market that wishes to see 100 per cent funding of solutions, and also for retail investors. McKinsey says that the retail adviser of the past is moving from being “a stock-picking adviser”, to “the ETF asset allocator” of the day, and envisages the passive industry, as represented by exchange-traded funds, will grow to a massive $1.6 trillion business by 2016. Meanwhile there is also discussion as whether “smart beta” is a fad or the future. “ Passive funds in certain Passive funds in certain markets can badly expose investors to risk from overmarkets can badly expose dominant sectors, as they only track by investors to risk from overmarket capitalisation. The FT says that “smart beta”, sometimes known as dominant sectors” “advanced beta”, “can be understood as an umbrella term for rules-based investment strategies that do not use the conventional market capitalisation weights that have been criticised for delivering sub-optimal returns by overweighting overvalued stocks and, conversely, underweighting undervalued ones”. The FT points out that interest in smart beta indices has been fuelled by the global financial crisis, which prompted many investors to become more focused on controlling risks than simply maximising their returns. One issue that remains is whether any rules-based system of investing can eliminate the risks it so wishes to avoid.

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Active management – the Aberdeen view The main criticism of active management is that the cost of performance is expensive relative to passive investing, and that most active managers underperform over time. While the bull market of the 1990s lifted all boats, the following decade has been characterised by disappointment and a fundamental revaluation of risk – and what might constitute ‘safe haven’ markets. In addition, Aberdeen’s portfolios are typically concentrated, which in turn offers a different risk profile from the index. Lessons from the 2008 financial crisis, where all major asset classes (once expected to behave differently) fell, led to changes in how managers managed multi-asset as well as equity funds. This redefining of what investors understand as risk is now significant. Passive funds have a role in eliminating manager risk, but investors are still exposed to market risk. Active management aims to reduce the risk in downturns; indeed it is this downside component that makes them an attractive option during periods of low returns and volatility. We also believe diversification is important in reducing risk. Aberdeen aims to reduce risk by finding investments for portfolios that in aggregate will reduce risk by lower correlations. Indices by contrast can over-concentrate in specific sectors depending on the market cap make-up of a particular country. Passive funds, although cheaper, typically underperform their indexes because they still carry some costs, and of course are unable to outperform by their very nature.

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Sources Kirshni Totaram, Coronation Fund Managers, “The Active v Passive Debate” (April 2013) http://www.google.co.uk/url?sa=t&rct=j&q=&esrc=s&frm=1&source=web&cd=2&cad=rja&uac t=8&ved=0CCgQFjAB&url=http%3A%2F%2Fwww.coronation.com%2Fassets%2Fza%2FPerso nal%2FPublications%2FCorospondent%2F2013%2FApril%2FCorospondent%2520Apr il%25202013.pdf&ei=rpJMVYrXOe-P7AaWmoDgDA&usg=AFQjCNGbnv5TTw4nTNGYY33dksa qOWJCyQ Scott Vincent, Green River Asset Management “Is Portfolio Theory Harming Your Portfolio” (April 2011) http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1840734 Elroy Dimson, “Investing in a low return world”, Dimson, Marsh and Staunton, London Business School Asset Management Conference (April 2013) http://www.slideshare.net/londonbusinessschool/dimson-investing-in-a-low-returnworldlbsamc19apr13 Bank of America Merrill Lynch, “The Bond Era Ends” (October 2012) http://www.merrilledge.com/Publish/Content/application/pdf/GWMOL/ BofAMLRICoverview09Oct12.pdf Merrill Lynch Wealth Management, ‘A Transforming World’ (2013) http://wealthmanagement.ml.com/publish/content/application/pdf/GWMOL/AR9D50CFMLWM.pdf CREATE, ‘Investing In A Debt-Fuelled World’, Amin Rajan (2013) http://www.create-research-uk.com/?p=research Barclays Equity Gilt Study, 58th Edition (2013) http://www.google.co.uk/url?sa=t&rct=j&q=&esrc=s&frm=1&source=web&cd=1&cad=rja&uac t=8&ved=0CCEQFjAA&url=http%3A%2F%2Flwmconsultants.com%2Fwpcontent%2Fuploads%2F2013%2F09%2F20130221-Barclays-Equity-Gilt-Study-2013%25E2%2580%2593-58th-Edition.pdf&ei=MZNMVZuVJuLd7QaiyICACg&usg=AFQjCNHhW6 exulX6tZwPaKCT4mxChA2jag Boston Consulting Group, “Global Asset Management: Capitalizing on the Recovery” (July 2013) https://www.bcgperspectives.com/content/articles/financial_institutions_global_asset_ management_2013_capitalizing_recovery/ Casey Quirk, “The Complete Firm 2013: Competing for the 21st Century Investor” (February 2013) http://www.caseyquirk.com/whitepapers.html

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“Credit Suisse Global Investment Returns Year Book 2013”, Credit Suisse Research Institute (February 2013) http://www.almenni.is/wp-content/uploads/Credit-swiss-2013_yearbook_final_web.pdf I. Walter of INSEAD, “The Global Asset Management Industry: Competitive Structure, Conduct and Performance” (1998) http://www.insead.edu/facultyresearch/research/details_papers.cfm?id=1211 ‘Investment Management after the Global Financial Crisis’, CFA (2012) http://online.wsj.com/ad/article/assetmanagement-crisis McKinsey 2013 http://www.btinvest.com.sg/system/assets/17804/2013%20asset%20management%20 brochure%20final.pdf UBS, “Evolution of the asset manager” (October 2012) http://www.static-ubs.com/global/en/asset_management/gis/current_perspectives/_jcr_ content/par/teaserbox_3/teaser_10.824663487.file/ dGV4dD0vY29udGVudC9kYW0vdWJzL2dsb2JhbC9hc3NldF9tY W5hZ2VtZW50L2dpcy9Fdm9sdXRpb24tb2YtdGhlLWFzc2V0LW1hbmFnZXIucGRm/ Evolution-of-the-asset-manager.pdf “Markets: the investor’s dilemma”, John Authers, Financial Times (July 2013) http://www.ft.com/cms/s/2/efa26a96-e98f-11e2-bf03-00144feabdc0.html#axzz2cPP1pjnO Wall Street Journal (August 2012) http://online.wsj.com/ad/article/assetmanagement-crisis

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Global Convergence

For almost two centuries, the history of the global economy broadly reflected divergence in average incomes. The idea of convergence in economics gained currency in the 1990s, on the back of the theory that poorer countries’ per capita incomes will tend to grow at a faster rate than those of richer economies. This is sometimes known as ‘the catch-up effect’. As a result, all economies should eventually converge in terms of their per capita income. Consequently, developing countries have the potential to grow at a faster rate than those of developed countries; poorer countries should also then be able to catch up.

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Such a shift, however, is not uniform across emerging nations. In a piece written for The Economist recently, one writer commented that China and India are quickly gaining ground, as are many other historically underdeveloped countries. And yet, the article points out, many poor parts of the world continue to lag behind, showing no signs of convergence with the zone of wealth and power. The article continues: “It’s also true that they say that the most nondeveloped countries are experiencing slow growth, if not stagnation”. The example given is that, according to the IMF, the Haitian economy shrank over the preceding year by more than 5 per cent, the lowest ‘growth rate’ in the world. Every five years, the National Intelligence Council produces a 20-year predictive analysis of the world’s evolution, “Global Trends 2030”. “This analysis is considered to be the best long-range geopolitical forecasting conducted by the US government”, says US Security expert Thomas Barnett. “Global Trends 2030” broadly depicts three hypothetical future worlds and examines their implications, mainly from a US perspective. In one scenario, the US turns isolationist in the future and major conflict break-outs in Asia. In another, the US and China build a productive working relationship “around which the global economy does well”. In the third scenario, global institutions falter and major powers become the focus of regional economic blocs, hindering the world economy and technological cooperation. Changing certainties Commenting on this analysis, Myron Brilliant, a senior vice president for international affairs at the US Chamber of Commerce, says that, if you look ahead to 2030, the lines thought-leaders often draw between developing and developed countries may further blur. He argues that some countries – particularly China – may behave very differently from some of the other countries with which they are often grouped. Phrases like “BRIC” may therefore be a little misleading if one assumes some homogeneity of behaviour and development outlook. On the positive side, Brilliant states that in the past few decades one billion people have been lifted out “ the global financial crisis of poverty. With another billion-plus people may have changed expected to make this social and economic migration between now and 2030, he believes we some nations’ attitudes can be optimistic about our collective future. “Will to development” these [emerging] countries work with us in tangible ways in supporting innovation, promoting environmental collaboration and fostering stronger health care?” Brilliant asks. Among a number of possible obstacles, he points out that the global financial crisis may have changed some nations’ attitudes to development. “Will these countries adopt a market-based approach to their economies, or will they implement approaches that undermine the principles of national treatment, level playing field and open markets?” he asks. There are views now that a hybrid state-backed mercantilism is a sturdier economic model for development and Brilliant comments: “This argument will play itself out in the 2030 scenario much as those capitalistsocialist models contended in the second half of the 20th century.”

