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このたび CREATE-Research 社の”Investment Innovations: raising the bar”と題する調査報告書を、ホームページに掲載しました。同社は、英国の独立系のグローバルなコンサルティング会社であり、金融、航空宇宙、IT、石油、製薬、テレコム等の幅広い産業をカバーしています。
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以上Investment Innovations:raising the bar

Author: Prof. Amin Rajan
First published in 2011 by:
CREATE-Research
Vauxhall Lane
Tunbridge Wells TN4 0XD
United Kingdom
Telephone: +44 1892 526 757
Fax: +44 1892 542 988
Email: amin.rajan@create-research.co.uk© CREATE Limited, 2011
All rights reserved. This report may not be lent, hired out or otherwise disposed of by way of trade in any form, binding or cover other than in which
it is published, without prior consent of the author.
The findings and views expressed in this report do not necessarily reflect the views of Citi and Principal Global Investors. Whilst every effort has beentaken by CREATE-Research to verify the information, neither Citi nor Principal Global Investors and their affiliates can accept any responsibility or
liability for reliance by any person on this information.

Foreword
We at Principal are delighted to be involved as joint
sponsors of this new report from Amin Rajan and
CREATE-Research.

This edition of CREATE-Research’s annual survey
examines the industry’s continued need to innovatein order to produce better outcomes for clients.

The topic of innovation is a very important one that has
been the subject of confusing comment by many in themarket over the past few years.

This year, insights from asset managers have been
augmented with the perspective of pension funds, withparticipants hailing from Asia, Europe, the US, and otherparts of the globe.

Up until the financial crisis, many of the ‘innovations’ onoffer basically involved greater leverage, which proved
very dangerous when times got tough. But there are
more rewarding innovations, such as emerging markets,and life cycle funds for defined contribution plans.
These can help investors to attain their objectives andcontrol their risks.
This study shows investors taking a more thoughtful
approach to these innovations, and highlights many
opportunities in this time of change.

Not all innovation is positive, of course. Nevertheless,
new tools have allowed clients to harness the growthof emerging markets and to better manage risk acrossthe globe.
A key aim of this year’s survey is to explain why
innovation sometimes works and why other times itdoes not.
The CREATE-Research findings show that the asset
management industry needs to focus not on new
vehicles but on the innovation process itself.
We at Citi are happy to partner with CREATE-Research,and through this survey we hope to provide food forthought for our clients.

Jim McCaughanCEO
Principal Global Investors

Neeraj Sahai
Global Head
Citi Securities and Fund Services

IAcknowledgements
This report presents the results of our 2011 annual
global survey.
The last decade witnessed the widespread adoption ofsome 35 investment innovations. This is the first reportof its kind to perform a reality check on what worked,
what didn’t and why.
After the traumatic events of the last decade, innovation
has had a bad press. So, it is a tribute to the investmentcommunity worldwide that it has collaborated with us inhighlighting the key lessons from the past as it faces achallenging future.
My foremost thanks go to 108 pension plans and 396
asset managers, consultants, administrators anddistributors who participated in our two separate
surveys and to those who were engaged in the followup interviews.
The majority of them have been our constant survey
participants since 2000 when the current series started.
They and others have helped to create a credible
impartial research platform that aims to promote goodpractices in investment management.

Prof. Amin Rajan
Project Leader
CREATE-ResearchII

I would also like to thank Citi Securities and Fund
Services, and Principal Global Investors who jointly
sponsored the publication of this report, without
influencing its findings in any way. It has been an
enormous privilege to work with them.
On this occasion, their excellent contacts in Asia Pacifichelped me greatly in understanding the future funddynamics of this vibrant region.
My special thanks also go to our media partners, FTfm
and IPE, for their help in launching the two surveys on
which this report is based.
Finally, I would also like to thank my colleagues whohelped at every stage of the research programmewith their customary zeal and diligence: Naz Rajan, Dr
Elizabeth Goodhew, Leanne Perry and Kirsty Langley.
I have had more help on this occasion than before. Evenso, if there are errors or omissions in the report, I am
solely responsible.

“Discovery consists of seeing what everybody
has seen and thinking
what nobody has thought.”
Albert Szent-Gyorgyi

Contents
Foreword

I

Acknowledgements

II

1 Executive Summary

01

2 Report Synopsis

033	An open mind
What do pension plans think?

17

4	Room for improvement
What do asset managers think?

29

5	Ideas beget ideas
How do asset managers aim to do better in future?

41

III

1 Executive Summary
Since 1980, investment innovations
have come in five distinct clusters:

Even so, five innovations delivered
most value:• new asset classes• emerging market equities• new asset allocation techniques• emerging market bonds• new risk and returns enhancing
tools• high yield bonds• new theme funds• new business models.
Although coming on-stream at
different times, their substantive
adoption occurred in the wake ofthe 2000-02 bear market.
Focusing on the last decade, thisreport assesses their impact on thebasis of two global surveys.

