Evolution of the asset manager

ab Asset management research October 2012

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Executive Summary

•The asset management industry is undergoing profound changes in response to economic, demographic andindustry-specificpressures

•The end of the benign economic backdrop known as The Great Moderation, with high growth and low inflation,hascreatedatougherenvironmentforinvestors

• Increasing life expectancy and aging populations create further pressure as the Baby Boomer generation starts selling investments to fund retirement spending

•Low real returns on equities since the peak of the dotcom bubble in 2000 have undermined faith in the equity risk premium

•The secular bull run in bonds is approaching its natural limit as government bond yields in the US, Japan, Germany and the UK move closer to zero

•The assumptions behind the Capital Asset Pricing Model (CAPM) and Modern Portfolio Theory (MPT), two academic models that have been widely used in the investment industry, look increasingly unrealistic

• Investors now have shorter time horizons and increased aversion to risk

•Emphasis is moving away from performance relative to benchmarks and toward investor outcomes such as income generation and avoiding large drawdowns (i.e. peak-to-trough losses)

•Thefocusisalsoshiftingfromspecificassetclassestoholisticsolutionstomeetinvestors’needs

• Investors based in emerging markets make up a growing proportion of the industry’s client base, and havedifferentcharacteristicstothosebasedindevelopedmarkets

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IntroductionA basic premise in the theory of evolution is that species must adapt to a changing environment in order to survive. This holds true for companies as well as flora and fauna. Eastman Kodak, for example, filed for bankruptcy protection earlier this year after adapting too slowly to the shift from 35mm film to digital photography. In contrast Apple, which was faster and smarter in adapting to changes in computing, telephony, photography and other fields, became the world’s biggest company by market capitalization this year. Service industries, including financial services, are no exception. Asset management firms in particular need to evolve their business models.

This paper sets out evolutionary pressures and responses seen in the asset management industry over the last 30 years and makes a case for where the industry may be heading for the next 10 years or more. The evolutionary pressures come from three primary areas: economic, demographic and endogenous changes to the industry. Figure 1 summarizes the changes we see between the way the industry used to (and still largely does) manage client assets, and the way it will need to do so over the next decade and beyond. We go on to examine the old and the new asset management industry in more detail, and to describe the economic, demographic and industry-specific forces that are pushing asset managers to adapt in order to survive.

Figure 1: The changing face of asset management

The old way The new way

Investment content •Financeas‘science’withmanyrulesofthumb

•Basedonbenchmarks

•Investors’incomeandliquidityneedsarenotthe main focus

•Longtimehorizon

•Investorsseenasrational,profit-maximizingagents

•Equilibriumapproachtovaluation,volatilityandcorrelation assumptions

•Slowprogresstowardsglobalandalternativeinvesting

•Fixedapproachtostrategicassetallocation

•Financeseenasadaptive

•Basedonclientobjectives(e.g.incomeandliquidityneeds, limited drawdowns) and investment outcomes

•Shortertimehorizon

•Acceptancethatinvestorsarenotalwaysrational,profit-maximizingagents

•Flexible,continuallyupdatedviewsonvaluation,volatility and correlation

•Incorporatesbehavioralfinance

•Passive,globalandalternativeinvestingseenasmainstream and continuing to grow

•Dynamicassetallocationanda‘stractical’(strategic/tactical) time horizon

Product categorization •Largelybyassetclassandmanagementstyle •Largelybyriskreturnprofile,outcomeandfactorexposure

Investment teams •Organizedbyproductoffering

•Expertinanarrowfocus(e.g.USgrowthequities,orEuropean high yield debt)

•Littleinteractionwithotherinvestmentteams

•Centersofexcellencethatcutacrossassetclassesandregions: asset allocation, manager research, risk management, beta structuring

•Regionalandasset-classspecialistsremainbutinteractmore with each other

Client base •‘Institutional’clientseffectivelydefinedaspublicandprivatedefinedbenefitpensionplans

