Investment professionals fail to utilise new asset management research, Edhec says

Date: Monday, March 3, 2008
Author: Hedgeweek.com

Investment professionals are often familiar with the latest research findings and asset management techniques but rarely use them, according to the Edhec European Investment Practices Survey, carried out by the French business school with backing from Newedge, the newly-established joint venture bringing together the brokerage businesses of the Crédit Agricole and Société Générale groups.

The in-depth study of the risk management, portfolio construction, strategic allocation and performance measurement practices of European asset managers and investors was carried out last year by the Edhec Risk and Asset Management Research Centre.

Edhec surveyed 229 institutional investors and asset managers that were largely representative of the European asset management industry in terms of nationality and volume of assets under management. The respondents had a total of more than EUR10trn in assets under management and almost 50 managed more than EUR100bn each).

Edhec says failure to take advantage of research advances results in inefficiencies that have an impact on investment performance and risk management. The study identifies four key areas of the investment process where there are wide gaps between state-of-the-art research and industry practices.

The authors say risk management and portfolio construction have improved since an earlier Edhec survey in 2002, but not sufficiently. Although a majority of managers take the core-satellite approach to asset management, many neglect the fundamentals of this approach and fail to take full advantage of the opportunities it provides for improved management of absolute and relative risk.

For example, 23 per cent of survey respondents believe actively managed funds in traditional asset classes belong to the core element of the strategy, a belief that results in inefficiency in terms of tracking error management, searches for managers, and overall management costs.

In addition, new risk management techniques such as portable alpha (used by 21 per cent of survey respondents) and completeness portfolios (used by 9 per cent), the use of which is facilitated by the core-satellite approach, have been taken up by very few European asset managers.

However, Edhec cites as progress the fact that the majority of respondents no longer consider volatility alone to be representative of investment risk; instead, they use value at risk and conditional value at risk as indicators for portfolio risk management.

The lessons from the post-2000 crises and the growth of absolute performance offerings have allowed the asset management industry to appropriate concepts hitherto used exclusively by investment banks, the report says, but this progress has its limits. When they calculate VaR or CVaR, more than 42 per cent of survey respondents assume the normality of returns, an assumption that the authors say makes their calculations neither relevant nor realistic.

In addition, the report says, traditional indices and benchmarks remain predominant, despite their flaws. Since 2000, index providers have offered new forms of indices in response to criticism of the lack of efficiency and stability of style- and sector-based biases, and above all of the momentum of capitalisation-weighted indices, which are considered problematic by virtually a majority of European asset managers and investors.

However, this criticism has not yet had an effect on the choice of benchmark. Assets indexed to major capitalisation-weighted indices account for more than 75 per cent of all assets managed by survey respondents.

This predominance has not prevented the emergence of alternative forms such as equally-weighted indices or fundamentals-based indices, which are used by nearly 20 per cent of respondents. However, these alternatives are not set to take over as the new benchmarks for index-based management in the short term.

Indeed, a majority of respondents believe fundamental indices are representative of value-type active strategies and are thus not neutral benchmarks or vehicles for long-term allocation. Ultimately, only 35 per cent of respondents believe these new indices are preferable to traditional capitalisation-weighted indices.

According to the authors of the report, the greatest surprise to emerge from the study is that more than 42 per cent of the European institutional investors surveyed do not explicitly take their liabilities into account when drawing up their asset allocation strategies.

Where investors do manage assets and liabilities, they favour simple solutions such as cash-flow matching or liability-driven investment, which now account for nearly half of the asset-liability management approaches used. A very small number (19 per cent) examine extreme shortfall risk measures, with the majority limiting themselves to average risk indicators.

Performance measurement is still the stumbling block in the dialogue between investors and asset managers. The Sharpe ratio (used by 80 per cent of respondents) and information ratio (used by 70 per cent) are still the most frequently used gauges of performance. This popularity rests on a conceptual framework that has been tried and tested but that has several drawbacks, in particular in measuring the real added value of active management.

Although managers now fairly often use measures of extreme risk to construct their portfolios, these measures are used much less frequently when reporting on performance and on the risks borne by funds or mandates. Fewer than 30 per cent of survey respondents use VaR-based measures to evaluate risk-adjusted performance.

The relative performance of a portfolio is still often measured (33 per cent) by comparing returns to a market index, although research has long since established that this is not the best way to make allowances for the risks taken by the investor and to measure the value added by investment management. Likewise, while 70 per cent of respondents use the information ratio, only 7 per cent take into account the risks of downside tracking error that underlie the calculation of this ratio.

Finally, the industry as a whole speaks of alpha, but very few professionals measure it correctly. More than 62 per cent of respondents look at performance in peer groups, easily the most popular method of measuring alpha, far ahead of methods involving multi-factor models that are widely backed by financial research but used by only 23 per cent of respondents.

Edhec says it aims to draw the attention of regulators and professionals to the findings of this study, believing that, as things currently stand, practices in the European asset management industry have failed to keep up with the research advances of the past 20 years.

It argues that failure concerns both professionals and researchers, who do not put the transfer of knowledge to the industry - viewed more often as a source of corporate patronage than as a testing ground - at the heart of their work and of their objectives.

Edhec Business School, founded in 1906, has 4,700 students, of whom more than 25 per cent are from abroad, at its three campuses in Lille, Nice, and Paris, and 100 full-time faculty. Its Risk and Asset Management Research Centre, which has 35 staff, aims to produce asset management and alternative investment research and facilitate its corporate use, including six industry-sponsored programmes focusing on asset allocation and risk management in traditional and alternative investment.