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Brilliant also explains the changes around traditional balances of power that will lead to new uncertainties; “The period in which the US and Europe account for 50 per cent of world trade is passing,” he says. “A new and far more multi-polar world of trade powers and regional hubs is emerging. Managing this concert of commercial powers will be every bit as challenging as balancing military and security relationships in the 19th century.”

Key points • “Convergence” theory – a fashionable term since the fall of Communism – expects poorer countries to “catch up” with richer ones. • It is not equal across all developing countries, either in a secular or a cyclical sense • Developing countries are now not certain to adopt market-based approaches to their economies, especially post-crash • Investment in the developing world will overtake high income countries by 2020 • The world’s future will be multipolar and interdependent • The doubling of the world’s middle classes has huge demographic and resource implications • Developing countries’ higher savings rates means they are fast becoming major investors in the world economy • Developed nations are now in a two-speed recovery • International equity markets are seeing continuing convergence, but bond markets are volatile • One author labels this new economy the “Old Normal”, recalling the multipolar world of the 18th and 19th centuries, with the division between investments yielding safer low returns and speculative higher-return assets Optimism in some quarters Stephane Garelli, Professor at IMD in Switzerland, in a recent article for City AM newspaper, points out the amazing changes the last quarter century has ushered in. “The last 25 years saw a historic shift from a divided world to a global one,” he says. “Communism collapsed and states representing nearly half the world’s population turned to free market principles. But while the world economy became more open, countries remained diverse”. Today Garelli points out, there are more than 1,000 companies in emerging economies with revenues above $1 billion, adding: “This massive shift in industrial activities was initially driven by lower labour costs. And while emerging economies exported, richer countries faced deindustrialisation and rising structural unemployment. In the last 20 years, the US, Britain and Japan have each lost about 20 per cent of their industry in terms of its share of GDP.” 56

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Kermal Dervis, Vice President and Director of Global Economy and Development at the Brookings Institution, in a paper called ‘World Economy: Convergence, Interdependence and Divergence’, explores the trends around convergence. A key question is whether this new convergence is likely to continue, he says, thereby leading to a fundamental restructuring of the world economy over the next decade or so. As well as remarking on the two well-covered trends of globalisation and demographic change, Dervis points out the significance of changing investment behaviour by emerging market nations. “A third significant cause of convergence is the higher proportion of income invested by emerging and developing countries – 27 per cent of GDP over the past decade compared with 20.5 per cent in advanced economies,” he says. This, he expects, will facilitate a transition from low-productivity sectors such as agriculture to high-productivity sectors such as manufacturing, which should accelerate “catch-up growth”.

“ developing economies are fast becoming major investors in the world economy and by 2030 will account for more than 60 cents of every dollar invested”

Changing capital markets A recent World Bank report, ‘Capital for the Future: Saving and investment in an interdependent world’, found that developing economies are fast becoming major investors in the world economy and by 2030 will account for more than 60 cents of every dollar invested. The report explains that this represents a fundamental shift with respect to historical performance: for four decades (through the 1990s), developing countries had been accounting for just about 20 cents for every dollar of global saving and investment.

The report states that total investment in the developing world is expected to overtake that in high income countries before 2020. Developing countries will – for the first time in history – become major sources, destinations and potentially also intermediaries of global gross capital flows. Future trends in investment, saving and capital flows will affect economic conditions from the household level to the global macroeconomic level, the report says, with implications not only for national governments but also for international institutions and policy coordination. The report also issues a warning about the consequences of an absence of policy support, continuing: “Without timely efforts, some countries will be left behind. And, more importantly, even within otherwise successful countries, some people will be left behind. Policy makers preparing for this change will thus benefit from a better understanding of the unfolding dynamics of global capital and wealth in the future.”

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Interdependency and income disparities Dervis points out a couple of catches in the path to “convergence”. One is interdependency, and another is income distribution imbalance. The global growth declines in early 2012, which were due much more to macroeconomic and financial sector management issues than to long-term supply-side factors, “vividly reflect this worldwide interdependence”. I am optimistic about the world economy in the long run, in significant part because the factors driving global convergence still exist. Communications and transportation costs continue to decline, global trade barriers lessen, and most developing nations see the benefits of learning from the advanced economies, as China and others have. Further, governance structures around the world are improving both at the level of governments and of corporations, which also spurs further growth in financial and other markets, aiding economic efficiency in multiple ways. Global policymakers must do all they can to encourage these trends, because we will all benefit, even though it may be scary to see other countries catching up with us. Trade liberalization must be pushed forward, as will hopefully occur with the Trans-Pacific Partnership between the U.S. and Asia. We also need to give developing countries a greater weight in our global institutions such as the International Monetary Fund. Nations are more likely to help advance our common interests if they share in the governance and the gains from global cooperation. No one wants to play by rules that someone else sets and can change arbitrarily. Public Policy Viewpoint by Douglas Elliott, Brookings Institution “The world of the future will be ever more multipolar and interdependent, with global markets offering the potential for rapid economic progress,” Dervis concludes. “Whether this potential can be realised may depend largely on how well international cooperation improves both the effectiveness of national macroeconomic policies, by taking into account their spill-over effects, and how much it encourages greater balance and equity in the distribution of the fruits of growth.” Clearly not everyone believes the pace of convergence will be the same across different areas over time and, in ’Investing in a Debt-Fuelled World’, Amin Rajan offers some explanations as to why that could be. In one theme, a Catch-22 will characterise the dynamics of deleveraging as, in Europe, the main thrust for governments will be led by cuts. The fundamentals of the US economy, by contrast, look good due to a pick-up in the housing market. And whilst after 2008 the emerging markets lifted the global economy, after the steep downturn, Rajan points out, “the locomotive role has fallen on to the US”. So we are certainly seeing a two-speed recovery process in the developed nations, with Europe remaining caught in the vicious cycle triggered by both austerity and reforms. Economic growth in the fast lane, however, will also remain below historic averages as, after long periods of economic growth, countries such as China, Taiwan and South Korea are maturing into developed economies.

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Governance issues On the broader theme of the extent to which globalisation is actually happening, various interpretations are being given. In ’The Globalisation Paradox’, for instance, Professor Dani Rodrik makes a strong argument that globalisation has gone too far. One example he highlights is the classic “trilemma” behind the euro crisis. The European project, led by a political elite from the start, has found that people actually do not feel themselves to be part of their broader regional identity, instead seeing themselves first as citizens of their own nation, next as members of their local community and last as global citizens. The quote used in this context is that “The Achilles’ heel of global governance is a lack of clear accountability in relationships”. Overall, Rodrik sees a challenging debate ahead for the global economy, with high debt, low growth rates and contentious domestic politics across much of the developed world on the one hand and, on the other, emerging economies currently in no position to try to fill the gap. In an annual report produced by UBS, called ’Investing in 2013’, the bank dwells on different outlooks for future trends. Key considerations highlighted by the report include the interconnectedness of many of these long-term trends, and that high-growth countries with a favourable long-term demographic, such as India, are likely to increase their share of global GDP. Rapid GDP growth in emerging markets can offset stagnating GDP elsewhere – for example, Chinese growth increased demand for industrial metals, while population growth and rising prosperity in emerging markets continues to boost demand for foods and fertilizers. These long-term trends are significant for both the future for economies, and investments within them; however, they are not without their complications, as is illustrated by a number of other recent reports. Disparities in the developed world In ‘A Transforming World’ (May 2013), Merrill Lynch argues “dynamic forces are sweeping across the globe”, which are changing our lives and creating a wave of opportunities but also problems. Merrill Lynch looks at a number of the “megatrends” that are affecting us, including the increasingly global nature of investing. It observes that, during the financial crisis and its aftermath, US investments were buoyed by a global view of the US as a relative safe haven, especially as the European debt crisis unfolded. As a result, US equities tended to outperform, but, as shifts in global markets accelerate, Merrill Lynch argues it makes sense to consider a more global point of view, adding geographical diversity to portfolios by investing in markets that are favourably priced at the moment.