• exchange traded funds (ETFs).
Pension plans that benefited fromthem attribute their success tostrong beliefs in their intrinsic
worth, a disciplined approach tobuying and selling, and in-housecapabilities to chase early moveradvantage.
They got the timing right.

One involved 108 pension plans
and the other involved 396 asset
managers, pension consultants,
third party administrators anddistributors – from 30 countries.

Innovations that delivered least
value include:

Together, they represent a
combined AuM of around US$29
trillion.

• portable alphaFour headlines have emerged
from our surveys.

1. Innovations work as longas we know their limits
Adoption of the identified clusters
gained significant traction acrossthe Atlantic in the last decade.
But the 2008 credit crisis
overwhelmed their impact.
Strategies that were meant tothrive on volatility – e.g. hedge
funds and currency – cameunhinged. Their idiosyncraticrisks were overwhelmed by thesystemic ones.

1• liability-driven investing• leverage• structured products• currency funds.
Pension plans that lost out attributethe outcomes to the absence of
intrinsic value, herd instinct andlow engagement with their asset
managers.
They did not heed the ‘healthwarnings’.
Nor did they have the skills andgovernance to enter into anything
complex or risky.

2. Asset managers should
improve the old before
creating the new
Pension plans want asset managers
to take four actions that canpotentially improve the outcomesof the last crop of innovations:• deliver better returns per unit ofrisk within a more symmetricfee structure• deliver greater transparency
and simplicity, so that the
intrinsic worth of their assets
is not concealed by devices
such as derivatives, leverageand shorting; these should
complement, not conceal,
product integrity• create a strong overlay of humanjudgement in risk models andinvestment processes• develop better proximity toclients in order to minimise the‘wrong-time’ risks.

3. The innovation boat is
unlikely to be pushed
out too far
A number of innovations are in
the pipeline. Their impact will bemodest over the next three
years but will build up as thedecade progresses.

Their immediate aim will be to
improve the product features
outlined above.
Over time, four innovations arelikely to prove especially disruptive
to the existing business models:• the likely abolition ofcommissions in the retail space inEurope and Asia
• the adoption of high watermark
fees in the absolute return space• the morphing of defined
contribution (DC) products in
the retirement space• the emergence of state-of-theart data warehouses in theadministration space.

4. There needs to be aclear line of sight
between innovations
and client needs
Pension plans accept that
innovations cannot deliver
replicable outcomes. Nor can they
do without them.

Thus, they want to be assured
that their asset managers seek
‘best endeavour’ outcomesvia product integrity, processintegrity, operational excellence
and interest alignment.
The likelihood of such outcomesmay increase if:• there is greater client
engagement that seeks new
ideas as much as manages
expectations of what can andcan’t be achieved in today’s
markets, with random burstsof risk-on/risk-off that ignore
the fundamentals• innovations stem from managers’
core skills as distinct from puremarket opportunism• innovations walk the fine line
between revenue streams for
asset managers and credible
opportunity sets for their clients.
Over this decade, theinvestment value chain will
be distinguished as much byintrospection as innovation.

Both the size of their current
deficits and the returns required to
fix them remain daunting in today’s
low return environment.

2

2 Report Synopsis“Is this the magic
moment to remake
the investment
industry?”

In the last decade, the charm of
uncorrelated absolute returns
captured the imagination of
investors who had hitherto relied ona raging bull market to do the heavy
lifting for them.
Numerous investment innovations
were duly adopted: some new, somerevived versions of the old.
New asset classes emerged. Somewere offshoots of long only funds.
Others were genuine alternatives.
New asset allocation techniques
were also created as strategic asset
allocation became more dynamic.
New risk hedging and return
enhancing tools accompanied themin the institutional market.
Finally, new theme-based products
were introduced in order to meetthe diverse needs of retail investors.
Coming in dribs and drabs over theprevious 20 years, their substantive
adoption accelerated in the wakeof the heavy losses inflicted by the
2000-02 bear market.
It shifted attention from relative toabsolute returns; from mainstream
to alternatives; from asset investing
to liability matching.