•Retailinvestingdominatedbymutualfunds

•Hedgefundsanoveltyformostinvestors

•Activeinvestingseenasstandardpractice

•Definedbenefitplansclosingandbeingreplacedbysovereignwealthfundsandfamilyofficesintheinstitutional client base

•Definedcontributionasthedominantformof savings vehicle

•Hedgefundsandotheralternativesasamainstreaminvestment

•Passiveincreasinglyreplacingactive

Distribution teams •Focusedonsellingaproduct,whichmaybejustonepart of the overall investment package a client needs

•Sellingprocesstypicallyshortandone-off

•Oftenrewardedforgrosssales

•Oftenreachingtheclientthroughanintermediarysuchas an investment consultant or wholesaler

•Highleveloftechnicalskillandinvestmentknowledge

•Long-term,strategicpartnershipwithclients

•Rewardedfornetnewmoney,soincentivizedtokeepexisting clients

•Maybesellingaholisticsolution,notjustasingleproduct

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The old way: Remember the 1990s?The asset management industry in the 1990s was less complex than it is today. The investment universe was largely divided into asset classes – above all equities and bonds, bothofwhichgenerallywentup.Other,‘alternative’assetsreceived little attention from most investors. Private equity and hedge funds were active but their growth was limited to well-heeled individuals and some forward-thinking pension funds. Driven by the need for further specialization, and with consultants taking the lead, equities and bonds were subdivided into categories such as growth equities, small-cap equities, high yield corporate bonds and emerging market debt. The investor base in developed markets was largely divided into defined benefit plans and mutual funds and mostly dominated by domestic equities and bonds.

The 1990s were good times for investors. Figure 2 shows that equities, bonds, private equity and hedge funds all achieved impressive total returns over the decade, both in absolute terms and relative to longer-term historical averages. After a decade or more of rallying markets, there was strong faith intheequityriskpremium(see‘DrTheory,meetMrPractice’,page 6). The theory went that investors simply had to allocate as much to equities as their risk tolerance would allow and thenwaitforthemarketsto‘cometheirway’.Foralongtimetheequitymarketsdidjustthat–andwhentheydidn’t,steadily rising bond prices cushioned any fall. Figure 3 shows thattherewasjustonequarterinthe1990swhentheS&P500Index fell more than 10%. (That was in 1990, and within six months the index was reaching new all-time highs).

Figure 2: Those were the days

Annualized real returns in %

Figure 3: Thin tails

QuarterlychangeintheS&P500Indexinthe1990s

Basedontotalreturns,adjustedforUSconsumerpriceinflation.Source:MSCI,Barclays,GreenwichAssociates,HennesseeGroup,Triumph of the Optimists (by Elroy Dimson, Paul Marsh and Mike Staunton), Credit Suisse, UBS Global Asset Management.

Source: Datastream, UBS Global Asset ManagementThe old way The new way

Investment content •Financeas‘science’withmanyrulesofthumb

•Basedonbenchmarks

•Investors’incomeandliquidityneedsarenotthe main focus

•Longtimehorizon

•Investorsseenasrational,profit-maximizingagents

•Equilibriumapproachtovaluation,volatilityandcorrelation assumptions

•Slowprogresstowardsglobalandalternativeinvesting

•Fixedapproachtostrategicassetallocation

•Financeseenasadaptive

•Basedonclientobjectives(e.g.incomeandliquidityneeds, limited drawdowns) and investment outcomes

•Shortertimehorizon

•Acceptancethatinvestorsarenotalwaysrational,profit-maximizingagents

•Flexible,continuallyupdatedviewsonvaluation,volatility and correlation

•Incorporatesbehavioralfinance

•Passive,globalandalternativeinvestingseenasmainstream and continuing to grow

•Dynamicassetallocationanda‘stractical’(strategic/tactical) time horizon

Product categorization •Largelybyassetclassandmanagementstyle •Largelybyriskreturnprofile,outcomeandfactorexposure