“ By 2030 the number of people worldwide defined as middle class is likely to double to 2 billion”

The report points to some of the profound long-term transformations occurring in the world today, involving demographics and shifting alignments of global power. It cites, as do others, the emerging middle class; according to some forecasts, the majority of the world’s population will have risen out of poverty in less than 20 years. By 2030, the report notes, even by conservative

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estimates the number of people worldwide defined as middle class is likely to double to 2 billion. This is one of the largest demographic waves ever actually witnessed. Even so, the trend of ageing populations means that, by 2030, the median age in wealthy countries that belong to the OECD is likely to jump to nearly 43 years old, up from 38 in 2010. The median age has already eclipsed 45 in Japan, and Germany. In the US, where the demographic swell of the ageing baby boomer generation could be fiscally destabilising, the median age is 37 and by 2030, 20 per cent of the US population will be over the age of 65. Impact of China’s transformation China’s ageing population has prompted public discussion of an end to its one child policy. One impact of this, and various other trends, will be how to address concerns about resource sustainability. A number of papers have discussed the issues surrounding the need for water; not least whether there will be sufficient supplies to support the growth in livestock as people’s diets become increasingly protein-orientated. In the West, meanwhile, government austerity and central bank policy is arguably distorting what growth there might actually end up being. The transforming world Merrill Lynch describes means we have to look at our investments and portfolios differently from in the past. The case for convergence in international bond markets is less convincing, not least for eurozone sovereign debt following the crisis. Elsewhere, an announcement in July 2013 by the Hong Kong Monetary Authority may be significant in the evolution of the offshore renminbi bond market. The People’s Bank of China has now underwritten liquidity, meaning the alignment of pricing between China’s onshore and offshore bond markets may close. This may prove the tipping point for the internationalisation of the renminbi. It’s not just economies that are converging but regulatory policy as well. Once the domain of the national regulator, regulation is increasingly driven at a trans-national level. If you want to check out the regulatory transformation agenda you go to the G20 website; bank capital, stress testing, shadow banking policy and much more are all determined at G20. For implementation, have a look at the EU Commission, since this is where the pan-European Directives and Regulations are drafted to implement the G20 policy. Lastly, delivery (and little else) is entrusted to the domestic regulator - German’s BaFIN, the French AMF, the British FCA – who implement and supervise the broader EU policy. Even this is under threat with the creation of the three EU super-regulators to cover banking, insurance and investment business. A legal and regulatory perspective by Simon Morris, Partner, Cameron McKenna Re-convergence or divergence in international equity markets There are papers now exploring the convergences between international stock markets, as well as economies. At the International Journal of Financial Research, ‘What is the degree of convergence in developed equity markets?’ investigates the sensitivity of international equity market returns, using MSCI indices as widely tracked global equity benchmarks of stock exchanges traded throughout the world.

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The results show that all analysed developed equity markets are moving towards greater integration in terms of increasing correlation. They are also interdependent and affected by globalisation processes, showing strong and lasting relationships between each other. However, bilateral convergence of international equity markets is not an equal process where different clusters of markets are engaged in different manners. In a parallel report by the Czech National Bank in February 2013, which examines the relationship between the Russian and Chinese stock markets, the authors conclude: “Overall, we find evidence for gradually increasing convergence of stock market returns after the 1997 Asian financial crisis and the 1998 Russian financial crisis. Following a major disruption caused by the global financial crisis, the process of stock market return convergence resumes between Russia and China, as well as with world markets.” The report adds: “We also find that the process of stock market return convergence and the impact of the recent crisis have not been uniform at the sectorial level, suggesting the potential for diversification of risk across sectors.” In a 2012 report from academics at the University of Piraeus and Nevada, the authors found convergence at a country level for stock prices – but then at a price volatility rather than stock price level. “While traditional portfolio management strategies usually follow a top-down procedure, assuming that country-level effects drive financial aggregates (e.g., stock returns), our empirical results suggest that the equity markets of 33 of the 42 counties in our sample do form a unified convergence club,” the report concludes. “The empirical findings, however, also show more numerous stock-price convergence clubs in certain industries. That is, country factors play a more important role in the actual convergence in real stock “ the volatility of stock prices explaining prices than industry factors. Conversely, the volatility of stock prices exhibits much more exhibits much more evidence of convergence than stock prices. evidence of convergence These findings should assist portfolio managers in the design and implementation of than stock prices” appropriate portfolio management strategies.” The future is the past The last word on economic – rather than market – convergence should on merit go to Adam Posen of the Peterson Institute for International Economics. In a paper called ‘The Global Economy is now distinctly Victorian’ published in August 2003 by the FT, Posen points out that the world now has high real economic volatility despite relative price stability. “This state of affairs is in fact a return to the Old Normal of the late nineteenth century,” he observes. “It is a world we can understand, even if we do not like it.” In a brief trawl through history, Posen reminds us there have been long periods, such as at the end of the 1800s, where multiple reserve currencies co-existed. He reflects on the uncertainty of a multipolar world in which no-one has sufficient authority to protect intellectual property rights. “Remember,” he says, “that Germany and the United States reverse-engineered British innovations in the Victorian age.” Acknowledging the quite sharp division between investments

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yielding safer low returns and speculative higher-return assets, Posen views large state-backed national infrastructure projects as being similar to nineteenth century development, adding: “The Old Normal is thus a tale of the global economy returning to unfettered markets in many ways.” And, as unpalatable as some of the process might be, Posen thinks it is likely to last. Global convergence: Aberdeen position As a predominantly bottom-up investment manager, Aberdeen’s investment style is termed as “fundamental” and we examine portfolios from the stock level upwards. As a consequence, the way we analyse equities, for example, is by using traditional valuation measures based on the financials of the companies we analyse, their historic records and a comparison against other similar industries. Convergence has, however, driven the sorts of companies we believe will succeed as a result of themes such as a growing middle class and the success of well-established industries that will help power the economies of Latin America, India and increasingly China. For direct investment in many developing countries, however, as shareholders we need to feel assured that companies treat minority shareholders fairly – in a way that would be considered as standard in many countries of the West. There are political risks associated with many developing countries, and governance risks which would be considered generally unusual in the West. Our views here are similar for credit in companies, with a focus again on whether pricing is fair value relative to what we believe is the reasonable price of a bond over its duration. In terms of our view as investors in sovereign debt, as fundamental investors we again have to recognise that the world has changed, and that the US and UK economies are engaging, as with the eurozone, in a form of financial repression that is delivering near-zero or even negative interest rates. This means we look beyond our traditional competencies in finding alpha across the fixed income suite, but are devoting more energy to value-added returns where pricing anomalies and volatility can be captured to our investors’ advantage. At a corporate level, our belief in the world markets of the future is evidenced by the location of many of our international offices in overseas regions such as South East Asia. Strong communication and teamwork across continents underscores our understanding that interdependency will identify both pricing anomalies and value opportunities for the global investor.