To assess their impact, we haveconducted two global surveys of
two groups of asset management
buyers and sellers – as outlined in
the Executive Summary.
These were asked four questions
central to our remit:• which innovations worked, which
didn’t and why?
• what improvements are
essential?
• what should be the main thrustfor innovations over the next
three years?
• what specific actions do theycall for?
In the second survey, involving
asset managers, pension
consultants, third party
administrators and distributors,
asset managers predominated.
Hence for brevity, it is referred toas the “asset managers’ survey”
in this report.
The details of countries and theasset coverage of each survey are
given in the table below.

Survey participants by geography and size of AuM
Australia
Austria
BahrainBelgium
CanadaChina
Denmark
FinlandFranceGermany

Hong Kong
India
Ireland
Italy
Japan
KuwaitLuxembourg
Malaysia
Netherlands
NorwaySource: Citi / Principal / CREATE Survey 20113

Saudi Arabia
Singapore
South Africa
South Korea
Spain
SwedenSwitzerland
TaiwanUK
USA

AuM (US$ trillion)

Asset Managers
27.6
Pension Plans
1.75

The surveys were followed up by
structured interviews with senior
executives in 90 organisations in
12 major fund markets aroundthe world.
Given the multi-lingual backgroundof these participants, their views
as presented in the case studies in
the main body of this report arenecessarily paraphrased.

Adoption: an overview
Some 35 innovations saw
significant adoption in the last
decade: 29 were customer-focusedthat aimed to deliver better returns(the four outer circles in the
diagram below); and 6 wereservice provider focused that
aimed to improve businessresilience (inner circle).

In most cases, the US was both theprincipal innovator as well as theearly adopter.
Its long-renowned entrepreneurial
culture is one factor. Another is
its large pension backyard whichcurrently harbours 58% of theworld’s total pension assets of some
US$27 trillion.
The UK and Continental Europe
were late adopters, embracing mostinnovations by the middle of thelast decade, but they led the way
with LDI.

Now, their maturing liabilities
are forcing them to look at moreinnovative solutions. Before long,adoption of the mark-to-market
rules will also emerge as anotherdriver of adoption.
Against this background, the next
two pages shed more light on
our key findings on the study’sfour central questions. They are
immediately followed by the core
themes emerging from them.

In marked contrast, other large
pension markets like China, Japanand South Korea chose to remainhome-biased, bond-biased andpeer-biased.

Which innovations were widely adopted in the 2000s and who were the early adopters?

Asset classes and asset allocation techniques• Global equities• Emerging market equities• Convertible bonds• High yield bonds• Emerging market bonds• Currency funds• Real assets & infrastructure
US, UK, Netherlands,
Australia, Singapore

New asset
techniques• LDI• Distressed debt
• GTAA• Age-based retirement funds• Risk-based retirement funds• Unconstrained mandatesNewenhancing toolsNewbusiness models• Outsourcing of back office• Outsourcing of distribution• Fiduciary management• Client service models• Innovation models
US, EU,
Switzerland

US, UK, Netherlands,
Switzerland• Derivatives for hedging
unrewarded risks• ETFs• Hedge funds• Portable alpha• Leverage• Shorting
US, Canada, UK,
SwitzerlandNew
theme funds• SRI• Environment• Water• Renewable energy• Shari’ah• Capital protection• Tax efficiency
US, EU, Malaysia,
Canada, Singapore

Hedging & returns-enhancing tools and theme funds

New
asset classes

Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“By 2007, asset management
resembled investment banking:a product machine pushed tothe tipping point.”“Our innovations wereincremental; their effects
were not.”“By staying away from complex
products, were Asian investors
unsophisticated or smart?”

4

The score cardthey had the skills and governancethat chased intrinsic worth via earlymover advantage.

The 2008 crisis overwhelmed
most innovations. Even a seen-it-all
investor was stunned.

Third, they were less aware of theconditions in which innovations
work because of low engagementwith their asset managers.

Innovations that delivered least
value include: leverage, structured
products, currency funds, andportable alpha. They worked forsome investors but not others.

Yet, for the decade as a whole, fiveinnovations have been identified
as delivering most value (chart
below): emerging market equities (astand out), emerging market bonds,
high yield bonds, liability driven
investment (LDI) and ETFs.

This assessment by pension plans
is duly echoed by their asset
managers, but with one caveat:
innovations were not inherently
unsound if their ‘health warnings’
were heeded.

The rest of the innovations fell
between the two extremes, as
shown in Sections 3 and 4.

Clients have learnt one lesson:
unlike cars and computers, fundproducts don’t have replicableoutcomes and a definable shelflife: timing and market
environment matter.

Pension plans that lost out report
three contributory factors.

Those pension plans that benefited
single out three factors acting intheir favour.