Investment teams •Organizedbyproductoffering

•Expertinanarrowfocus(e.g.USgrowthequities,orEuropean high yield debt)

•Littleinteractionwithotherinvestmentteams

•Centersofexcellencethatcutacrossassetclassesandregions: asset allocation, manager research, risk management, beta structuring

•Regionalandasset-classspecialistsremainbutinteractmore with each other

Client base •‘Institutional’clientseffectivelydefinedaspublicandprivatedefinedbenefitpensionplans

•Retailinvestingdominatedbymutualfunds

•Hedgefundsanoveltyformostinvestors

•Activeinvestingseenasstandardpractice

•Definedbenefitplansclosingandbeingreplacedbysovereignwealthfundsandfamilyofficesintheinstitutional client base

•Definedcontributionasthedominantformof savings vehicle

•Hedgefundsandotheralternativesasamainstreaminvestment

•Passiveincreasinglyreplacingactive

Distribution teams •Focusedonsellingaproduct,whichmaybejustonepart of the overall investment package a client needs

•Sellingprocesstypicallyshortandone-off

•Oftenrewardedforgrosssales

•Oftenreachingtheclientthroughanintermediarysuchas an investment consultant or wholesaler

•Highleveloftechnicalskillandinvestmentknowledge

•Long-term,strategicpartnershipwithclients

•Rewardedfornetnewmoney,soincentivizedtokeepexisting clients

•Maybesellingaholisticsolution,notjustasingleproduct

0 2 4 6 8 10 12 14 16

US Bonds, 1900-2011

US Equities, 1900-2011

Global Hedge Funds, 1990s

US Private Equity, 1990s

Global Bonds, 1990s

Global Equities, 1990s

0

3

6

9

12

15

>20%15% to 20%

10% to 15%

5% to 10%

0% to 5%

-5% to 0%

-10% to -5%

<-10%

Num

ber o

f qua

rters

Dr Theory, meet Mr Practice

Financial markets are scrutinized by academics as well as investors. Academia, as well as the asset management industry, is being forced to rethink the investment world in light of events.

By the 1990s, investment theory was dominated by the capital asset pricing model (CAPM) and the work of Nobel PrizewinnerHarryMarkowitz,knownasModernPortfolioTheory (MPT). The CAPM assumes that investors are rational, that they can trade without transaction costs and without influencing the price of the assets they are trading, and that they can lend and borrow unlimited amounts at the risk-free rate of interest. It also makes other assumptions, includingthe‘normal’distributionofinvestmentreturns.MPT,whichaimstooptimizerisk-adjustedreturns,assumesthat correlations between asset classes are fixed and constant forever – a flawed assumption. It also requires estimates for the future returns and volatility of each asset class. These estimates are often based on the equally flawed assumption that levels of returns and volatility in future will be similar to those observed in the past. In the real world, it is vanishingly rare to find a situation where investors, and the investments available to them, meet the assumptions of MPT and the CAPM. If you can find them, then MPT is as good a way of managing money as anything.

These assumptions were never held to be 100% accurate in practice.However,marketpractitioners,everkeentoadda veneer of science and legitimacy to their art, used CAPM and MPT as if they were a hard science with immutable facts instead of the stylized version of reality that they actually are. The asset management industry created an entirelexicontogowiththe‘science’–termslike‘alpha’,‘beta’,‘trackingerror’,‘standarddeviation’and‘duration’not only served as short-hand for professionals but had the added benefit of confusing lay people about the level of complexity in the markets.

From the late 1990s onward, market events, combined with advances in behavioral finance, have made the CAPM’s assumptions look increasingly far from reality. The ballooning and bursting of the dotcom bubble, with its echoes of the tulip mania and South Sea bubble episodes in bygone ages, wasareminderthatinvestorscanbedrivennotjustbyrational analysis but also by collective mania. After Lehman Brothers’ bankruptcy in 2008, market participants suffered from the disappearance of liquidity and from spiking transaction costs, including very wide bid-ask spreads in previously liquid markets where trading costs had been negligible. Institutions accustomed to borrowing at interest rates near the risk-free rate could no longer do so. And events in sovereign debt markets have called into question the very concept of a risk-free rate, which old textbooks define as the interest rate paid on government bonds that were assumed to have no default risk. The performance of equity markets has undermined faith in another of the CAPM’s tenets, which holds that investments in risky assets outperform lower-risk investments over time thanks to a risk premium. At the time of writing, the MSCI World Index of global equities is far below the peak it reached more than 12 years ago in 2000.

