Compensation and Reward in the Financial Services Industry is aligned with the old model. Roland Rousseau believes that these need to change in order to allow the model to adapt to the changing times and technologies.
This discussion is sponsored by Absa, a member of Barclays. David Williams is with Roland Rousseau, who’s Head of Barclays Risk Strategy Group at the Absa Investment Conference. Roland, you’ve got a panel discussion today that you’re chairing and it’s a short topic that you’ve got to deal with – ‘Active is Dead?’ Is it?
Well, let me start with something Winston Churchill said many years ago. He said, “Everyone tries to do their best but that’s not good enough. What we need to do is what’s required.” So what is happening in the investment industry is we’re all trying to find the best fund manager. We’re all trying to beat a benchmark. We’re all trying to chase past performance but that’s not what’s required. That’s doing your best, so what is required is actually somebody who can manage client’s risk, rather than chasing higher returns to beat a benchmark. The industry is going through a major rethink as to the value proposition of how you should invest, so the concept of Alpha is a technical description of what is skill. Is skill beating a benchmark because I can show you many examples of how I can beat a benchmark without skill? A very quick example would be if you came to me and said, “Here’s a benchmark of 50 percent equities and 50 percent bonds, please outperform that.”
I will go and put 65 percent in equities and the rest in bonds, and I’d play golf for three years because I know that equities, over time, beat bonds but that’s a higher risk than the benchmarks. So I’m generating not through skill because I’m playing golf every day, and excess return I’m just generating excess return by taking more equity risk. This is how most skill is badly measured, is people say he’s at the top of the ranking he must be good, but you don’t always want the person who generates the best return. You want somebody who actually is consistently delivering a proper risk adjusted return, which is the correct definition of skill. It’s not ‘did I beat a benchmark’. It’s not ‘did I win an award’? So the approach now is to say ‘can we lower costs for clients’ absolutely. ‘Can we lower risk’ yes we can because all the evidence shows this.
‘Can we all outperform’ no because it’s a zero sum game, so for every winner there has to be a loser, and if you listen to Charles Ellis, who’s presenting at the moment, he’ll tell you that it’s actually a losers game, chasing Alpha, because when you introduce costs – there are more losers than winners. His view is very much that Alpha is better.
If this is the case, is the industry resisting this? Are they catching up? What’s happening?
Okay, a very good question. The trend is that we have in any industry, the music industry, the publishing industry all of these industries have been majorly disrupted and some people have not survived that disruption, or some companies have not survived that disruption because they were sort of resilient in sticking to what they’ve always done. Those are the ones who are going to have to be very careful because if they’re going to sell this so-called Alpha or the skill, when we are going to uncover that that’s just excess risk, and not specifically skill. Then they’re going to have a problem, so we probably, like in any other industry, are going to see some major new entrants, who are going to disrupt the existing incumbents, so it’s again this whole robo-advice space.
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Is the Uber coming to the investment management industry? The Uber is not going to sell past performance. Uber is not going to say I won an award. Uber is going to say ‘I will show you that I can lower your risk for you’ because all the scientific evidence shows that it’s easy to lower risk. If you take the top 40 shares on the stock market, 20 percent sits in Naspers. That’s not a very, well diversified portfolio, so I can just equally weight the shares, and I get lower risk, right. So it’s easy to lower risk but nobody is doing it because we pay people to outperform. We want somebody to beat everybody else, but what’s happening is they’re taking on additional risk that’s unnecessary, so let’s remove the unnecessary risk, and those are the winners in the industry.
What have you done in your business to change this?
One of the things that is new to South Africa, not just us but several banks are working on, is what can we provide to help people manage risk better? The way to do that is to, first of all break down this concept of risk, because what is it? Some people say its volatility. Some people say it’s something else, so academic research has shown us that we can breakdown risk into risk factors. There’s political risk. There’s economic risk. There are all those kinds of risks but if I can just take equities for example, we’re even breaking down equity risk. There is something called value risk.