First, they relied on financial
engineering to extract value where
there was none. Second, they reliedon external advice to the extent
that often promoted a herd instinct
that prevented buying on the dips.

First, they had clear investment
beliefs that guided their choices.
Second, they had a disciplined
approach to buying and selling thatminimised behavioural biases. Third,

Hence, it is unwise to throw theinnovation baby out with thebath water.

In the last decade, which innovations delivered most value and which delivered least value?
% of respondents from the pension plans’ survey
40

30

20

10

0

10

20

30

40

50

60

Emerging market equities
Emerging market bonds
High yield bonds
Liability driven investments
ETFs
Global equities
Portable alphaCurrency funds
Structured products
Leverage
Delivered least value

Delivered most value

Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“Which asset manager can claim
Apple’s historic run of successes?”

5“Many innovations may enjoy a
15-minute fame. What matters is
how you use them.”“Best innovations minimise
investor foibles and choose theright time. Success is as muchabout ‘when’ as ‘what’.”Required improvements
In the last decade, as the equity
risk premium dried up, liabilitymatching became essential.
Neither asset managers nor
pension consultants receive highplaudits for helping pension plans
to manage the ensuing transition:a sign of new urgencies as muchas old weaknesses. Overall, asset
managers score better.
The pension promise was easy tomake, hard to keep. Three changes
will help in the future.
First, pension plans want future
innovations to improve two productfeatures that directly impact theirbottom line: the risk-return tradeoffs and their fees and charges. A
new asset class won’t help while all
the money is locked into the old.
Second, they want risk models
and investment processes tohave a strong overlay of humanjudgement, especially while theglobal economy remains exposed tosystemic shocks. Investors can nolonger rely on the rear-view mirror.
Third, pension plans in Asia go evenfurther: they want their managers
to have a strong regional presence,as China reshapes the global
economy and emerges as a fundsuperpower. Proximity is vital for
promoting diversification and the
buy-and-hold culture.

Future innovations
Over the next three years,
innovations will aim to deliver
the three identified changes via
product-deepening more than
product-widening: improving the oldbefore creating the new.

Client pressures will be one
factor. Another will be fresh
headwinds from four sources:
product commoditisation bybanks; regulatory creep;
uncertainty in the global economy;
and scarcity of talent with new
insights and gut instincts required
to exploit this uncertainty.
More than ever, talent will be a key
differentiator. There is a shortageof people who understand the new
global economic dynamics and its
impact on financial markets.
As highlighted in the Executive
Summary, some innovations arelikely to prove especially disruptive
to the existing business models.
These will change, in any event, as
the established trends continue.
In particular, the multi-boutiquemodel will spread from the West to
the East in pursuit of local presence;and outsourcing will spread fromback to middle office activities inpursuit of operational excellence.
The US will retain its pre-eminence
as the pioneer as well as the early
adopter of new innovations; eventhough fresh net inflows will mostly
emanate from the East.

Conclusion
Lessons have been learnt byinvestors and their managers.
Pension plans have learnt that asset
allocation is the alpha behind alpha.
That means not going to anythingradically new without strong
investment beliefs, a disciplined
approach to trading and skill sets tounderstand risky products. Hence,attempts are being made to developthese requisites within better
governance structures.

Two lessons have been learnt byasset managers.
First, innovation is no longer about
competitor leapfrogging.
Rather, it is about creatingproducts via a robust process thatgenerates new ideas, evaluates
them, converts them into
something that is fit-for-purpose
and seeks the ‘best endeavour’outcomes. Such processes are now
being taken on board.
Second, clients as well as third
party administrators need to be
involved as innovation partners.
Accordingly, client engagement
is improving.
Administrators are also being
encouraged to fast forward theirprogress on the investment
value chain by developing corefunctionalities that ensure
product integrity.
The crisis marked the end of achapter in the history ofinvestment innovations: more amoment of introspection than themother of invention.
Clients have wised up. Assetmanagers have started a fresh
narrative on what they can deliver.
Time will tell whether their current
efforts will fare better thanprevious ones.
The rest of this section drills deeper
into these findings by expanding on
the core themes that emerged fromour two surveys.

6

Theme 1: 	Client engagement is rising in order to minimise
inflated expectations
Just under a third of asset
managers have engaged theirpension clients when innovating the
products sold to them.
At the other extreme, another third
have rarely consulted their clients.
Such engagements typically solicit
new ideas, manage expectations
and raise awareness.
On the surface, client engagement
seems weak. Below it, however,positive undercurrents are evident.
Engagement was even lower five
years ago, when asset managers
were largely dis-intermediated byconsultants in most of the defined
benefit (DB) and DC markets.

