The End of the 'Belle Epoque' For Money Management - Or Just the Beginning?

Core business lines will feature products with less performance risk, such as ETFs, lifecycle funds, and product structures…Conversely, higher-alpha products with incentive fees will be more lucrative, but risky, given their reliance on key talent and sustainable performance—lightning in the proverbial bottle. Fund managers will experiment with several business models to retain the necessary talent, including partial ownership and multiaffiliate structures.

- Putnam Lovell, “After the Belle Époque: The Future of Fund Management”

In this comprehensive report (free with registration) on the future of global money management, Putnam Lovell refers to the past 25 years as a “Belle Epoque”, when the industry was “blessed with a childhood built on government subsidies” (pension legislation etc.). Now, says the firm, the industry is set to experience “turbulent markets, onerous client demands, fierce competition and shifting sources of revenue.” Furthermore, they say, ”Demographic trends and relentless innovation have combined to create powerful forces that are revolutionizing the marketplace.”

But contrary to the report’s contention that the Belle Epoque is over, we say it has just begun.

Students of history will know that “Belle Epoque” (“Beautiful Era”) refers to a period in Western Europe beginning in the mid to late 19th century and ending with World War I. While it’s true that the Belle Epoque was marked by advancements in standards of living and wealth, it was first and foremost an era of rapid technological, political, artistic and scientific advancement (witness Pasteur, Freud, Nietzsche, Faraday, Darwin). In fact, it is often called “The Second Industrial Revolution”.

If Putnam Lovell is right, the next few decades will see unprecedented innovation and progress in the global money management business. Much of this progress will be built on one simple and common “technological” advancement – the separation of alpha and beta. Thus, the Belle Epoque has just begun.

Like the growing ubiquity of municipal electricity in the latter half of the 19th century, the spread of alpha-centric strategies will have widespread implications. As we often argue on these pages, the demarcation between “hedge fund” and “long-only” industries will fade away. The resulting paradox will be a growth in alpha-centric strategies and a potential decline in the pure-play hedge fund sector.

Says Putnam Lovell:

Alternative investments already have entered the mainstream, and will account for 51% of the industry’s revenue by 2012. Non-correlated alpha continues to remain the primary destination of reallocated assets from giant, if shrinking, DB plans…Significant future growth will come from products such as long-short vehicles, all-capitalization funds and concentrated portfolios.

Not only can long-only managers more easily improvise such extension strategies, but also these disciplines are more digestible for institutional investors souring on higher-fee, opaque, and often index-tracking hedge funds. Extension products also anticipate the converging market of traditional and alternative investments.

Plentiful sources of cheap beta will continually challenge the proliferation of hedge funds. At least 2,000 hedge funds and funds of hedge funds, roughly 20% of the current total, will wither away by 2012, especially as shrinking levels of liquidity expose their true value to investors.

But equally as important as “non-correlated alpha” is “cheap market-matching exposure”. Continues the report:

Continued acceptance of the portable-alpha portfolio construction model will reshape the beta end of the industry, with exchange-traded funds maintaining their breakneck growth rates from professional buyers seeking cheap market-matching exposure.

Strangely, this “breakneck growth” isn’t expected to increase the overall percentage of assets investors allocate to passive strategies. But alternatives (including extension strategies) are expected to increase their share by 2.5x over the next 5 years – increasing their share of revenues to over 50%. (as illustrated below in a chart from the report).

While the topic of fees may sounds like an operational one on the surface, manager compensation is a critical dimension of alpha-centric investing. The report had a lot to say on the issue:

Performance-based fees will become more prevalent, fundamentally altering the cash flow dynamic of the global fund industry.

As institutional investors allocate more money to hedge funds and private-equity vehicles, they appear to have become more comfortable with the idea that performance-based fees should form at least part of a manager’s compensation. Cheaper exchange-traded funds and derivatives have convinced many investors that they should only pay for true alpha, and a growing number feel they can encourage such absolute returns by allowing managers to keep a portion of them. Even more conservative professional buyers are warming to the idea of fulcrum schedules: with these, annual fees are still calculated as a percentage of managed assets, but the fee ratio rises as performance exceeds an agreed benchmark.

The rising proportion of performance-based fees will be one of the most powerful long-term catalysts reshaping a fund management industry.

But acceptance of innovative fee structures seems to differ across countries. According to the chart below, Canadian pensions seem particularly averse to non-traditional compensation arrangements.

This report is a must-read for anyone still in need of convincing that the investment management industry is about to undergo a radical change. Putnam Lovell’s prediction is that “renaissance” money managers will prevail clearly shows that - contrary to the title of this report - we are only now entering a “Beautiful Era” in global investment management.

These firms—sometimes labeled “modern” or “converged” or “renaissance,” depending on which jargon to which one wants to subscribe—will rank among the most successful asset managers within a decade…”