Behavioral finance has blossomed into a fertile area of academic research, which has shed light on the irrationality of investors. For example, experiments have undermined the assumption that there is an “indifference price” at which people are prepared either to buy or to sell – an “endowment effect” makes people attach a higher value to something, such as a financial asset, simply because they already own it. Other insights include investors’ tendency to suffer more displeasurefromalargelossthantheenjoymenttheyreceivefrom an equally large gain, and their reluctance to invest in areas where they have previously made losses.

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For investors and their advisors, the key task was to choose one or more asset classes with a suitable risk-return profile, and to pick managers who would perform well in their specialist asset class. For portfolio managers, success was measured by performance against their benchmark – so a US equities manager, for example, would hope to outperform theS&P500Index.Iftheindexfellby20%andthemanager’s portfolio fell by 15%, the manager was considered tohavedoneagoodjob.Decidingwhichactivemanagerto hire dominated much of the investment decision-making process, with asset allocation taking a back seat.

Importantly, the behavior of market returns during this period validated how people perceived the fundamental drivers of marketreturns.Humanstendtofocustoomuchonrecentevents. A decade of positive returns led investors to believe that was the norm and, importantly, to craft a series of false heuristics, or experience-based problem-solving techniques, basedonarelativelyshort-termdataset.Hencethecultofequities was born. This manifested itself in Modern Portfolio Theory, which is theoretically appealing but flawed in practice(see‘DrTheory,meetMrPractice’,page6).

The industry that we see today has its roots in this series of events. Investors’ drive into bonds has similarities with the earlier shift into equities. One of the simplest behaviors is performance-chasing – looking at a previous year’s performance as a guide to the future. Nowhere is this more in evidence than in the government bond market, where we genuinely question how many investors understand that the yield on the bond is the bond’s best estimate of its total return. For many government bonds, the yield is now extremely low or even negative.

For‘distribution’–theassetmanagementindustry’stermfor sales and client relationship management – the goal in the 1990s was simply to sell a product. The product was

usually a fund or portfolio devoted to a specific subset of equities or bonds. The asset managers themselves were seen as providers of products, not as advisors to investors – that role was left to investment consultants serving institutional investors and to financial advisors serving individuals who engaged in portfolio construction using the heuristics mentioned above. The selling process was typically short-term and often one-off. Distribution teams were often rewarded mainly or solely for gross sales rather than net sales, and therefore not incentivized to keep existing clients. Asset managers were on some occasions fired for underperformance versus a benchmark but they were largely kept from determining whether the benchmark was suitable. Asset managers did (and do) fulfill their fiduciary duty to clients but there is an impediment to having a complete view when the manager is left out of the most important part of the value chain.

Parallel evolution in emerging markets

This paper focuses on developed markets, which still account for the lion’s share of the asset management industry, including some 90% of institutional assets under management. But emerging markets seem certain to play a bigger role in the industry’s future than they have done in its historytodate,justastheyaccountforagrowingshareofglobal GDP.

Sovereign wealth funds already play a big role in the global investment landscape, not least as the main shareholders in some large, listed companies. They account for a growing share of asset managers’ institutional assets under management. As defined benefit pension funds close, sovereign wealth funds are growing dramatically. Importantly, there were a large number of pension funds – over 172,000 at their peak in the US alone, a figure that had fallen to 23,000 by 2009. In contrast, the number of sovereign wealth funds is much smaller – approximately 70. The industry’s evolution described in this paper – from a range of benchmark-based, subdivided asset classes to a products-plus-services model that meets clients needs more holistically – applies to sovereign wealth funds as much as to any other type of client.