Figure 1.1

The resulting gulf has been oneof the reasons why clients do notrate highly their asset managers
and pension consultants in various
activities that add value.

Rather, it is about managing
money within a definable rangeof outcomes. Every position in therange is a matter of conviction,
not guarantees.

However, the crisis has forced asset
managers into a more concerted
effort to understand, anticipate andmeet the needs of pension plans.

Even fat-tailed risks cannot be
managed without a high tolerance
for ambiguity that looks at risks
from different angles.

It is being driven by regular focus
groups, pulse surveys, informal
contacts and joint seeding of
new products.

It is now widely acknowledgedthat without greater client
engagement, hopes will always
run ahead of expectations.

Clients are being made awarethat innovation is not about
predictable outcomes.

How often has your asset manager involved you when innovating the products that you
buy from them?
Pension Plan’s responses
1%

34%

26%

39%
RarelyOccasionally

Frequently

Invariably

Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“No wonder so many plans areon their knees. Their peer andmarket benchmarks removed
accountability for outcomes.”

7“We knew that Madoff was stealingfrom someone. We didn’t think it
was us.”“In today’s real-time world,correlated mistakes are common.
The herd mentality amplifies
market cycles.”Theme 2: Regulatory creep will ease the innovation tempo
According to over 40% of pension
plans and asset managers, two
drivers will influence the pace andcontent of innovations after thecrisis: an accelerated switch from‘products’ to ‘solutions’; and fall-out
from new regulation.
In the DB space, the switch willbe led by LDI, as the use of themark-to-market rules spreads from
Europe to the US, Japan, Canada,
and South Korea.
In the DC space, it will be led
by advice-embedded products,
diverting assets from DB plans andtrust-based DC plans.
Another important driver will
be regulation. Unlike banks andinsurance companies, asset

managers do not expect anything
draconian beyond the AIFM
Directive and the revised MiFid
Directive in Europe; compulsory
registrations of hedge funds in the
US; a review of supers in Australia;
and more stringent scrutiny ofmutual funds in Asia.

ever roar back to life again.
Regulators are also creating
unintended consequences by reinterpreting the old rules.
For example, pension plans in the
Netherlands are obliged to value
their illiquid assets conservatively
and declassify gold as a monetary
asset. Some Scandinavian plans
are prevented from investing inemerging markets.

Even so, the current regulatory
creep is forcing introspection.
The Dodd-Frank Act in the US will
demand more onerous oversightand operational capital from bankowned asset managers, without
reducing systemic risks.

Worse still, a Japanese style
20-year flatline is notinconceivable, especially since
the S&P’s recent downgrade
warning on the US economy.

Beyond that, Solvency II rules in the
EU will force insurance companies
to divest risky assets; reinforcing
doubts about whether equities will

The identified innovation drivers
are unlikely to favour copycats.

Figure 1.2 	What factors will drive innovation in global asset management over the next three years?
% of respondents
50 40 30 20

10

0

10

20 30 40 50

INNOVATION DRIVERS:
An accelerated switch from ‘products’ to ‘solutions’
Fall out from new regulation
Asset managers need to develop new revenue streams
Large deficits experienced by DB pension plans worldwide
Dearth of credible DC products
Changing client needs post the credit crisis
Asset managers are discovering new investment capabilities
Overt suggestions from clients

Asset Managers

Pension Plans

Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“After 20 years, average DC planbalances are $45k in the UK, $58k
in the US and $119k in Australia.
What can that buy?”“The mutual fund model is flawed:
with few ‘sale’ recommendations,hidden charges, and no big switch
to cash when necessary.”“Solvency II and Basel III will divert
interest from risky assets. Who will
buy equities in 5 years?”

Theme 3: 	Product-widening and product-deepening will characterise
future innovations
2008 was a watershed. It forced
a discernible shift from productpush to investment-pull. Before
then, new product ideas principally
came from sales and productdevelopment teams. Clients andinvestment professionals took aback seat. Now, it is the other way
round. This speaks to an important
theme: innovations only work if weknow their limits. Problems arise
from delusions that markets canbe tamed.
Against this background, 88% ofasset managers foresee further
product innovations over the next
three years. Of this, 52% expect‘incremental’ ones. These will aim
to improve the inherent featuresof existing products more thancreating new ones. Another 36%
expect ‘wholesale’ innovations.