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Sources The World in 2030: Are we on the path to convergence or divergence? Myron Brilliant (May 27, 2013) http://gt2030.com/201205/27/the-world-in-2030-are-we-on-the-path-to-convergence-ordivergence/ Office of the Director of National Intelligence: Global Trends, 2030, Alternative Worlds (December 2012) http://www.dni.gov/files/documents/GlobalTrends_2030.pdf Convergence, Interdependence, and Divergence, Kemal Dervis, Brookings Institution, IMF (September 2012) http://www.imf.org/external/pubs/ft/fandd/2012/09/dervis.htm What is the Degree of Convergence among Developed Equity Markets, Ekaterina Dorodnykh, International Journal of Financial Research (April 2012) http://www.sciedu.ca/journal/index.php/ijfr/article/view/971 A World of Convergence: Kemal Dervis, Brookings Institute, Project Syndicate (April 23, 2012) http://www.project-syndicate.org/commentary/a-world-of-convergence World Bank: Capital for the Future: Saving and Investment in an Interdependent World (May 2013) http://siteresources.worldbank.org/EXTDECPROSPECTS/Resources/476882-1368197310537/ CapitalForTheFuture.pdf WTO: The Future of Trade: The Challenges of Convergence http://www.wto.org/english/thewto_e/dg_e/dft_panel_e/future_of_trade_report_e.pdf City AM article, Stephane Garelli, (May 13, 2013) http://www.cityam.com/the-forum?page=5 The Globalization Paradox: why global markets, states, and democracy can’t coexist, Professor Dani Rodrik (March 2011) http://ukcatalogue.oup.com/product/9780199603336.do “A Transforming World”, Merrill Lynch (2013) http://wealthmanagement.ml.com/publish/content/application/pdf/GWMOL/AR9D50CFMLWM.pdf

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“Investing in 2013”, UBS (November 2012) http://bit.ly/1cKmcZj Convergence of Returns on Chinese and Russian Stock Markets with World Markets: National and Sectoral Perspectives (February 2013) http://ner.sagepub.com/content/223/1/R16.abstract Country and Industry Convergence of Equity Markets: International Evidence from Club Convergence and Clustering (July 2012) http://faculty.unlv.edu/smiller/CONVERGENCE_STOCK_MARKETS.pdf The Global Economy Is Now Distinctly Victorian, Adam S. Posen, Peterson Institute for International Economics (August 6, 2013) http://www.piie.com/publications/opeds/oped.cfm?ResearchID=2450

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Outcomes and Solutions

The expression ‘solutions’ has become so overused that the industry at last is taking a different determination of refining its intended meaning. It means, in the main, ‘outcomes’ and an investment approach focused more on risk and absolute returns. Low yields, volatile markets, extreme events and pressing demographics are all driving attention towards solutions-based investments.

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McKinsey & Company‘s 2013 report ‘Outcomes Are The New Alpha’ declares that more than 80 per cent of asset managers now place “solutions” among their top three growth priorities. The average firm interviewed by McKinsey for the survey is expecting its solutions business to deliver more than a quarter of its flows, and one-sixth of revenues, by 2015. Skill challenges for asset managers There are a number of obstacles which are making it difficult for asset managers to adopt solutions at the centre of their business, the first of which – and McKinsey spots it – is those firms “stuck in legacy resource allocation decisions”. Unlike previous generations, McKinsey points out that those now retiring are heading en masse for target dates without significant DB pensions to support them. They also explain that asset management firms under-invest in understanding client needs, particularly in the retail sector, and in packaging those needs in a way that resonates with consumers and their advisers. They harshly explain there are hundreds of failed ”me-too products”, a myriad of “solutions” in search of an ill-defined problem, and many great products that fail to be understood. As a result, not all asset managers will manage to make the jump into offering solutions as part of their skill-set ‘package’. Holistic solutions will often now require firms to manage not just assets, but also the risk from generating income, preserving capital and managing volatility and longevity, and it is these challenges, back at the product level, that are seen to affect the asset management groups today. US management consultancy Casey Quirk believes that in the institutional market: “Investment consultants serving US institutional investors increasingly favour managers that focus on outcomes, not just products.” Beyond McKinsey, UBS’s ‘Evolution of the Asset Manager’ report from October 2012 is centred on investor outcomes, but observes that “investors have shorter time horizons and they are taking a shift towards specific solutions, and around that orientation is the type of products that investors want to buy”. UBS concludes that, in adapting to a tougher environment, there will be new types of product with new measures of success. The primary goal of some multi-asset income strategies, for example, is not to beat a benchmark per se, “but to meet clients’ expectations about the total risk and return they experience”. They explain that investor psychology demands that asset managers acknowledge the potential short-term market moves without losing sight of long-term investment goals and investment perspectives, particularly when markets are stressed.

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This, along with investors taking a more global perspective and other changing dynamics, is putting new pressures on asset managers to try to understand centres of excellence in their own organisations. The internal talent and skills are different too. Risk managers, for example, can help a manager selection team improve its performance by evaluating the underlying drivers of risk, and asset allocators can help underlying equity bond and manager selection teams by having a view of the broad market environment.

“ new pressures on asset managers to try to understand centres of excellence in their own organisations”

UBS concludes that the investment environment has undoubtedly become harsher since the balmy days of the late 1990s, and that asset managers need to help their clients set realistic goals, work harder and be more innovative with their investments. This type of challenge chimes with the CREATE report, ‘Investing in a Debt-Fuelled World’. CREATE talks about “solutions alpha” in the report summary, and explores the increasing personalisation of risk for defined contribution members. Personalisation of risk Meanwhile, as traditional pension fund defined benefit schemes close, there will be an increasing move towards “solutions”, particularly in the area of LDI or out-risking to help resolve the liability pensions problems that are affecting DB schemes. Personalisation of risk, however, is ushering in new essential craft skills around the areas of life-styling, orientation of target risk and target date funds. This type of innovation around products is likely to continue, but the ability of asset managers – or at least traditional ones – to respond to it may be challenged. CREATE points to the innovations taking some of the best features of DB plans over into DC plans. A quote from one of their interviews is: “In the last decade, target date funds have taken off in America, holding over $400 billion of assets currently. This – and the switch from asset accumulation to income generation – will characterise the pension markets of the coming decade.” The main problems that are leading to solutionorientation as a business approach are low yields, volatile markets, longevity of funds (particularly pension funds that are under pressure) and the need to be able to find asset returns in an environment where even sovereign risk is actually risky. So, opportunities to succeed will lean on those asset managers who are able to develop more flexible and dynamic asset allocation in their models. This challenges traditional balanced managers who had a concept that the results of a 60/40 bonds/equity allocation would look after themselves. Nowadays risk needs to be targeted in a far more calculating way, and requires “dynamic asset allocation”, an acquired skill that can look at all dimensions of the asset universe. This is a brave new world for asset managers, and not all are comfortable with it.

“ Nowadays risk needs to be targeted in a far more calculating way”

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Need to change for DC schemes BNY Mellon and Cass Business School in a white paper called ‘Outcome oriented investing for retirement – from the DC scheme member’s perspective’ explore the need for life-styling to move away from mechanical asset allocation. They believe that there is a solutions deficit that has not yet entirely been resolved. Traditional DC life-styling approaches are producing, in their view, “ever-lower eventual pensions as a result”. Their paper examines a “dynamic” investment strategy that is outcome-driven, targeting the generation of an income in retirement that will offer a minimum acceptable replacement ratio, relative to the income earned during employment. This strategy, in their view, recognises investors’ attitudes to risk, and takes a flexible approach to the decumulation phase, which is particularly relevant in markets and countries dealing with an ageing population. They believe that a more dynamic investment and annuitisation strategy can deal with the lack of certainty in other areas. Investing in real assets After 2008, the increasing demand for protection, in particular against extreme events, has resulted in the development of new instruments for hedging, within which the liquidity has also improved. This desire to develop new hedging instruments, which within itself can carry costs, is being responded to by other asset managers trying to see that hedging could be a solution to innate volatility. Fund manager Pioneer Investments say that hedging is not a “free lunch”, because it comes at a cost, and that’s why they say that their hedging strategies are based on a conscious analysis of costs and benefits.

Key points • Extreme events, low yields, volatile markets and low returns are driving forces towards a different sort of investing • Central bank experiments and ultra-low interest rates are leading to a search for yield • “Tail risk” from the global financial crisis is driving investors to find ways to mitigate that threat • 80 per cent of managers now place “solutions” among their top three growth priorities, according to McKinsey • Investors have shorter time horizons • DB schemes are looking for solutions to out-risk and solve liability problems • DC schemes have personalised risk; life-styling needs to move away from mechanical asset allocation

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They explore “real assets” as one way to help diversification. They discuss investing in infrastructure, commodities investments and total hedge fund assets, which they say have surged in the last quarter to $2.2 trillion of assets under management globally. This reflects the response to the negative real rates on core government bonds that are now the “new normal”, to use PIMCO’s phrase. The primary objective of long-term investors needs to be the protection of purchasing power. Pioneer is therefore not surprised that some investors are moving towards real assets as a basis for where they are investing, as opposed to ‘traditional’ allocation into equities and bonds. “Tail risk” is the aspect that reminds people that, actually, there is a danger related to investing overall. It became a hot topic after Nassim Taleb’s ‘Black Swan’ in 2007, and is one which has seen that investors cause the most problems with their holdings, and that the causes of fat-tailed outcomes can be managed in certain ways, all of which have pros and cons. Tail risk exists, but equally, to deny it exists means that you will not avoid the risk. To manage it, one has to enumerate the different possible outcomes. These outcomes may include adopting a lower beta strategy, remaining in the market less than one would have done traditionally, or some form of passive or active hedging policy to try to reduce the volatility that is coming through on an unexpected basis.