Most sovereign wealth funds manage the financial assets of emerging economies that stem from exports of either commodities such as oil or manufactured goods. Importantly, many sovereign wealth funds do not view risk and return in the same way as traditional pension investors. Some sovereign wealth funds have higher risk tolerance, a longer time horizon, and are willing to take on an illiquidity premium. Others are intolerant of any loss, and cannot be expected to be value buyers in risk assets. They may have either lower or higher risk aversion than traditional pension funds and so will have very different reaction functions in themarket.Thebottomlineisthat‘institutional’marketparticipants have become much more heterogeneous over the last decade.

The other key category of emerging markets client is the burgeoning class of households sharing in the prosperity of emerging economies. They range in magnitude from small retail investors, who generally lack the state-funded safety nets available in developed economies, to the extremely wealthy people known in industry parlance as ultra-high net worth individuals, who have investable assets exceeding USD30m. Like their institutional counterparts, many households in emerging markets acquired their money recently and may have different views on investing from their counterparts in the developed world, creating a more heterogeneous investor base. This is driven both by a lack of capital markets experience and by the fact that, for many families in emerging markets, investments in capital markets are not the primary retirement savings vehicle. It is common for the family’s house, business or children to be the primary means of saving.

What most investors based in emerging markets have in common is that they have different perspectives to most investors based in developed markets. One cannot classify “emerging markets” as a single category, since the term covers such a vast range of countries. With that caveat, we venture two generalizations. First, emerging markets investors are less focused on performance relative to benchmarks – faith in benchmarks is waning in developed markets too, but emerging markets never had the faith to start with. Second, many investors based in emerging markets have shorter, more demanding time horizons. They are less likely to accept short-term underperformance by an asset manager in the hope that the manager will perform well in the long run. By attaching importance to short-term performance and by focusing on investment outcomes rather than benchmarks, emerging markets are leading the way in two of the biggest global trends in the asset management industry – trends that apply to developed markets too.

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Drivers of changeThe‘oldway’ofassetmanagement,describedabove,served the industry well for many years. So why do asset managers need to adapt in order to survive? We highlight pressure from three forces: economics, demographics and industry dynamics.

In investment economics, it is important to distinguish between cyclical and structural changes. In the medium term, cyclical upswings tend to move risk assets such as equities higher, while downturns take them lower. In the long term, however, the economic environment is becoming less favorableforinvestors.The‘GreatModeration’thatbeganinthe early 1980s offered two big boosts to investors: steady economic growth with shallow recessions, and gradually falling inflation. This allowed central banks to reduce interest rates over the long term. This formed the basis for a bull market in bonds that has lasted three decades. Falling interest rates, combined with strong growth in GDP and corporate earnings, drove a bull market in equities, when sell-offs were generally reversed within a few quarters as the market hit new highs.

The Great Moderation is history – and so are the outsized average annual returns that investors experienced in the 1990s. Looking forward, economic growth in the developed world is likely to be lower in future, owing to a range of factors including the unwinding of debts that built up in the Great Moderation, and demographic change – the growth rate of the world’s working-age population has fallen by a third in the past decade, and will fall by a similar proportion over the next decade. The Statistical Behavior of GDP after Financial Crises and Severe Recessions,astudybyDavidH.PapellandRuxandraProdanattheUniversityofHouston,showsthatGDPtakesnineyearsonaveragejusttoreturnto pre-crisis levels. Advanced economies’ governments and central banks are running out of fiscal and monetary tools to stimulate growth without the risk of inflation. As a result, business cycles are likely to be shorter and more severe, without the automatic stabilizers that countercyclical fiscal and monetary policy provide. The bull run in bonds cannot go much further, since nominal yields are unlikely to go below zero for long periods. All this is hardly conducive to a new bull market in equities on the scale of the one we saw during the Great Moderation.