In the DB space, these will embraceassets such as agriculture, carbon
rights, intellectual property rights,
catastrophe bonds, shipping
contracts and wind farms. In the
DC space these foresee major
improvements in existing products
by creating a dynamic glide path,a stop loss mechanism and aseamless rollover into a retirement
solution that blends income drawdowns with annuities.
On the business model side,‘incremental’ innovations will see
the continuation of well-establishedtrends, whereas ‘wholesale’
changes will see their acceleration.
They will involve one or more of thefollowing: middle and back officeoutsourcing, distribution alliances,multi-boutique model, client service
model and new innovation processes
that deliver more robust products.

Likewise, operational innovations
foresee improvements in fund
restructuring, data warehousing,new technology and risk analytics.
Finally, distribution innovations
foresee ‘incremental’
improvements in service models
and sales channels; and ‘wholesale’
changes in fee structure resulting
from the dismantling of the oldstyle front-end, trail and exit
commissions in response to likely
regulatory pressures especially inEurope and Asia.
Among the innovations in theworks currently, five may prove
especially beneficial to end-clientsover this decade: the phasing out ofcommissions, the adoption of highwatermark fees, new DC products,
state-of-the-art data warehouses
and innovation tools.

Figure 1.3 What will be the scope of four distinct types of innovation in your business over the next
three years?
Cumulative % of respondents from the asset managers’ survey
60 50 40 30 20 10

0 10 20 30 40 50 60 70 80 90

ASSET MANAGERS' RESPONSES:
Product innovation

2
6

Business model innovation
Operational innovation
Distribution innovation

4
2

Nil

10 52

36

19 52

23

25 61

10

31 46

21

MinimalIncremental

Wholesale

Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“Real innovations will be very slow,
as in physics: from Archimedes to
Newton to Einstein.”

9“Embedded advice products andclient education will dominate thenext wave of innovation.”“Multi-locals in the East will takethe form of multi-boutiques in
the West. They will have a strong
local focus.”

Theme 4: Pension plans have an open mind about future innovations
When asked whether further
product innovation will deliver
genuine value for money to endclients over the next three years,
39% of pension plans said ‘yes’;
32% said ‘no’; and 29% said
‘don’t know’ (right hand chart).
In contrast, asset managers are
decidedly more optimistic (lefthand chart).
Pension plans anticipate nogroundbreaking innovations thatwill markedly help them.
Currently, 60% of DB plansworldwide have funding levels
below the statutory watermark.
70% need annual returns well inexcess of 6% to meet theirdeficits. These numbers sound likemission impossible in today’s low
return environment.

Hence, investment and noninvestment solutions are in
progress now.

been introduced since 2005, on
top of the closure of DB plans to
new members.

On the investment side, LDI iscatching on fast, especially inEurope and, to a lesser extent,
the US.

They include raising the retirement
age and the contribution rate.
Benefits based on final year
salary are being replaced by those
based on career average salary.
Discretionary indexation has beensuspended, where possible. Thesechanges have come in both private
and public sectors, via messy law
suits and piecemeal compromises.

Its returns-enhancing portfolios
invest in a range of strategies: withhigh alpha at one end and lowcost beta at the other. Its dynamic
version progressively immunises
risk as the funding ratio improves.
Its oversight requires transparency
of returns, charges, liquidity andscalability as part of innovation.
This is a far cry from the old 60:40
equity-bond mix, or its refinedversion like the risk-parity portfolio.
On the non-investment side, aseries of incremental changes have

By the end of this decade, mostprivate sector DB plans in Canada,
Ireland, the UK and the US may
close even for existing members;
with the balances reinvested in DC
plans. What was unthinkable five
years ago may be commonplace
5 years from now.

Figure 1.4 Overall, do you think that further product innovation will deliver genuine value toend-clients over the next three years?
Asset Manager’s responses

Pension Plan’s responses

19%
29%

39%

64%
17%

32%
Yes

No

Don’t Know

Yes

No

Don’t Know

Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“Five years ago, 70% of our new
business came from products thatwere less than three years old.
Now, it is 25%.”“The result is not the writingon the wall for investment
innovations, but only the
opening lines of a new chapter.”“As cash continues to pile up in
Asia, the fear is that all this money
cannot be put to work responsibly.”

10

Theme 5: 	Pension plans want to see in place mechanisms for ‘best
endeavour’ outcomes
Few innovations are pathindependent: the unexpected
often happens. In the 2000s,
leverage was the key source ofout-performance while it lasted. It
concealed the scarcity, persistency
and scalability of alpha. Investors’
foibles compounded the problem.
Lessons were learnt.
When asked in our interviews whatshould feature in the next wave
of innovations, eight were singled
out by pension plans worldwide:four relating to products and theother four to business models (seechart). The regional unanimity was

striking, albeit for different reasons:plans in the West need innovations
to remain solvent; plans in the East
need them to remain credible.
But they stressed that, insofar
as innovations cannot deliver
predictable outcomes, theyshould at least seek ‘best
endeavour’ outcomes.
These must be based on productintegrity, process integrity, businessresilience, operational excellence
and interest alignment (the inner
circle in the chart).

