AIMA

The Alternative Investment Management Association

Alternative Investment Management Association Representing the global hedge fund industry

The Impact and Lessons Learnt for Investment Managers

Garrett O'Neill and Stephen Kennedy

KPMG Ireland

Q1 2008

Since the summer of 2007 the financial services sector has been severely affected by one of the biggest crises ever to hit the sector, the well renowned credit crisis. Thus far banks have predominantly been impacted by the credit crunch and have suffered significant losses. The fund management industry has also felt the dramatic effects of the crisis. This recently published report is based upon a survey of 333 senior executives from across the global fund management community and investigates the challenges presented to fund management firms by the credit crisis and the strategies those firms are implementing in response.

Research has found that there is a widespread feeling that investment firms need to re-evaluate exactly what kind of business they are conducting and ensure that it is in alignment with client interests. The fund management industry now faces the significant challenge of adapting to a radically new business environment post the credit crisis and must focus on risk management processes and governance structures, in addition to the skills gap. The main issues of the research are now explored further.

Diminishing enthusiasm

The fund management industry is becoming more and more complex. This survey of fund management and investment professionals portrays that 57 percent of mainstream fund management firms are using complex derivatives in their portfolios. Furthermore 61 percent of fund managers now manage hedge fund strategies, which are often very complex. Fund managers believe that such strategies will continue to rise in the coming years. However, investors do not have the same enthusiasm for complex instruments. This is underlined by the fact that 70 percent of the investors who responded to the survey outlined that the credit crunch has diminished their desire for complex products.

Reduced trust

60 percent of mainstream fund managers stated that investment returns have fallen and an equivalent proportion noted falling subscriptions as people are beginning to save more and invest in less risky products. However, the impact is potentially more significant than short-term losses in funds, with six out of ten survey respondents outlining that trust in fund managers has been reduced because of the effects of the credit crisis. Fund managers need to prove their worth in the aftermath of this crisis but many of them will need to adapt in the coming months and years if they are to succeed.

Shortage of skills and experience

Certain aspects of fund management require careful consideration. There is evidence, for example, that the skill sets of staff have, to some extent, failed to keep up with increasing sophistication in fund management. 20 percent of fund manager respondents admit to having no in-house specialist with relevant experience of the complex financial instruments they have invested in. In addition, 32 percent of the institutional investors that invest in such instruments stated that they have no in-house expertise for these. Less than half (42 percent) of fund management firms noted that they can quantify completely their exposure to complex instruments. If the fund management industry is to retain the trust of investors, it is imperative for it to both develop the necessary skills and then offer these skills to investors.

Rating agencies are seen as providing little support; only one third of the respondents agree that rating agencies provide an accurate assessment of whether an instrument will default and just 1 percent of respondents think rating agencies are very accurate in predicting defaults.

There needs to be a focus on obtaining experienced personnel from investment banks, especially in derivative operations and risk management, as it is difficult to develop adequate skills in-house. Furthermore, it is expected that the current slowdown may drive a wave of innovation in incentive plan design. We are already seeing some financial institutions shifting their balance of their incentive plans to greater reliance on long-term performance. The issue of symmetry of interests between investors and executives is critical if management and shareholder interests are to be aligned.

KPMG1

Enhanced risk management, valuation methods and governance structures

Improving risk management has come into greater focus as a result of the market turmoil. While many investment management firms have developed sophisticated risk management capabilities, there is still a shortfall across the industry. 38 percent of respondents to the survey stated that their firms have formalised operational risk frameworks in the past two years, due to managing more complex strategies, with another 27 percent planning to do so in the coming two years. Valuation methods have also come under the spotlight and a third of firms say they have reviewed this activity, while an equivalent proportion will do so in the coming two years. However, many of the currently employed risk management measures are backward-looking in nature and lack the ability to take in current data or views about the future. In addition, 38 percent of the survey respondents reported that they have reviewed governance arrangements and a further quarter intend to do so in the next two years. Fund management firms need to re-evaluate the kind of business they are conducting and the risks they are running.

KPMG2
Customer focus

Investor confidence has been greatly affected by the credit crisis and investors’ appetite for risk has decreased as a result. In a time of investor conservatism, fund managers will need to place greater emphasis on how they can add value to their customers. The risk is that investors will reject further change particularly if it involves complex strategies. This is illustrated by the fact that 70 percent of investor respondents to the survey outlined that the credit crunch has decreased their desire for complex products. The fund management industry will need to balance these competing demands; the need for innovation on the one hand and the demand for greater simplicity from their clients on the other. To achieve this they need to pay particular attention to customer demands and will need to develop products and services that perform adequately in changing economic environments. However, it is not just a one way process and investors need to have an adequate understanding of what they are investing in.

Improved transparency is also required for the market to improve and there needs to be a move to simplify and standardise what information is needed to make better investment decisions. Market participants need to work together on this, if this goal is to be achieved. This should help restore investor confidence and attract long-term savings.

Challenges ahead: Potential keys to success

Key Findings
Conclusions
Possible Actions
Returns, assets and demand for complex instruments to fall in the next two years
Firms are likely to concentrate on reviewing the client proposition in the
short term
·         Fund managers will need to re-design their client propositions focusing on what clients want whilst at the same time developing unique selling points in order to stand out from competition
 
·         Business model review
 
Investment managers are worried that the market has lost trust in them
Short and long term damage will require building back trust
·         Enhancing client communications
 
·         Customer centric product development
 
Getting the right skills set and the right risk measures
Inability to fully understand complexity due to lack of internal know-how
·         Recruit from investment banks to gain
know-how
 
Rating agencies have been challenged to keep ratings up with the changes in the market
Fund managers ended up taking more risk than they thought they were taking
·         Review risk and valuation models
 
·         More focus on internal analytics
 
Changes to risk and compliance framework, valuation methods and governance
Firms are significantly enhancing investment risk processes and governance
·         Regulation may emerge to drive change. In some cases self-regulation will be the starting point
 
·         Upgrade of people, processes, governance and incentive plans re-engineered
 

Conclusion

Yet again, we find that investors have suffered losses as a result of over-exuberance. While the fund management sector has not been as badly affected as the banking sector by the credit crisis, the landscape has changed and many investment management firms need to re-position themselves. The industry will continue to grow in the medium term due to the increasing age and affluence in developing countries. Sophisticated instruments have a place in the investment management industry and can help investors better manage and control their risks. These tools and techniques, however, must be well understood before they are employed. There is no justification for a manager investing clients’ assets in securities which, by their own admission, they do not fully understand. The Report has sought to examine some of the challenges that fund management firms currently face and some of the strategies they have adopted or plan to adopt. It remains to be seen how fund management firms translate the lessons of today’s turmoil into better returns and higher assets.


 

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