The key demographic phenomenon for the asset management industry is the aging of the baby boomer generation. In developed countries such as the US, birth rates soared in the years after the Second World War. The generation born between 1945 and 1964, 79 million-strong in the US alone, achieved its maximum earnings power in the 1990s, when they were investing large sums to finance a comfortable retirement. Their average income is 50%

bigger than that of the previous generation at the same age, as shown in Figure 4. Thanks partly to big increases in life expectancy and improvements in education, they are the richest generation ever, collectively earning USD 3.7 trillion. And thanks to the benign economic backdrop described above, during the Great Moderation they grew accustomed to short, shallow recessions, and to long-term increases in the value of both equities and bonds.

Those days are gone. The baby boomers are around retirement age, so as a group they are investing less and gradually selling their investments to finance their spending. In addition, they are leaving the labor force, sometimes coupled with too little savings or too much debt. They have a shortening time horizon, and like most investors they are more risk-averse following the bursting of the dotcom bubble in 2000 and the post-Lehman financial crisis. Investors are nervous, and have less faith in financial assets.

Industry dynamics have changed too. In the 1990s, the equity risk premium was an article of faith – investors believed that equities would always outperform over a period of several years. Anyone with a long time horizon and reasonably high risk tolerance was steered into equities, while risk-averse investors with a short time horizon were told to buy bonds. The emphasis was on picking the right manager, one who would generate alpha by outperforming a single-asset benchmark. As a rule of thumb, investors and their advisors spent 80% of their time on manager selection, and only 20% on asset allocation.

Now, the equity risk premium looks less reliable – at the time of writing, global equities are below the levels they reached in 2000. This should be no surprise in a historical context. Figure5onpage10showstotal,inflation-adjustedreturnson US equities since 1871, based on year-end data. There were four separate periods when returns were negative over more than a decade: from 1901 to 1919, from 1928 to 1942, from 1968 to 1982, and from 1999 to date.

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Figure 4: Two generations

Average income per person in the US, in real USD rebased to the year 2000

Source: McKinsey Global Institute, UBS Global Asset Management

0

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30000

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Born 1945-1964Born 1925-1945

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Government bonds in the developed world no longer look risk-free, particularly in the eurozone, and certainly from a real return perspective. In fact, the risks associated with owning bonds were perhaps the risks that the baby boomer generation underestimated most. Investors are searching for safety in new places, and also looking for risk premiums instrategiesandassetclassesbeyondequities.‘Alternative’investmentsaregoingmainstream.Hedgefundsandlessliquid investments are gaining market share from traditional mutual funds. Consistently achieving alpha has proved possible but very difficult – particularly after fees and other expenses, and especially in a low-return world.

Consultants have expanded the range of services that they offer. Meanwhile, many asset managers – particularly the larger ones – have risk managers, actuaries, and even manager selection teams embedded in the traditional asset management structure. Who is getting squeezed? It is the mid-sized manager that lacks the resources to provide a holistic solution but is too big to be a small, nimble boutique.

These changes are against a backdrop of defined benefit (DB) pension plans closing at a rapid rate and being replaced by defined contribution (DC) plans. There are two important points about this change. First, for the most part DB plans were managed under a fiduciary framework of oversight, theso-called‘prudentmanrule’,asenshrinedintheUSbythe ERISA Act. The switch to DC plans has put employees’ retirement savings largely into the hands of the beneficiaries themselves,whoaremostlyuntrainedandsubjecttotheperformance-chasing and short-term horizons associated with retail investors. Second, people are simply not saving enough for retirement in their DC plans.

These economic, demographic and industry-specific changes combine to form an environment where asset managers must change if they are to flourish. Below, we describe how some are adapting and evolving – a process that is already visible but far from complete.

The new way: Adapting to a tougher environmentFor many investors, the 21st century has so far been a period of shattered expectations. Government bonds are no longer risk-free, yet they offer lower yields than ever. Investing in equitiescanloseyoumoneynotjustoveroneyear,butover a decade or more. Liquidity – the ability to sell assets at close to the stated market price – cannot be taken for granted. Scarred by the financial crisis, investors care more about liquidity and limiting downside losses. The low-yield environment is difficult for income investors.

