Inversion therapy:
the investor as benchmark

The pension and funds management industry needs to redefine performance to an absolute return measure, according to The Influential Investor: How Investor Behaviour is Redefining Performance, a paper that is the result of 12 months of research with more than 3000 investors and investment providers across 68 countries.

The report, which sought to uncover the forces that will shape the investment management industry over the next decade, found that while relative performance based on peer groups or indices may serve the provider, the investor’s view of value is more complex and reflects their own personal blend of alpha seeking, beta generation, downside protection, as well as liability and income management.

“In the future, the investor will be the benchmark,” says Suzanne Duncan, global head of research at State Street Centre for Applied Research and co-author of the report.

The Influential Investor states that performance is the most highly rated factor by investors but it is simultaneously the number-one weakness when rating managers.

“Our research finds that the value proposition must evolve to one that defines performance as personal, a new definition of performance in absolute returns,” Duncan says, “but we are yet to see an academic framework that defines performance as personal.”

Personal, in three parts

State Street has developed a framework for this new definition that is made up of three components:

• an alpha-seeking component, which will only be paid for if it is reached;
• income management, which will be different for each investor and requires the income stream to be managed and protected in the context of the aims; and
• liability management, which Duncan says has begun with liability-driven investing but hasn’t gone far enough.

“Investors need to understand current and future cash flows and manage to that,” she says.

The State Street research shows that investors are too busy looking at what their peers are doing and not defining performance as personal to what their own needs are.

“There is so much pressure, so investors are looking at what their peers are doing, but they need to look at their own needs and the needs of their beneficiaries, and manage that. It is an exciting period because there is awareness of the issues and the need for outcome-oriented investing and there can be experimentation around that.”

Industry direction

The impact of this shift will be massive, the industry will need a keen understanding of the role of local intelligence in decision-making systems, the report says.

It will need to streamline the delivery model at both industry and organisational levels to eliminate complexity and bring strategic priorities in line with what investors want most: personal performance.

And it will need to define a formula for sustainable returns to account for investors’ unique performance goals, to align fees with value delivered and to be fully transparent so the investor can appreciate that value.

“Under the new definition of performance, the investor is the benchmark,” she says. “This will have a profound change and impact. The system itself is in the way. There is too much of everything – funds, service providers, fees – the delivery model will be rationalised.

“Everyone has to agree with what we mean by success; there are different expected outcomes by different participants. If there is a precise definition of what performance means then there is a level of commitment. Investors need to measure success on their own income and balance sheet, not some other.”

The research also identified that the investment management industry is very different to other industries in the number of layers and level of participants or players.

“There are too many levels of decision-making in the governance structure. We looked at the added value across each layer, and there is not enough value to have that level of intermediation,” she says.

 How retail and institutional investors behave

Behind these headline findings, State Street examined the behaviour of retail and institutional investors, concluding that investors are not acting in their own best interests.

For example, while retail investors say they will invest more aggressively, they are moving more towards conservatism that is demonstrated by a 30-per-cent average allocation to cash.

Similarly, institutional investors are not acting in their own best interests and are becoming more aggressive due to what they see as artificially high expectations.

For institutional investors, the ultimate allocation in terms of growth is alternatives, but they also cite that their greatest risk is their inability to deal with the risks of these assets.

“There is a divergence of goals by institutional investors: they are looking at alternatives and they also believe they’re not prepared to handle the risks associated with their actions,” Duncan says. “There is nothing wrong with alternatives or risk per se. But there is herding and convergence into alternatives, and they believe that they’re taking on risks and there is a knowledge gap in that. There is not the evidence they have the governance structure or investment knowledge.”

She says investors are also becoming increasingly aware of the system’s instability.

“There is a very low level of trust in markets and in regulators.”

To access the full report, click The Influential Investor.