“ “Tail risk” is the aspect that reminds people that, actually, there is a danger related to investing overall”

Diversified growth funds Other fund managers are exploring diversified growth funds which look at the risk appetite of investors, and at what pension funds can try to do by managing different types of assets and portfolios. In other words, they set out to manage the active risk, rather than necessarily the market risk. The market risk has been highlighted in many so-called hedge funds, insofar as they actually had more embedded beta than perhaps their investors originally thought. Tail risk remains a problem for many, and banks are coming up with different options strategies as potential ways of reducing that tail risk in portfolios, but as said previously, this comes at a cost. In a paper explaining the use of diversified growth funds by pension funds, authors from ClearPath Analysis explain that these funds do not remove risk, but offer a different type of risk. They say: “it should be stressed that investors do not remove risk when moving from multi-asset to diversified growth to absolute return funds; they simply change the type of risk relied on from market risk to manager/active risk.” They also observe that the fund managers operating in this space are not a homogenous group: “Diversified growth managers differ by investment horizon, derivative usage, fee structures, the allocation to exotic or illiquid assets and the use of active underlying funds and multi-manager structures.”

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Retail investors are also bewildered. They are looking for some level of certainty in their investing, and increasingly education is coming to the fore to try to explain volatile markets and uneven returns to investors. Understanding the history of capital markets encourages a mind-set about ourselves, our goals, the nature and power of capital markets and the limits of human intelligence and skill, according to Stuart Fowler, author of ‘No Monkey Business’. Investment is fundamentally about buying assets whose returns are likely to meet the ultimate consumption needs of the investor, which is poorly measured by the more mechanical return versus market risk metrics that were traditionally used. Public policy should encourage an outcome-oriented approach. One of the key places to do that is in the realm of pensions. Far too much time is still spent by pension trustees focused on alpha and beta, without sufficient regard for the actual goal, which is to ensure that pension promises are met. In particular, pension promises are essentially fixed income liabilities, with an interesting admixture of longevity risk, and investments need to reflect the nature of those promises. The mismanagement of pension risk is keenest in America’s state and local pension funds. A focus solely on expected return, and strong incentives to be overly optimistic about it, helped create very large pension deficits that taxpayers will be called upon to fill in, along with retroactive cuts to promises made to workers. More generally, we also need to take public policy actions to encourage annuitization or other means to ensure that individuals are adequately protected from the risk of outliving their savings. Too much attention remains focused on the accumulation phase and not enough on the decumulation phase. Public Policy Viewpoint by Douglas Elliott, Brookings Institution Fowler explains that, as a narrative, investing has three protagonists: your money; the markets; and the people in between. While relating investment to tasks for your money or personal life goals makes it more relevant, it also helps you keep control of the agenda. He argues that it is important to understand the numbers in the form of probabilities as that is the language that best conveys the risks that you might find yourself exposed to. However, for Fowler, it is also important to explain that you want people to trust themselves more and the industry less. It is through this process that they will get to understand why the solutions we are all striving for may be suitable for ourselves, first and foremost, and not just a solution which is foisted upon us.

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In conclusion Since the global financial crisis in 2008, there has been a growth in demand for strategies and investments that protect against significant negative returns. Meanwhile, yields on what were once considered safe government bonds such as gilts and T-bills have fallen so low that there is no obvious benefit from these once traditional safe havens. With uncertainty introduced through central bank experiments such as quantitative easing, investors are challenging the merits of traditional investing techniques, such as traditional balanced funds for pensions. During 2008, assets showed themselves to be more correlated than historically would be expected, which leads institutional and retail investors alike to seek out ways to meet their investment outcomes, and at the same time limit their risk exposure in the event of a repetition of the crisis. Aberdeen on solutions “I think it is very important to be transparent and upfront about the outcomes of investment rather than the complexity of getting there.” Andrew Laing, Deputy CEO, Aberdeen. “We focus very much on the outcomes we want to deliver, and we find solutions to problems. We don’t want to get caught up in highfalutin language and complex ideas.” Anne Richards, CIO, Aberdeen. There is a strong and growing demand for a range of multi-asset and alternative solutions to meet a wide variety of client needs. Aberdeen is developing our offering in response to the increasing capabilities of our competitors, who have invested heavily in this area in recent years. Our Solutions team has evolved through the combination of different products that have come into the group through a variety of acquisitions. It is now moving to a functional structure organised around key areas of expertise that can be used across the entire solutions portfolio. Our risk management controls are both specific to asset classes and characterised by clients’ own risk appetites, objectives and mandate constraints. While the strength of Aberdeen’s investment decision-making process is predominantly qualitative, we draw on a number of quantitative inputs, particularly when working with hedge funds and multimanager portfolios.

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Sources McKinsey & Co: “The Asset Management Industry: Outcomes Are The New Alpha” http://mminst.org/sites/default/files/Searching_for_Profitable_Growth_in_AM.pdf Casey Quirk, “Sharpening Focus on New Frameworks – 2013 Consultant Search Forecast” (January 2013) http://www.caseyquirk.com/pdf/2013-consultant-search-forecast.pdf “Outcome oriented investing for retirement”, BNY Mellon/Cass Business School http://www.cass.city.ac.uk/__data/assets/pdf_file/0019/106615/Outcome-oriented-investingfor-retirement.pdf Pioneer, “The New Frontier of Diversification: Alternative Investments” (November 2012) http://corporate.pioneerinvestments.com/insights.html Parametric, “Tail Risk Strategies; Options Strategies: An Alternative to Expensive Complex Tactics”, Research Brief (March 2012) https://www.summitas.com/system/files/secure/Parametric%20-%20Tail%20Risk%20 Strategies%20-%202012.pdf ClearPath Analysis, “Investing in diversified growth and multi-asset funds” (Nov 2012) http://www.lgim.com/library/capabilities/Investing-in-Diversified-Growth-and-Multi-AssetFunds-2013.pdf Credit Suisse, “New Normal Investing: Is The (Fat) Tail Wagging Your Portfolio?” (April 2012) https://www.credit-suisse.com/asset_management/downloads/marketing/new_normal_ investing_white_paper_042012.pdf Allianz Global Investors, “Managing Tail Risk” (June 2012) https://larrysiegeldotorg.files.wordpress.com/2013/12/siegel_sexauer_managing-tailrisk_2013_10_07.pdf Stuart Fowler, “No Monkey Business: What investors need to know and why” (2002) http://www.fowlerdrew.co.uk/monkey/wp-content/uploads/introduction-new.pdf

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Risk

Risk is one of those slippery, undefinable and abstract concepts. It means different things to different people – its essence is embedded in the eye of the beholder.

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Some context It can be tempting to dive into such a large and far-reaching subject that touches every aspect of our daily lives such as risk. However, we should first take a step back and consider its history and origins. Because if we consider why and when risk measurement techniques were conceived, we can start to piece together the whole story behind risk and contextualise it. For example, why didn’t the Ancient Greeks attempt to tackle the subject? They had (most of) the tools and intellect but never made the leap. Even as the Hindu-Arabic number system spread throughout the world in the 1200s, it still took another 300 to 400 years. The eventual trigger was the Renaissance and the gradual removal of religious shackles - the shedding of the belief that destiny is mapped out. After all, why would you even think to try and tame and manage risk if you didn’t think you could influence future events? The Renaissance unleashed a sudden curiosity, freedom of thought and a passion for experimentation, which meant that it was only a matter of time before a greater understanding of risk was sought out and achieved. While the initial impetus was provided by Italian thinkers, it was only a matter of time before the French, with their love of maths, got their teeth into the subject. The fertile environment provided by the Renaissance paved the way for Blaise Pascal and Fermat to found decision theory. Pascal took probability theory into new territory by linking it together with decisionmaking under certain conditions. Pascal’s wager is classic insight here. Faced with the decision as to whether to believe in God or not, the rational choice is to live as though God exists. The downside to taking this approach, only to find out he doesn’t, is finite (the sacrifice of some short-term pleasures), whereas the flipside is to face an eternity in hell. To turn to some of the techniques and tools that have been developed over the years, the Gaussian Bell Curve is the cornerstone of probability theory and still sits at the heart of risk management as we now know it (Value at Risk). The German mathmatician Carl Friedrich Gauss, formalised the notion of “normal distributions”. When depicted visually, a sample of data points exhibiting ‘normal’ behaviour will look like a bell curve, with levels of probability (or confidence” as the jargon goes) applied to the likelihood of any given data point sitting within one, two or three standard deviations from the centre.