Warren Buffett is a value investor but value investing is risky but it’s a good risk, so there are good risks and bad risks in the market. You want to take value risk but you could be wrong for long. That’s why it’s risky, so for the last five years value investing hasn’t worked. Ninety percent of fund managers have underperformed the market in the last five years because they’re all doing the same thing.
Isn’t the point of value investing you’ve got to take a longer horizon?
Correct, but the thing is your clients are not wanting in this day and age to sit for five years, or even longer, waiting for that very short period of sharp out performance, and then long periods of underperformance again, because that’s what happens with value. It’s a very cyclical payoff. Can we build a portfolio that doesn’t just have value in it and yes, you can by having a Momentum index, so indexation. The move to indexation is actually to access risks. It’s not about passive. It’s not about giving up on active. It’s about empowering somebody who is active to choose which risks they want and when, because at the moment you’re stuck with your fund manager, who is a value manager for all eternity, and you’re going to have very uncomfortable nights of sleep for very long periods of time. Can we build more diversified portfolios and portfolios that can adapt to changing market conditions more quickly, absolutely?
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Yes. You mentioned award, people go for the behaviour that is rewarded.
Correct.
Whether it’s your peers or your employer or the industry itself, what is rewarded will happen, so isn’t it time to change the rewards?
Absolutely, so the topic of the debate today is ‘Is Alpha Dead?’ and I would say the way we are incentivising people is dead. Not the need for skill. We need skill but the skill is not to beat a benchmark and win an award. The definition is, for example, imagine we paid fund managers to lower risk because actually that’s what clients want. They don’t want you to beat the market with excess risk by buying and putting all your money in resource companies, which have done exceptionally well now, and you’ve beaten the market. But you actually want that kind of return in your portfolio because it’s incredibly risky, so if we just change the way we pay professional investors to lower risk the whole industry will be turned on its head because they don’t know how to do that at this point, so we need a whole new way of thinking. That’s where the disruption is going to come in.
Who’s going to come to market and say ‘I can lower your risk please reward me on that basis’, so it’s nothing wrong with awards. It’s the awards are chasing something that is not in the client’s best interest necessarily.
How long is it going to take because it sounds to me like whatever people feel about it now, this is the way it’s got to go?
This is nothing new internationally. We are probably ten years behind in South Africa because you have seen. Right now in Europe, there are actually court cases for people to say there’s legal action being taken against active fund managers because they are taking active fees and they’re delivering passive performance. They’re saying ‘pay me a lot of money for me to beat the market or beat my peers’ but they’re not. There’s actually class action lawsuits happening, so you can see that this is not something that is going to happen. It is happening internationally. I don’t think that will happen, necessarily in South Africa, but you can see that people are very dissatisfied with the value proposition that they have received from an investment institution.
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As an outsider it seems also what’s changed, let’s say 30 years, 50 years ago certainly, active meant you had better information. You had better insight. You knew more people. You knew more companies. Now there’s this never-ending flood of very good hard data and information, so everyone has got access to that.
Correct.
Active is there’s much less space for active to be active, if that makes sense.
That’s true, so one of the key disruptions is, like in any other industry the photographic industry has been disrupted by technology but isn’t it ironic that in investment management industry we still do what Benjamin Graham suggested in 1936, the first man to suggest value investing? We still do that, 100 years later, which industry is still doing what they did a 100 years ago? There has to be a major disruption coming and it’s going to be technology. The answer to your question is the activity going to move from humans to machines. Machines can manage and monitor and measure risk much better than humans can because humans are just not suited to take 20 variables at once, in their mind, and understand that is the oil price, the Rand, interest rates, the Fed – all of that in combination. How is that impacting my portfolio? No human can solve that problem but we have the technology.
It’s just that fund managers still sell the romantic notion of a human. It’s like flying in an aeroplane. The pilot has to be there. The pilots do nothing in aeroplanes nowadays. They just sit there in case something goes wrong. That’s what we’re going to see in the investment management industry.
I’ve been speaking to Roland Rousseau, Head of Barclays Risk.
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