June 2012

Head of the Class:Lifting the Fog

Illustration by Jonathan Bartlett

Equity managers have watched their business shrink for years, as stocks drain from institutions’ strategic allocations. This is not due to any particular strategy but rather is indicative of a general dissatisfaction with equities altogether. “In the U.S., a big reason [for the move away from equities] is that corporate pension plans are de-risking,” says Marko Komarynsky, director of U.S. investment manager research at Towers Watson in Chicago. Value managers have not suffered as much as their colleagues in terms of growth, but when added  up, the erosion in assets and revenues is substantial nonetheless. Hence, some firms that realized poor results in the financial crisis have taken the once unthinkable measure of adopting new investment processes. Top performers, however, have not missed a step.

As a group, U.S. large-cap value managers suffered a significant loss of business. Strategies in the eVestment Alliance universe held assets of $736.5 billion in first quarter 2007 but just $500 billion at year-end 2011, down 32% over five years. The Russell 1000 Value Index lost 14% over the period, accounting for $100 billion of the decrease, and net cash flows away from value strategies came to $119 billion. The migration slowed in 2009 and 2010 but surged back to $20 billion in 2011.

To be fair, U.S. large-cap growth managers fared even worse. Total assets were down 25% between 2007 and 2011, a drop from $530 billion to $396 billion, but a cumulative 12% gain in the Russell 1000 Growth Index masked net asset flows away from managers of 31%­—or $166 billion. U.S. equity strategies of all types, passive included, saw five-year outflows of $570 billion.

Re-examining Risk 

Recent difficult markets have not helped the value managers’ cause. “Institutions are also re-examining their risks and moving away from active management,” says Komarynsky. “In large-cap strategies, it has been tough to justify that managers could generate a reliable source of alpha over time, especially in an environment of lower returns.”

Against the Russell 1000 Value Index, the median large-cap value manager delivered just 1.54% of excess return for three years and 1.88% for five years, both annualized as of December 2011. With separate account fees running at 75 to 100 basis points annually, many managers are barely earning their keep.

A Different Mindset 

For those managers facing performance challenges, the reasoning behind investment processes is under the microscope more than ever. “With stocks hit as hard as they were in 2008, it made us think of market relationships in a different way,” says Komarynsky. “It led managers to look at portfolio construction and risk management more closely and, for some, to invest in new programs or processes for measuring risk.”

It used to be that consistency was desired above all, but after the markets of 2008 blew the lid off many strategies, sponsors and their consultants have begun to evaluate new ideas. “Some managers think they may have been too lax with their colleagues and are taking a harder, devil’s-advocate stance on the other side of decisions,” notes Mark Stahl, senior vice president at institutional investor consultants Callan Associates in San Francisco. “Others realized that large committee structures were getting in the way of making quick decisions and have shifted to a smaller group.”