Via these, asset managers must
exercise a ‘duty of care’ and create
products that are fit for purposeby addressing the eight questions
listed in the outer circles. Of these,
five represent areas regarded as
being crucial in delivering a winwin for clients and managers alike:trade-offs, investment focus, risk
overlay, emerging markets andoperational excellence.
Each of these is now consideredin turn.

Figure 1.5
Trade offs
Investment
focus

How can our products
deliver more returns
for less risk?

Do we have a clear
strategy to exploit theirinvestment dynamism
and market
opportunities?

Do we use our corecapabilities and eschew
bells & whistles
overlays?

Retirement
solutions
How do we capitaliseon ageing
demographics?

Emerging
markets

Best endeavour
outcomes via:
• Product integrity• Process integrity• Business resilience• Operational excellence

ServicemodelsDo we know ourclients’ dreams andnightmares?

• Alignment of interest

Risk overlay

Operational
excellenceDo we know how tomobilise our intellectual
capital to generate
insights andforesight?

Do we use ourthird party
administrators
as innovation
partners?

Innovation
tools
How do we capture,evaluate andimplement newideas?

model innova
iness
tion
Bus

uct innovation
Prod

What questions do asset managers
need to address to deliver the‘best endeavour’ outcomes?

Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“For much of the last decade,asset managers spent a lot of time
worrying about almost everything
but their customers.”

11“Problems arise from the delusionthat markets can be tamed.”“It’s time to improve the existingmousetraps rather than create
new ones.”

Theme 6: 	Pension plans want a better risk-return trade-off within avalue-for-money fee structure
According to pension plans, the top
five features that need improving
are as follows:
60% of pension plans want
improvements in the risk-return
features of different asset classes.
New products also need to be stresstested against extreme scenarios.
51% want fees and charges to be
the cornerstone of the alignment ofinterests. Worldwide, a meritocratic
incentive structure remains a
dream. Whereas the poorest
performing managers charge thelowest fees, the best performing
managers do not always charge thehighest fees.
43% want greater transparency inthe investment process as well as

outcomes. Many want independent
performance attribution analysis
that singles out, for example, theroles of skill, luck, momentum,
industry sector and growth.
33% want greater simplicity inproduct design, its marketing and
its after-sales service.
23% want better client engagementin product design and follow-up
portfolio reviews.
Notably, far fewer managers
perceive the need for
improvements in each of theseareas. The perceptions gap is
especially striking in the two areasthat directly impact on clients’bottom line: risk-return trade off,
and fees and charges.

Asset managers recognise theseimperatives but many doubt
whether they can be delivered
over the next three years. The
trade-off is a matter for markets
as much as human ingenuity; fees
and charges are difficult to adjustin what is a fixed cost peoplebusiness that cannot be leveraged
in a flat market; and greatertransparency may undermine
the competitive edge.
Yet, the winds of change are
evident.

Figure 1.6 Which of the following fund product features will need to improve most over the next
three years?
% of respondents
30

20

10

0

10

20

30

40

50

60

PRODUCT FEATURES:
Risk-return trade off
Fees and charges
Transparency
Simplicity
Client engagement
Customisation
Volatility
Liquidity
Asset Managers

Pension Plans

Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“High watermark fees will be thebiggest disruptive innovation inthis decade. They killed off many
130-30 strategies.”“With mediocre returns, Australiansupers are under pressure to drive
down fees and improve returns.”“Without better returns, DC plans
will be on the same death road as
DB plans.”

12

Theme 7: Asian plans want innovations to be rooted in distinct skill sets
In Japan, 20-year duration zero
coupon bonds are common. Some
80% of pension assets sit inpassive funds. Asset allocation isdriven by law or peer pressure.
Bond-bias and home-bias arepronounced. These anecdotes tella bigger story: Asian institutional
investors are very risk averse.

But they want to be satisfied
that innovations in these buckets
solely stem from managers’ coreskills, as distinct from pure market
opportunism – as happened whensome long only managers went
into hedge funds after 2004, as if
they were fads requiring no unique
skill sets.

However, due to their fast
maturing liabilities, pension
plans, state social security plans
and insurance companies arevariously showing interest in areas
characterised by seven distinct
product buckets (see chart below).

