If you think the last 25 years have been a wild ride, just wait for the next 25. During the past quarter century, investors have moved from clipping coupons from bonds to blink-of-the-eye transactions. U.S. pension funds have gone from bank-run domestic stock and bond portfolios to a dizzying array of mandates. Computers have replaced slide rules, equity markets have gone wild, and money management has expanded into a $19 trillion industry.
Where does it all end?
But it clearly evolves, often down unpredictable paths. "Back in 1988, how many would have projected the Internet revolution? Few if any," said Rob Arnott, managing partner of First Quadrant LP, Pasadena, Calif.
In fact, the Internet is expected to be one of the key drivers of the next 25 years, as investments -- compounded by expected growth in retirement systems around the world -- are increasingly democratized.
While it's impossible to predict the future, there are some clear -- and some not-so-clear -- trends on the horizon.
PENSION FUND STRUCTURE
Pension fund executives may radically overhaul the way they invest assets, creating "smarter" structures targeted to add value. The result: greater levels of passive investment and overall downward pressure on fees.
Instead of focusing on unpredictable market returns, pension executives will shift to controlling risk, some experts say.
"Forget about asset allocation. The future is risk allocation," said Ron Layard-Liesching, partner and director of research at Pareto Partners, London.
Globalization of trade and investment will continue its relentless course, although there may be bumps -- witness Malaysia's recently imposed currency controls, and Russia's defaults on its debts.
Potential ramifications: Pension funds might start investing on a purely global basis, eliminating their home-country biases.
"U.K. pension funds may start asking themselves why they invest more in (U.K. wine and spirits seller) Matthew Clark than in Coca-Cola," said John Gillies, senior consultant with Frank Russell Co., London.
Money managers will travel the road to becoming global powers, although the rise in defined contribution plans might turn money management increasingly into a commodity.
New pension markets, particularly in Europe, offer increased growth prospects.
Access to capital will change as stock and derivatives exchanges around the world continue to form alliances and, ultimately, unite into a single, seamless electronic entity.
There will be "one exchange out there in cyberspace," said Gary P. Brinson, chief executive officer of UBS Brinson, Chicago.
THE INFORMATION AGE
The information revolution may be in its early stages, with radical implications for capital markets; processing of information; and accumulation, distribution and consumption of wealth.
Technology will affect the way firms do business. Money managers, like other businesses, increasingly are using teleconferencing and other tools to make the world smaller, both in running their businesses and communicating with clients.
At the same time, powerful demographic forces will alter the investment landscape.
Retirement savings will surge for perhaps the next dozen years, but when the first wave of baby boomers retire in 2010, the result could be a massive selloff of assets over successive years.
Development of pension and other savings vehicles in Europe and emerging markets will pour money into global markets, possibly pushing stock prices far higher than their already lofty levels.
Pension plans around the world will become more flexible, building in the best elements of defined benefit and defined contribution plans, although some experts predict a shift back toward defined benefit plans.
'NOTHING IS ASSURED'
Despite the growing global financial turmoil, most experts still believe the markets will recover. In the short term, however, worldwide stock prices face a bear market, and some money managers wouldn't rule out the possibility of a global recession.
At any rate, few expect the incredible equity returns of the bull market of the past 15 years to continue. Most observers tend to extrapolate from current trends --always a danger, given that no one can predict technological innovations, world wars or sometimes even secular trends.
"Nothing is assured. Ten years ago everyone wanted to copy the Japanese. Now nobody wants to be near them," said Tom Richards, principal at the consulting firm of Richards & Tierney Inc. in Chicago.
Going forward, experts believe pension executives will have to better manage their funds. Double-digit returns are unlikely to continue, most observers said, although some believe returns will bounce back after a hiatus.
Still, it will not be easy to shift investor expectations. Recent surveys suggest U.S. mutual fund investors expect annual returns of 20% to 30%, while institutional investors anticipate annual returns of 8% to 10%.
Twenty-five years ago, institutional investors thought a 5% annual real return was overly ambitious, said First Quadrant's Mr. Arnott. "Now, it's the opposite: A 5% real return is viewed as conservative. So we have this seesaw going on for the past 25 years."
For the next 25 years, there will be growing awareness of pension costs and the need to provide added value, he said.
Pension fund trustees have focused most on the area they can manage least -- the selection of money managers, said Roger Urwin, head of Watson Wyatt Worldwide's global investment practice, Reigate, England.
Each trustee board makes its decision on what has worked for it, he said. Some cut their losses from underperforming managers, while others wait through the economic cycle.
"Each trustee board has its own mythology," Mr. Urwin said. In the Middle Ages, "there were a zillion different cures for warts.
"What actually was happening was that the warts cured themselves after two years."
Trustees haven't used smart investment structures in the past, he said. "We are where we are almost because of serendipity of circumstances" -- that is, the enormous high equity returns of recent years.
Keith Ambachtsheer, president of KPA Advisory Services Ltd., Toronto, advocates a near flip-flop of today's typical U.S. investment structure. Because active managers can't consistenly add value, he believes the correct ratio of passive to active managers is 75% to 25%.
A small number of large, global players -- perhaps fewer than 10 -- would provide passive investment services, while a larger number -- possibly in the hundreds in the United States -- would provide active approaches. And they would be paid performance-based fees so if managers failed to beat their benchmarks, they would get subsistence-level payments, he said.
"What it means is active management is going to shrink rather significantly," Mr. Ambachtsheer predicted.
Also under this scenario, pension funds and money managers alike would shift their focus from asset allocation to controlling risks.
"As we go forward, the big challenge that both sponsors and managers (face) . . . is to come to grips with what is reasonable in relation to the risks that are borne," Mr. Richards said.
"Although you can't forecast returns, you can forecast risk. Risk is a stable parameter."
Mr. Brinson, who wrote a seminal paper on long-term asset allocation, agreed on the importance of risk tolerance. Pension executives, he said, will question whether their asset mixes are optimal, and whether they might obtain the best risk-return ratio with a completely different mix of equities and bonds.
More aggressive portfolios might be leveraged, while more risk-averse portfolios would have their volatility ratcheted down accordingly.
Pareto's Mr. Liesching argues the problem with traditional asset allocation stems from key problems with mean-variance analysis -- the major investment tool used by pension fund executives to create an efficient frontier by which asset allocations are set.
"The idea that there is a risk-return frontier is a bit of an illusion," he said.
In an unpublished paper, Mr. Liesching argues that "optimal" investment strategies just reveal the limitations of the assumptions built into the model.
First, there are problems in applying a normal bell curve in asset allocation. While bell curves are perfectly symmetrical, investors seek asymmetric returns -- that is, they want to enjoy upside returns while limiting downside risk.
What's more, normal bell curves are poor fits for the "tails" -- the extreme outliers -- of financial return distributions. That's because all of the cumulative returns are found in the "fat tails," he maintains. For example, when comparing U.K. equity returns with cash since 1970, cutting out the largest 4% of monthly equity returns eliminates the outperformance of stocks.
And, as if Mr. Liesching hadn't thrown enough wrenches into the machinery of modern portfolio theory, he challenges typical notions of diversification:
* First, noise in the data often disguises high correlations.
* Second, investors care about low diversification of market declines, not rises; current data generally do not make that distinction.
* Third, diversification among managers also requires they obtain their information from different sources, or pension funds could end up with unacceptably high aggregate levels of risk.
Mr. Liesching also questions the efficient frontier and the idea that pension funds can trade off between asset mixes to obtain their investment goals. Returns are measured against the strategic asset allocation divined from the mean/variance analysis, which is based on assumed returns, variances and correlations.
"However, there is a fundamental problem with this analysis: Both risk and returns change over time -- the strategic allocation does not embody a constant risk appetite," he wrote. High equity risk premiums have been out of whack -- relative to downside risk -- for decades.
While risk and return variables may be fickle, Mr. Liesching argues, a pension fund's liability profile is much more stable. Regular monthly rebalancing already has been shown to outperform traditional balanced management by more than 100 basis points per year. The next step is to rebalance assets based on risk, thus stabilizing a fund's asset risk exposure, he added.
