MISYS White Paper – Searching for Alpha: Considering Alternatives to Generate Growth
“Difficulties strengthen the mind, as labour does the body.” – Seneca.
Things are not getting any easier for asset managers, the gatekeepers of institutional assets with the power to make or break portfolios. In a new white paper entitled Searching for Alpha: Considering Alternatives to Generate Growth, Misys, one of the industry’s leading financial software companies, highlights three challenges faced by the investment management community, and four ways to potentially overcome them.
Those three challenges, says Misys, include: poor performance from traditional asset classes; more demanding investors who, following the harsh lessons of 2008, are less willing to accept paying high fees for poor performance; and regulatory pressure, in particular the restrictions facing insurance companies under Solvency II.
“Our systems support extensive asset class coverage, and are helping asset managers meet these challenges. Really, the key takeaway of this white paper is that while the market situation for asset management firms is very difficult, there are different ways to adapt and meet these challenges, depending on each company’s expertise,” comments Sylvain Privat (pictured), buy-side product manager, Misys.
Government intervention has seen bonds markets in the western hemisphere drop substantially in 2012. Declining yields in what is set to remain a zero rate world as economies fail to break out into any meaningful recovery make fixed income and equity markets increasingly tough asset classes for institutions to derive income. The Misys white paper alludes to the fact that global equities might face a bear market of another 10 years’ duration, based on historical secular bear markets.
Under Solvency II regulation, insurance companies will need to satisfy the Solvency Capital Requirement (SCR) to demonstrate their ability to withstand systemic shock and protect investors. A 39 per cent capital charge will be placed on equity, and a 25 per cent capital charge on real estate. More worryingly, as the white paper points out, for investors holding hedge funds and other such vehicles in their portfolios, if there is no clear way to assess exposure pertaining to each of Solvency II’s market risk categories they will be classified as “Other Equity” and hit with a 49 per cent capital charge.
This is a big concern that places investment managers under a lot of pressure to provide more effective transparency or else risk losing investors.
On greater investor sophistication, Privat notes that increasingly investors want to see better returns as a result of the higher fees they are paying:
“If investors aren’t getting alpha they won’t want to pay additional fees. That’s why they are starting to focus on passive investments like ETFs. There’s also a rising appetite for systematic products because investors want complete visibility of risk, which these products offer. Investors want to know what are the hidden exposures and how their portfolios will behave during market shocks. They also want a clearer understanding of liquidity risk in the portfolio.”
Four attributes for success
The Misys white paper focuses on four key areas for asset managers to think about if they wish to remain relevant and competitive against a challenging backdrop.
1. Alternative Investments
Thanks to the higher margins that alternative products such as hedge funds, private equity, real and estate and commodities can generate, they are becoming increasingly important to investors chasing yield. For traditional asset managers, they need to think about “internalising some strategies to remain competitive”, says Privat. “We are starting to see clients use our system for alternative asset classes. It gives them the opportunity to diversify away from traditional asset classes and generate non-correlated returns.”
Crucially, it appears some investors are now developing their own alpha strategies and going direct to managers, as opposed to relying on the previous FoHF model. This is good news for asset managers, but again, it’s only those who are willing to adapt, strengthen their operational infrastructures, and have the right systems in place that will succeed.
“Direct investment into alternatives will continue but at the same time investors are becoming more demanding because of regulatory constraints. Insurance companies and pension funds will need stronger due diligence processes and place even more transparency demands on alternative asset managers,” says Privat.
2. Solvency solutions
Misys suggests that successful managers will be best placed to help insurance firms negotiate Solvency II and adapt to the wider shift toward liability-driven investments (LDI). Ultimately, the shake-up in asset allocation means that investment managers must be willing to take a flexible approach by delivering cost-effective solutions to investors, understand the regulatory nuances and provide appropriate levels of transparency. This is what investors will need as they switch from assets towards liabilities, and comply with SCR.
One potential concern for alternative managers is that hedge funds might lose their lustre as alternative investment risk becomes harder for investors to justify under Pillar II of Solvency II. “It is a genuine threat and some managers are already thinking about how to help their clients meet these requirements,” says Privat, agreeing that data transparency and the ability to demonstrate full compliance will put managers in a stronger position.
“It’s also about ensuring they have a good overview of the global picture affecting insurance companies and pension funds. Any investment that generates returns that are uncorrelated to the rest of the portfolio is not a risk, whereas some capital requirements are being asked for correlated assets. Transparency really lies at the heart of this.”
3. Passive offerings and ETFs
ETFs are attractive to investors because of the transparency they offer and the fact that they are relatively low-cost products. They represent one of the major growth areas and Privat says that traditional asset managers are trying to improve their ability to deliver core portfolios based on the usual industry benchmarks by adding risk-taking portfolios using a diverse risk-weighted approach.
“Nowadays, having core strategies that replicate an index for lower fees is becoming a must-have for asset managers.” Combined with alternative products, Private believes the only way for managers to satisfy investor demand “is to consider those asset classes that are growing and which are providing the highest margins”.
Finally, with investors more focused on having customised solutions that meet their risk profile, asset managers should be willing to offer a wider range of options, and that, says Privat, means mastering “the entire spectrum of asset classes from cash instruments through to derivatives”. With new asset classes emerging, such as South American fixed income derivatives, Hong Kong’s growing RMB bond market, and the introduction of centralised clearing for OTC derivatives contracts in 2013, mastering the use of derivatives could become critical for asset managers in order to deliver truly bespoke portfolio solutions.
“Although it will be an operational challenge for asset managers to adapt their systems to cater for centralised clearing, in the long run the OTC market will become similar to the listed futures and options derivatives market, which will mean that liquidity and bid/ask spreads will improve.
“To succeed, asset managers will need to provide investors with transparency, diversification and customisation.”
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