So asset managers now have to work harder to satisfy their clients. That means taking the best practices from recent decades and adapting them to the new investing environment. From the 1950s through the 1970s, what investors wanted above all was a positive real return. From the 1980s onward, asset managers were expected to offer exposure to specific asset classes or sub-classes either through a benchmark-beating active fund or through a benchmark-tracking, low-fee passive fund. In future, they must do all that and more. They need to focus on investor outcomes, such as the level of income generated and the degree of protection from inflation and from falling asset prices.

For investment content, that entails new types of product with new measures of success. The primary goal of some multi-asset income strategies, for example, is not to beat a benchmark per se but to meet clients’ expectations about the total risk and return they experience.

Insightsfrombehavioralfinance–see‘DrTheory,meet Mr Practice’, page 6 – are changing the industry. A starting point is to abandon the assumption that investors (or markets) are rational or that the utility curve is stationary. Asset managersmustacknowledgethatforclients,thejourneyisasimportant as the destination. Clients want to achieve certain investmentobjectivessuchasincomeorcapitalappreciationbut they also want to avoid the trauma of large, sudden losses even if such losses are reversed over time. Markets are driven by swings in investor sentiment as well as by changes in fundamentals, particularly in the short-to-medium term – a fact that investors can use to improve their performance, particularly with regard to market timing. So investor psychology demands that asset managers acknowledge the potential of short-term market moves, without losing sight of long-term investment goals and valuation perspectives

Figure 5: Patience required

Real total return on US equities, with dividends reinvested, logarithmic scale rebased so that December 31, 1871 = 1

Based on year-end data. Source: Irrational Exuberance (Robert Shiller; Princeton University Press, 2000, 2005, updated), UBS Global Asset Management

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20111991197119511931191118911871

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– particularly when markets are stressed and risky assets arefalling.This‘reflexivity’ofthemarkets–theimpactthatmarket moves have on investor portfolio preferences, which in turn impact the markets – will continue to amplify market volatility for the foreseeable future.

Investors now have a more global perspective, and the movement of non-domestic assets from the periphery to the core of investment strategies is now well advanced – though it still has further to go. The same may be true of passive investments and the booming market for exchange-traded funds (ETFs). Passive investments are important building blocksforanoverallinvestmentstrategy.However,yieldsare low in the new investment environment, and the secular bull markets in bonds and equities may well be over. Passive exposure to global bonds and equities may no longer give investors the outcomes they desire, though they can seek to improve their investment outcomes through active asset allocation and broadening their portfolios with additional asset classes such as real estate, currencies and commodities.

Both investment teams and distribution teams must do more than they used to. While a role remains for specialists in subsectors of asset classes, these can be thought of as components. Large asset management firms not only need to provide the components, they also need to combine the components into a complete investment portfolio. In other words, they must offer clients comprehensive solutions to their investment needs – needs that the new regulatory and investment environment are creating and changing with increasing frequency. That requires capabilities in areas including asset allocation, risk management and derivative techniques, as well as investment teams specializing in narrow areas such as US equitiesoremergingmarketdebt–and/oramanagerselectionteam that can choose suitable third-party specialists in these areas. This creates an additional evolutionary pressure, as the services provided by asset managers increasingly overlap with those provided by consultants.

These various centers of excellence should complement and assist each other. Risk managers, for example, can help a manager selection team improve its performance by evaluating the underlying factor drivers of risk. Asset allocators can help underlying equity, bond and manager selection teams by having a view of the broad market environment.