Leading pension funds, he concluded, are starting to apply risk allocation to many areas: "global allocation (to exploit risk/return imbalances between markets), long/short strategies (to exploit the information on overvalued securities), private equity and venture capital (to be rewarded for taking liquidity risk)."
If risk allocation is the way forward, some experts maintain that strategies that separate a manager's ability to deliver added value from the performance of the underlying asset class is the next logical progression.
While the concept is in its early days, experts say some of the United States' biggest pension funds are re-evaluating how they structure their portfolios.
Officials at Amoco Corp. are cited as way ahead of the pack for their pioneering work on "portable alpha," but sources say pension officials at IBM Corp. and General Motors Corp., among others, are studying the concept.
Market-neutral funds are an obvious example of how this can be accomplished. William E. Jacques, chief investment officer at Martingale Asset Management LP, Boston, gave this example:
Say a pension executive believes a particular U.S. small-cap equity manager would add value. But it's hard for a multibillion-dollar fund to hand over a lot of money to the manager because only so much can be invested in small-cap stocks and still add value. The problem: The value to be added from stock selection is tied to the underlying asset class. As Mr. Jacques said, "They're like Siamese twins: they're hooked together."
The answer is to hire the small-cap manager for a long-short strategy, balancing its buys against its sells, but using the Standard & Poor's 500 index as the underlying asset class through derivative contracts or swaps, he said.
WILL FUNDS BUY CONCEPT?
Whether any but the largest pension funds will embrace this complex concept is an open question. Martin Liebowitz, executive vice president of Teachers Insurance and Annuity Association -- College Retirement Equities Fund, New York, cautioned that with any of the risk allocation models, "you have to be careful that they are not too subject to model risk."
The problem with portable alpha strategies is their complexity, he said. "You are crossing three bridges to get to only one island."
Mr. Jacques, whose firm sells market-neutral products, thinks plan sponsors will accept the product as a natural extension of indexation, in which one purchases the asset class instead of buying individual stocks.
"If you go back to the '70s, people said no way that (mutual funds) are going to become big. I think this is the same sort of issue," he said.
Similarly, First Quadrant's Mr. Arnott -- also a purveyor of market-neutral products -- believes that "a forward-looking fund, to be well-positioned for the coming years, has to reach out of the mainstream," and look to market-neutral, hedge funds and other alternative strategies.
PRESSURE ON FEES
While all pension funds might not go running into these strategies, most will be pushing to lower money management fees in the future, sources said.
And a move toward more structured portfolios will aid their cause, as pension funds pay low fees for passive and semipassive strategies and active managers come under greater pressure to earn their bread.
Experts say performance-based fees finally will take hold and will be based on the level of risk of the portfolio.
"Performance fees will prevail," said Simon Jeffreys, chairman of PricewaterhouseCoopers' global investment management group in London.
Overall, margins are expected to shrink, meaning volume will become even more important to sustain profitability.
And, despite the financial crisis in Asia and Russia's threats to turn back the clock on capitalism, money managers generally agreed globalization will continue, affecting global economics, investment policy and how money managers organize their business.
Patricia Dunn, chairman of Barclays Global Investors, San Francisco, said the rapid rise in wealth created by investments likely has caused a permanent change in people's attitudes around the world.
"I think it's hard to extrapolate from the way people have behaved in the past. There's not ever been the case that people have had discretionary wealth created by investment. It's a completely different starting point," she said.
"People may hunker down, home bias may become more obvious in the next few years," following the collapse of emerging markets of the past few years. But the trend toward globalization is "inexorable," Ms. Dunn said.
The economics and technology driving the U.S. experience will take hold around the world.
"It's the force of a river, it will not be shaped by borders," she said.
Not everyone agrees. Nandu Narayanan, portfolio manager at BEA Associates, New York, said the Asian crisis represents "the failure of capitalism."
"The mistake of globalization," he said, was that Western governments and investors have entered formerly command-and-control economies and tried to impose Western rules. The upshot of this sudden transition: Asian economies have plunged into bankruptcy, enabling Western investors to scoop up assets at bargain prices.