““Tail risk” is the aspect that reminds people that, actually, there is a danger related to investing overall”

English scientist Francis Galton was another key character in the story. However, while his theory of regression to the mean may have relevance in the natural world where there is a high degree of order, what about in more complex social systems which deal with the vagaries and irregularities of humans? How relevant is the concept if the mean isn’t constant and floats around?

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Aberdeen’s position on risk Risk is inherent to all that we do and what matters most is that we are prepared for it, do our best to turn it to our advantage and act knowingly on the risks we are able to assess. At Aberdeen, our approach to investment risk is to manage it mindfully at every stage of our investment process. Aberdeen is predominantly an active, fundamental, bottom up investor so our attitude to risk starts at the granular level of each individual stock. So risk assessment starts at the stock level by doing our own research and analysis and thereafter the risk management process continues throughout the whole portfolio selection and construction, operationally and then on an ongoing evaluation basis. We value teams at Aberdeen rather than individual fund managers as this helps us mitigate risk. Teams allow us to challenge the decisions being made by team members which helps to reduce subjective biases and potential mistakes in our assessment of the risks and possible returns in our choices. For us every investment decision made, regardless of asset classes, needs to consider risk as a rational part of the portfolio strategy and to weigh up the commensurate rewards. While volatility is the generally accepted definition of risk (Markowitz, Portfolio Selection, 1952), it is just a measure of temporary loss of capital (day-to-day share price undulations) rather than the far more important risks relating to permanent loss of capital e.g. bankruptcy. Tracking error constraints reflect fear of short-term volatility combined with a lack of appreciation of the power of compounding. Short-term volatility should consequently be viewed as the cost of good long-term performance rather than as a risk to be avoided. Net of fees, funds with low tracking error are almost certain to underperform. Understanding this entails understanding the information ratio, which measures outputs (fund performance, volatility) rather than inputs (holdings). The problem with the information ratio is that it will only ever say ‘buy this fund because it performed well before’. Volatility is not, therefore, a good measure of risk: it measures the normal ups and downs of share prices (temporary loss/gain of capital) not important risk associated with permanent loss of capital relating perhaps to bankruptcy or the gradual deterioration of a company’s business. Furthermore, high excess return that produced a high information ratio may be due not to skill but to luck, and thus not repeatable. Aberdeen’s approach to public equity investment is similar to that of a private equity manager: we consider each investment as if we were buying the entire company and making a long-term commitment to it. Over the long term, share prices reflect underlying business fundamentals; our time horizon is aligned with those of the companies in which we invest, not with market ‘noise’. We firmly believe that higher levels of concentration reflect strong conviction, and that risk is investing in a poor quality company and/ or overpaying, and is not related to share price volatility. Taking risk is an unavoidable dimension when generating returns – so every portfolio decision in a particular asset class needs to be evaluated and considered through the joint lens of the return opportunity for the risk taken. Our performance therefore in our fixed income portfolios is as much about avoiding losses as picking winners; we invest to seek attractive returns relative to the possibility of loss. Conventional wisdom about investment risk is changing however. Returns from bonds and equities are now widely expected to be below their historical averages and so looking at risk returns relative to benchmarks and peers is a conventional view that is being challenged. In an absolute return framework, for example, success is measured by the absolute level of return on an investment over a period of time. This contrasts with a traditional relative return framework where success is measured by performance relative to a benchmark. In a world with no risk-free rate, our risk concerns in our solutions business are about building a portfolio of different risks (not too many eggs in one basket), rather than thinking low and high risk relative to a guaranteed negative return.

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Risk is uncertainty And so armed with a little of the background, we can return to the nature of risk itself. Risk, ultimately, is about the future, and the inherent uncertainty built in to what lies ahead. In that sense, it cannot be about the past - unless of course you believe the past can predict the future. However, over the last few centuries we have devised methods that exploit numbers to analyse what happened in the past. How useful they are is contentious. It really boils down to the level of belief you have in the past’s ability to inform the future. John Maynard Keynes thought of risk in two parts: probability and uncertainty. The former is most useful in predictable and closed environments (like cards). Extrapolating from the past can help inform the probability of future events; however, it can only go so far. Uncertainty cannot be eliminated as the limits to our knowledge and understanding are huge. Gut and intuition play an important role in making up the deficit. Which poses the question as to whether the management of risk is best judged as an art rather than a science. An over-reliance on probability was akin to making the problem too easy in Keynes’ mind. With this in mind, measuring risk is therefore fraught with danger. Scientific proxies like volatility and standard deviation metrics are helpful, but they are just that, proxies, and should not be confused with the elimination of uncertainty. Unfortunately, in times of stability they all too often are. Risk models, whether economic or portfolio, are still obsessed with neat and elegant maths which assume ‘normal distributions’. Nassim Nicholas Taleb has arguably been the most eloquent at articulating the pitfalls of the Gaussian approach to risk modeling through his Black Swan analogy. However, providing a solution has proved far more difficult than merely identifying the problem. The financial world is not an easy model because it is constantly in flux, going through both cyclical and structural changes. This dynamism occurs because it is constructed and driven by humans. Yet the maths behind our understanding of it is, for the most part, both backwardlooking and static. The key word in the last paragraph was ‘dynamism’. It is dynamism that causes all the problems because it means that risk is ‘normal’ until it isn’t. Hyman Minsky understood this point. He reminded us that stability breeds instability and that the calm times encourage complacency which eventually leads to trouble. The financial crisis provided a more dramatic, practical reminder - with excessive and irresponsible leverage being the symptom of complacency. And so how can you deal with a dynamically shifting landscape? The weather system, and approaches to understanding it, would be an obvious starting point but its helpfulness is limited as we run into the natural versus social system problem again. Because we are fundamental players in the latter, complex interplay and feedback loops mean that obtaining any true understanding is like hitting a moving target. Perhaps the sheer scale of the task helps explain why no revolutionary changes have been made, and thought patterns when it comes to risk, at least to the outside world, seem remarkably similar to those that pre-dated the crisis.

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The great statistician Maurice Kendall once wrote, “Humanity did not take control of society out of the realm of Divine Providence to put it at the mercy of the laws of chance.” In the meantime though, it is unfair to be overly critical as encouraging progress is being made in certain areas. For example, Didier Sornette (a scientist specialising in dynamic systems in nature who has turned his attention to finance) is pioneering new techniques for analysing and interpreting data in order to identify bubble-like characteristics in areas of economics of finance. Sornette believes, and has much empirical evidence and predictive success to back up his claims, that the properties which pre-empt bubbles and crises can be detected before they boil over - leverage in the REIT market being the most emphatic example. More often than not, the signal does show itself - the challenge becomes identifying it in amongst all the noise, as well as gauging the systemic importance of the market in question. However, it is possible to monitor signals intelligently, and thus if applied either to policy or portfolio management, risks can be better managed. Those looking for greater detail on Sornette and his work should refer to the Financial Crisis Observatory he has set up, his 2003 book “Why stock markets crash” (notably written before the financial crisis) and a TED Talk in which he explains his “Dragon King” concept. The lesson of Sornette is important because it leads us into the realm of big data. Regardless of your perspective, making sense of the infinite reams of data that pass through our consciousness every day is becoming a major challenge. One approach to dealing with this problem is, to some degree, to ignore it and to focus on what you believe to be really important. However, as data visualisation techniques improve, contextualising and sorting large swathes of data should become far easier. Andy Haldane, Chief Economist and the Executive Director of Monetary Analysis and Statistics at the Bank of England, believes that the former is the best approach. And yet using the two together may be complimentary. The intelligent bit is knowing what to look for, but if data can be processed and presented in simple and relatable ways, decision makers should be able to cope with more information and, in turn, make better decisions. Much needs to be done on the data visualisation front, but it is certainly something to keep an eager eye on. Other attempts to solve the problem that uncertainty serves up would likely come from academia, where grappling with the ‘mathmatics of surprise’ would be a logical challenge. Whether or not the man-made tool is up to the task is another question altogether. Portfolio risk So far we have talked of risk in very broad and conceptual terms as we try to offer insight into its meaning. However, this is as good a point as any to introduce the myriad of different types of risk that affect portfolio returns. While it is impossible to capture them all here, these are the core types that permeate the world of investment: credit risk, liquidity risk, market risk, compliance risk, regulatory risk, political risk, legal risk, catastrophic risk and reputational risk. Making the distinction between more introspective portfolio risk and broader risks that affect the financial and economic system is important because, while they are inextricably linked, what really matters to a client is whether or not their investment portfolio performs as expected (as a minimum) and allows them to enjoy the benefits that those expected returns offer to their lives. aberdeen-asset.com