Even boutique investment teams that focus on specific asset classes or regions need to change their modus operandi in the new investment environment, since markets and economies are more interdependent than ever before. Worries over sovereign debt in Europe can cause a flight from risk that tramples equities in emerging markets, for example. So specialists can become better investors by talking to

specialists in other areas. In the recent market environment, macroeconomic drivers have been so dominant that it has been a struggle for fundamental stockpickers to make senseofthemarketmovements.Havinganunderstandingof the broader investment environment can help investors know when companies’ fundamentals will begin to reassert themselves.

Distribution teams also have to change. The emphasis is gradually shifting from selling single products to developing a deeper understanding of clients’ needs, and helping them develop and maintain the right investment strategies to meet those needs. This requires sales and client relationship managers to increase their level of investment knowledge and to develop deeper, longer-term relationships with clients and prospects. Especially for institutional or quasi-institutional sales, the role of the salesperson must transition from providing a standardized product to a role with more in-depth technical knowledge. This may mean splitting the salesrolesbetweena‘door-opener’andatechnicalsalesfunction. For large clients with many needs, there could be a‘keyaccounts’modelinwhichaclientrelationsmanager(CRM) acts as an intermediary, bringing in expertise from many parts of the asset management firm. The performance ofCRMswillincreasinglybeassessednotjustonattractingclients but also on keeping clients and becoming their trusted advisor who can aid clients in a variety of ways.

On the wholesale side, a similar change needs to take place. Instead of clients buying products based on asset classes, the market will likely shift to one where the client outcome is paramount. Given the aging demographics of developed markets, this may involve a better understanding of the impact on investors of drawdowns, i.e. peak-to-trough losses. And it may require characterizing products more accurately based on perceived risk rather than asset class delineation or more esoteric concepts such as tracking error.

The investment environment has undoubtedly become harsher since the balmy days of the late 1990s. Asset managers need to help their clients set realistic goals, and work harder and be more innovative to meet them. Evolutionary pressures are not making life easy for the asset management industry. But they are making it better.

AuthorsCurt Custard, CFAHeadofGlobalInvestmentSolutions

Matthew Richards, CFAStrategist, Global Investment Solutions

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The views expressed are as of October 2012 and are a general guide to the views of UBS Global Asset Management. This document does not replace portfolio and fund-specific materials. Commentary is at a macro or strategy level and is not with reference to any registered or other mutual fund.This document is intended for limited distribution to the clients and associates of UBS Global Asset Management. Use or distribution by any other person is prohibited. Copying any part of this publication without the written permission of UBS Global Asset Management is prohibited. Care has been taken to ensure the accuracy of its content but no responsibility is accepted for any errors or omissions herein.Please note that past performance is not a guide to the future. Potential for profit is accompanied by the possibility of loss. The value of investments and the income from them may go down as well as up and investors may not get back the original amount invested.This document is a marketing communication. Any market or investment views expressed are not intended to be investment research. The document has not been prepared inlinewiththerequirementsofanyjurisdictiondesignedtopromotetheindependenceofinvestmentresearchandisnotsubjecttoanyprohibitionondealingaheadofthedissemination of investment research. The information contained in this document does not constitute a distribution, nor should it be considered a recommendation to purchase or sell any particular security or fund. The information and opinions contained in this document have been compiled or arrived at based upon information obtained from sources believed to be reliable and ingoodfaith.Allsuchinformationandopinionsaresubjecttochangewithoutnotice.A number of the comments in this document are based on current expectations and are considered “forward-looking statements”. Actual future results, however, may prove tobedifferentfromexpectations.TheopinionsexpressedareareflectionofUBSGlobalAssetManagement’sbestjudgmentatthetimethisdocumentiscompiledandanyobligation to update or alter forward-looking statements as a result of new information, future events, or otherwise is disclaimed. Furthermore, these views are not intended to predict or guarantee the future performance of any individual security, asset class, markets generally, nor are they intended to predict the future performance of any UBS Global Asset Management account, portfolio or fund. Services to US clients for any strategy herein are provided by UBS Global Asset Management (Americas) Inc. which is registered as an investment adviser with the US Securities and Exchange Commission under the Investment Advisers Act of 1940.© UBS 2012. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved.