December 13, 2013

The role of Core Asset Managers in the Global Economy

By Yves Choueifaty, 300 Club

The asset management industry exerts unprecedented influence on the global economy. With global investable assets expected to increase to more than $100trn by 20201 (six times total US GDP in 2013), and the need to find scapegoats in the wake of the 2008 financial crisis, it is important to consider the role and responsibilities of core asset managers in the global economy.

One of the most fundamental purposes of the industry is to invest savings back into the economy in a way that maximises the scale of reward investors can achieve for a given level of risk and drives future economic growth and stability. It is this purpose that ‘core’ asset managers, who represent the bulk of investors’ portfolios in order to deliver returns in line with their long-term strategic asset allocation, need to remain resolutely focused on.

What really drives wealth generation?

At its heart, the job of core asset managers within the overall wealth creation process is about reinvesting savings into the economy to create wealth for investors through growth and development. Importantly, the real source of wealth is not the “skills” of portfolio managers, but the “skills” of employees working in the companies in which savings are invested. Labour, in other words. It is labour that, through innovation, productivity gains and corporate governance, for example, create wealth for the investor. This is especially true in the case of equity holdings.

The fundamental role of core asset managers is to act as a link between savings and labour and ensure the risks savers are taking are rewarded as well as possible. To achieve this as purely as possible, it is critical to immunise investors’ core portfolios against any kind of speculation.

Immunity from speculation

Whenever any investor builds a core allocation to any asset class, it is done out of the belief that risk will be rewarded by a risk premium. This risk premium can be defined as the return generated by the undiversifiable portfolio.

Core asset managers are access providers to that risk premium, without which a core allocation to any asset class is not justified, regardless of the manager’s potential skill. This involves building portfolios that are as protected as possible from any hypothetic phenomena (speculative bets), focusing purely on the existence of a future risk premium.

Importantly, the existence of a risk premium in the equity markets assumes solely that free enterprise and capitalism will survive, but does not involve making any bets on a specific bias, security or factor.

The word speculation comes from the Latin “speculare” (to see). A speculator assumes he or she has the capacity to see forward. In investment terms, it is someone who has a view on the future and implements a portfolio based on this view. This manager would be exploiting mispricings in the financial economy or markets by forecasting which factors are cheap and will rise, and which are expensive and will fall. This manager is therefore offering some degree of hypothetical added value through their potential ability to forecast, resulting in a biased portfolio.

Imagine there are two gold mines. A speculator will only buy one of them “speculating” on the fact that the other would soon be exhausted. A core investor, however, would evenly allocate risk to both mines, believing the likelihood of exhaustion is taken into account in the prices of both mines. This second approach provides access to the true equity risk premium, rather than trying to take advantage of mispricings.

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