Points of Inflection: Investment Management Tomorrow

In the future, the way investment professionals earn a living is going to be so different as to be almost unrecognizable. The world of investment management has passed through a point of inflection, which means the same forces that worked in a particular way for a long time have begun to operate in different and unfamiliar directions. The way we earn our living is going to be so changed as to be almost unrecognizable, especially in research, indexing, benchmarking, and long-only investing.Ever since May Day in 1975, brokerage revenue has been too low to finance investment research without the additional revenues of investment banking. But even though the old habit of paying for research with soft dollars made life easy for both managers and clients, those days are gone forever. As so often happens, this process ultimately ran to an extreme. Truly independent research—aka hard dollar research—will be the name of the game. Hard dollars come directly out of managers' pockets, but the net cost to clients should be no greater than before, and the quality of research should be higher. There is no such thing as a free lunch.Indexed investing faces serious problems with more frequent and costly turnover. In addition, the indexes no longer qualify as “diversified portfolios.” Finally, if expected returns are in single digits rather than double digits, reliance on market returns may fail to cover required returns, making alphas and active management increasingly important.Benchmarking locks skilled managers into style boxes or into slavishly following some passive portfolio. But maximizing returns means giving managers with skill the greatest possible breadth in security selection. Liberating skilled managers from constraints is the only hope for containing the exodus of the brightest people to the world of hedge fund investing.The critical question, however, is: Benchmarking to what? The true benchmark is the return required by the structure and timing of the investor's liabilities. The critical ingredient of performance measurement, then, is a manager's contribution to the fund's required rate of return relative to the risk the manager takes. Conventional applications of benchmarking miss this essential point, but the bursting of the bubble has begun to refocus performance measurement in the more appropriate direction of required returns and risk budgeting.As hedge funds demonstrate the utility of the short-selling function, long-only investing is becoming obsolete. There is no reason short selling should be the privileged sanctuary of those managers who call themselves hedge funds. Why should conventional managers continue to operate with one hand behind their backs? Conference agendas today demonstrate that short selling is rapidly moving into the mainstream.Investment management has passed through a point of inflection. The supply chain of investment research will never again concentrate under the roof of investment banking. When returns are not as easy to come by, the constraints on manager activity imposed by benchmarking are archaic. Indexing has become more costly and more risky. And tomorrow, new techniques—as well as old techniques such as selling short—that widen a manager's range of choices will make sense in comparison with the old ways of doing things.