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Much of the investment industry is unhealthily wedded to the concept of benchmarks. They do serve a purpose in terms of measurement of performance (relative to peers or a pre-determined index). However, more often than not clients are more interested in absolute outcomes as opposed to some relative measure. Furthermore, the existence of benchmarks encourages fund managers to hedge their career risk by herding to the consensus – as Keynes said (General Theory - 1936, pp. 157-158) “wordly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally”. But perverse incentives aside, the evolution of the investment industry has occurred with the efficient market hypothesis at its core. Intellectual giants such as Eugene Fama and Harry Markowitz put forward the notion that equities are always correctly priced because every market participant has all relevant and available information at their fingertips. This is plain wrong – yet that didn’t stop others building out the concept further. William Sharpe developed the Capital Asset Pricing Model and the Sharpe ratio which is a measurement device for risk-adjusted returns (but relies on a benchmark as a reference point). Fischer Black, Myron Scholes and Robert Merton applied the theory to the derivatives market – the famous Black-Scholes equation. Interestingly, as is so often the case, the great minds who create mathematically complex and sophisticated tools know full well their limitations – it is the lesser minds that follow, trailing behind, who fail to grasp the fallacies and plough on ahead as if the outputs are gospel. Emmanuel Derman, previous Head of Quantitative Strategies at Goldman Sachs, uses Fischer Black as a way of highlighting this point. “In one short essay he struck at the foundation of financial economics, stating that “certain economic quantities are so hard to estimate that I call them ‘unobservables’” one unobservable that he pointed out is ‘expected return’, the amount by which people expect to profit when buying a security. So much of finance, from Markowitz on, deals with this quantity unquestionably. Yet, wrote Fischer, “Our estimates of expected return are so poor they are almost laughable.” Risk, as every schoolchild knows, is an etymological chameleon. To the investment manager it drives growth and its absence flags stagnation. To the investor it signals the possibility of gain and also of loss. But to the regulator it’s something quite different – a phenomenon to be measured, managed and mitigated. Regulators worldwide are increasingly insisting that risk is at the top of each investment firm’s agenda and a core senior management focus. The thrust is systems and controls, and investment firms are reinforcing their risk management structures and scrutinising positions and transactions to ensure they all fall within their risk appetite. So investors need risk to drive growth, asset managers seek to harness it and regulators clamour for its calibration and control. The new virtuous circle for the investment world – and one where the skill lies keeping each stakeholder happy. Legal viewpoint by Simon Morris, CMS Cameron McKenna LLP

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It is no surprise that since the 2007/08 financial crisis these models, based on assumptions divorced from reality, have come under increasing scrutiny. A renewed hunger to build more accurate representations of the financial world has surfaced. And while there is still a way to go, the construction of more useful portfolios for clients is encouraging. The deviation away from traditionally ‘balanced’ equity and bonds, and the use of more niche areas of both aforementioned asset classes, as well as the use of more alternative assets such as property, infrastructure private equity and hedge funds, has undoubtedly resulted in more effective riskadjusted returns for clients as the benefits of holding uncorrelated assets has kicked in. We should, however, remain mindful that the benefits of diversification do tend to fade in times of stress – as correlations converge.

“In one short essay he struck at the foundation of financial economics, stating that “certain economic quantities are so hard to estimate that I call them ‘unobservables’”. One unobservable that he pointed out is ‘expected return’, the amount by which people expect to profit when buying a security. So much of finance, from Markowitz on, deals with this quantity unquestionably. Yet, wrote Fischer, “Our estimates of expected return are so poor they are almost laughable”.

Conclusion Risk is a subject that is always going to maintain an air of mystery. It’s unlikely elusive tendencies will ever be fully conquered. However, by thinking more intelligently about it and by accepting our cognitive limitations when trying to tame it, we can make progress by making better policy decisions at the macroeconomic level and better investment decisions at the portfolio level. And so, as we wait for the academics and industry professionals to invent the ‘mathematics of surprise’, we must adopt a practical and thoughtful approach to dealing with risk.

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Regulators view risk differently than investors do. They acknowledge that risk-taking is necessary for economic growth and for the returns that investors need, but they focus much more on the downside. Their big fear is that risks will blow up and harm the “real economy”. Fundamentally, they view the finance and investment sector as a black box that helps produce economic growth, but can cause recessions and unemployment when it goes wrong. In light of the global financial crisis that spawned the Great Recession, it’s not surprising that regulators are much more focused on tamping down risk than on the potential to stymie economic growth by discouraging innovation and initiative. It’s even less surprising if we remember that regulators receive almost no reward for helping the economy do better, but they are blamed heavily when markets blow up. It has become evident to almost everyone in the financial sector that the pendulum of regulation has swung too far and is making it too difficult to take risks. Underlying market liquidity, for example, is being sharply curtailed by limits on risk taking at banks and bank affiliates and by much higher capital and liquidity requirements for those key players. Banks and their affiliates are keeping much smaller inventories of securities and face strong cost pressures to widen their bid/ask spreads. This change has mostly been masked by the massive liquidity central banks have poured into the markets, but when we return to real life there will be significant economic costs from the new requirements. Do NOT, however, expect regulators to start easing up. Their asymmetrical personal risk/ reward structure will keep them adding layers of regulation for another couple of years. These will only slowly wear away as the costs to economic efficiency become more evident and the memories of the global financial crisis fade. Public Policy Viewpoint by Douglas Elliott, Brookings Institution

Key points • Risk boils down to the level of belief you have in the past’s ability to inform the future • While volatility is the generally accepted definition of risk, it is just a measure of temporary loss of capital (day-to-day share price undulations) rather than the far more important risks relating to permanent loss of capital • Much of the investment industry is unhealthily wedded to the concept of benchmarks but more often than not clients are more interested in absolute outcomes as opposed to some relative measure • Hyman Minsky reminded us that stability breeds instability and the calm times encourage complacency which eventually leads to trouble • More often than not, the risk signal does show itself - the challenge becomes identifying it in amongst all the noise, as well as gauging the systemic importance of the market in question • The deviation away from traditionally ‘balanced’ equity and bonds, and the use of more niche areas of both aforementioned asset classes, has undoubtedly resulted in more effective risk-adjusted returns for clients • At Aberdeen, every investment decision made, regardless of asset classes, needs to consider risk as a rational part of the portfolio strategy and to weigh up the commensurate rewards

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Sources: Peter L. Bernstein, “Against the Gods: The Remarkable Story of Risk” (September 1998) Robert Skidelsky, “Keynes: The Return of the Master” (September 2010) John Maynard Keynes, “The General Theory of Employment, Interest And Money” (December 2013) Didier Sornette, “Why Stock Markets Crash: Critical Events in Complex Financial Systems” (2004) Emmanuel Derman, “My Life as a Quant: Reflections on Physics and Finance” (2007)

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Page index A

Active management..............................................................................43 Allianz Global Investors........................................................................72 AMF...........................................................................................................60 Aspen Institute.......................................................................................14 Authers, John...................................................................................44, 52

B

BaFIN........................................................................................................60 Bank of America Merrill Lynch............................................................47 Barclays....................................................................................................41 Barclays Equity Gilt Study............................................................44, 52 Barnett, Thomas.....................................................................................55 Barra..........................................................................................................37 Barrow, Dubrow.....................................................................................10 BBC News.................................................................................................. 7 Behavioural finance........................................................................32, 36 Belsky, Gary.............................................................................................41 Black,Fischer, Scholes, Myron and Merton, Robert.......................78 Black-Scholes equation........................................................................78 Black Swan Theory.................................................................................76 Blue and Green.......................................................................................12 BNY Mellon......................................................................................68, 72 Bogle, John................................................................................................ 5 Bono, Edward D....................................................................................7, 8 Boston Consulting Group......................................................23, 44, 52 Brilliant, Myron...............................................................................55, 63 Brookings Institution............................................................................57 Browne, Christopher H..................................................................37, 41 BT Pension Fund....................................................................................... 7 Business Week........................................................................................10

C

Dervis, Kermal..........................................................................57, 58, 61 Dimensional Fund Advisors.................................................................34 Dimson, Elroy.........................................................................................52 Dimson, Marsh and Staunton.............................................................52 Diversified growth.................................................................................69 Dorodnykh, Ekaterina...........................................................................63 Dr Ramo...................................................................................................37 Dragon King theory...............................................................................77 Dunbar, Nicholas...................................................................................33 Dundee Corporation......................................................................39, 42

E Economist, The.......................................................................................55 EFAMA......................................................................................................25 Efficient market theory........................................................................37 Elliott, Douglas...............................................9, 18, 26, 34, 48, 58, 79 Ellis, Charles D..........................................................................37, 38, 41 ETFs...........................................................................................................50 EU Policy..................................................................................................60 Europe Arab Bank...........................................................................34, 41 European Commission.........................................................................17 Evolution of the fund manager..........................................................66

F

FCA,.............................................................................................23, 39, 41 Fama, Eugene...................................................................................40, 78 Fermat, Pierre de ...................................................................................74 Financial Analysts, New York Society of............................................ 5 Fischer Black...........................................................................................78 Fowler, Stuart........................................................................................ 72 FSA.............................................................................................................. 8 FT ...............................................................................................12, 44, 61

Capital asset pricing model..............................26, 33, 39, 40, 47, 78 Casey Quirk......................................................................................49, 52 Cass Business School............................................................................68 CFA.....................................................................................................46, 52 Cheng, Peng............................................................................................34 China...........................................................................................55, 58, 60 Churchilll, Winston.................................................................................. 7 CIA............................................................................................................... 6 CityAM.....................................................................................................63 Clarendon Lectures in Economics.....................................................41 ClearPath Analysis..........................................................................69, 72 Columbia Business School...................................................................37 Cornick, Roger........................................................................................11 Coronation Fund Management..........................................................47 Cox, Sir George.......................................................................................15 CREATE-Research.............................................................43, 45, 52, 67 Credit Suisse.............................................................................49, 52, 72 Cremers, Professor Martyn.................................................................46 Czech National Bank............................................................................61

G

D

Haldane, Andy............................................................................ 9, 10, 77 Harvard Business School...............................................................27, 28 Heskett, James.......................................................................................27 Hong Kong Monetary Authority........................................................60

Davies, Greg B........................................................................................41 DB schemes.............................................................................................68 DC schemes............................................................................................68 Decision theory......................................................................................74 Derman, Emmanuel..............................................................................77

82

Galton, Francis.......................................................................................74 Garelli, Stephane...................................................................................56 Gaussian Bell Curve...............................................................................74 Gauss, Carl Friedrich.............................................................................74 General Theory.......................................................................................78 Gilbert, Martin........................................................................................11 Gilovich, Thomas...................................................................................41 Global convergence..............................................................................54 Global Trends 2030...............................................................................55 Globalisation paradox..........................................................................59 GMO.........................................................................................................10 Goltermann, John............................................................................. 6, 12 Goodman, Ned........................................................................39, 40, 42 Graham, Benjamin........................................................................... 5, 38 Great rotation........................................................................................47 Greenfield, Kent.....................................................................................14 Greenspan, Alan.....................................................................................27

H

Global themes in asset management: our little rough guide

I

IMA.....................................................................................................17, 23 India..........................................................................................................55 INSEAD.............................................................................................46, 52 International Journal of Financial Research..............................60, 63 Investing in a debt-fuelled world.......................................................58 Jobs, Steve...............................................................................................10

J

JP Morgan................................................................................................14

K

Kahneman, David..................................................................................35 Kaplan, Professor Steven.....................................................................16 Kay, Professor John.........................................................................15, 17 Keynes, John Maynard..........................................................................76 Kendall, Maurice ...................................................................................77 King, Sir David........................................................................................21 KPMG.......................................................................................................... 5

L

Laing, Andrew ........................................................................................71 Lansons....................................................................................................25 London Business School.......................................................................52 Long Term Capital Management.......................................................33 Long-Termism.........................................................................................13 Loss aversion...........................................................................................33 Lowenstein, Roger.................................................................................33 Lund, Andrew CW..................................................................................15

M

Madoff, Bernie........................................................................................35 Mandelbrot, Benoit................................................................................. 5 Markowitz, Harry...................................................................................78 Maudlin, John..........................................................................................38 McKinsey..............................................................49, 50, 52, 66, 68, 72 Merkel, David..........................................................................................35 Merrill Lynch Wealth Management.....................................52, 59, 63 Merton-Markowitz................................................................................10 Minton, Bernadette...............................................................................16 Minsky, Hyman......................................................................................76 Mischel, Walter......................................................................................17 Modern portfolio theory.................................................26, 33, 34, 42 Modligiani-Miller...................................................................................33 Montier, James.........................................................................10, 38, 41 Morris, Simon............................................................... 7, 16, 28, 36, 78

N

Nassim, Taleb..........................................................................................69 National Intelligence Council......................................................55, 61 Nerkel, David..........................................................................................42 New Economics Foundation........................................................35, 41 Nozick, Robert................................................................................... 6, 12 Nusseibeh, Saker...................................................................................... 7

O

Obama, President..................................................................................23 Outcomes................................................................................................65

P

Parametric...............................................................................................72 Pascal, Blaise...................................................................................... 7, 18 People’s Bank of China.........................................................................60 Peterson Institute for International Economics.............................63 Pioneer Investments.............................................................................72

Polsky, Gregg D......................................................................................15 Posen, Adam....................................................................................61, 64 Pouget, Sebastian..................................................................................15 Probability theory..................................................................................74

Q R

Rajan, Professor Amin...........................................................................43 Real assets...............................................................................................69 Robinson, Michael .................................................................................. 7 Rodewald, Mark.....................................................................................12 Rodrik, Professor Dani...................................................................59, 63 Russell, Bertrand...................................................................................... 7

S

Saatchi, Maurice...................................................................................... 7 Saft, James.......................................................................................... 6, 12 Sarbanes-Oxley......................................................................................27 Scholes, Myron.......................................................................................78 Sharf, Joshua...........................................................................................33 Sharpe’s model, Sharpe, William................................................33, 47 Sharpe ratio............................................................................................ 78 Shleifer, Andrei.......................................................................................41 Simplicity................................................................................................... 4 Solutions..................................................................................................65 Sopory, Kapil...........................................................................................27 Sornette, Didier ..............................................................................76, 77 Squires, Jan..............................................................................................12 Studer, Quint..........................................................................................27

T

Tail risk...............................................................................................69, 72 Taleb, Nicholas.......................................................................................76 Thaler, Richard.................................................................................36, 41 The Loser’s Game............................................................................37, 41 Transparency...........................................................................................22 Totaram, Kirshni..............................................................................47, 52

U

UBS ..............................................................................48, 52, 64, 66, 72 UBS Asset Management......................................................................26 University of Columbia.........................................................................12 University of Piraeus and Nevada.....................................................61 US Center for Association Leadership..............................................23 US Chamber of Commerce.................................................................55

V

Value at risk.............................................................................................33 Vincent, Scott..................................................................................46, 52

W

Wall Street Journal.........................................................................25, 52 Walter , I...........................................................................................46, 52 Warren Buffett................................................................................26, 35 Why stock markets crash................................................................... 77 Wikipedia.................................................................................................23 World Bank.......................................................................................57, 63 Wright, William......................................................................................12 WTO.........................................................................................................63

Y

Young, Hugh....................................................................................29, 40

Z

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Global themes in asset management, second edition, May 2015

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