They also want each bucket tohave a clear value proposition
that is aligned with the underlying
business model of the manager (seethe box in the chart).
For example, the model should
ensure that managers have genuine
capabilities that can minimise thegap between actual and expected
returns for each bucket. It should
ensure that the fee structurereflects the value added in eachbucket. It should ensure thatmanagers can afford to close
funds that do not scale. Finally, it
should ensure that each bucket has
an operating model that is mostappropriate to its value proposition.
Notably, these imperatives arealso echoed by institutional
investors from various countries
listed under each bucket. Theirsolutions-driven investing is now
relying on distinct product sets
for the necessary components.

Figure 1.7 In the next wave of innovation, how do clients in different jurisdictions want their asset
managers to focus on their core capabilities?

Alpha(uncorrelated
absolute
returns)

Leveraged funds(e.g. hedge funds)

• US
• UK
• Netherlands• Scandinavia• JapanAlternatives exc.
hedge funds• US• Canada• EU• Australia

Absolute
returns over cash
benchmarks

• US
• EU
• Canada• Japan• China• India• South Korea• Malaysia

Total returns
over market
benchmarks

• US
• EU
• Japan• Australia• Latam• India• China• Singapore

Complex regulated
funds (e.g. Newcits)• EU• Asia• LatamBusiness model
Key focus:
High Returns ------ Modest excess returns ----- Market returns
Key driver:Best talent utilisation ------------- Client needs ------------ Asset gathering
Fees:
High ---------------- Variable ---------------- Low
Returns:
High dispersion ----------- Low dispersion----------- Zero dispersion
Scalability:
High ---------------- Variable ---------------- Low
Operating Model:
Single boutique -----------Multi boutiques --------- Integrated houses

Regulatedmutual funds

• US
• EU
• Asia• LatamPassives; ETFs

• US
• Japan• China• EU• Australia• India
Market correlation

R2=1

Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“Absolute return is a mental
concept. You can’t do it unless you
really believe in it. Never fall inlove with stocks you own.”

13“Innovations only work when
they build on the manager’s corecompetency. Asian investors don’t
go for funky stuff.”“Independent performance
attribution analysis is blowing
the cover on alpha managers.”

Theme 8: 	Uncanny instincts for threats and opportunities should
dominate risk overlays
It is widely held in the global
pension industry that the existingrisk models and investment
processes came unhinged in thelast decade when they didn’t
foresee the two vicious bearmarkets; they didn’t detect thetime bomb concealed in cheap
money; they didn’t see asset classcorrelation going through theroof; and they didn’t anticipate theunintended consequences of themark-to-market rules that turned
the US subprime crisis into a
global disaster.
They do not capture subtle
nuances of the evolving investment
landscape where risks are springing
up from unexpected sources: e.g.
the sovereign debt crisis in Europe,
upheavals in the Middle East andthe earthquake in Japan.

Black Swans cannot be predicted.
The least that asset managers andconsultants can do is to stress test
their ideas under extreme scenarios
via fundamental judgement thatis based on insights and foresightin the hierarchy of knowledge (thetop two layers in the chart below).
These combine what people thinkin their brain with what they feel in
their gut.
Existing quant models are goodat digesting the bottom threelayers - data, information andexplicit knowledge - which arewidely available.
However, they miss out the
fresh nuances which can only be
captured via gut instincts, hunches
and intuitions gained from yearsof experience on the part ofinvestment professionals. Thesecannot be modelled. Yet they aresorely needed as risk has gone evermore dynamic.
Usually, intuitions are sparked
by intensive “what if” typediscussions involving people withhighly diverse views and a hightolerance for ambiguity.
Pension plans want to see quantmodels and fundamental
judgement combined within acareful marriage of the two, duly
underpinned by incentives andsanctions. The narrative in the chart
exemplify different considerationsin the hierarchy.
Concepts like VaR, information
ratio and tracking error have lost
credence when decision speeds arecompressed from calendar time toreal time; and markets are moved
more by sentiment than history.

Figure 1.8 How do risk models need an overlay of human judgement and individual incentives?

“You’re fired, if you failto hit your target”

Foresight• who will turn us into forced sellers?

Insights“You’re rewarded, if you
exceed your target”

A qualitative risk overlay provided byexperienced professionals and advisors
asking questions like:• what’s the risk that clients could
lose capital?

Explicit Knowledge
Risk models
and quants

Information

Data
Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“Like alchemy and quack medicine,risk models thrive on investors’
wish to believe impossible things.”“A good risk overlay combines
personal insights, transparent
processes, efficient operations andwell crafted incentives.”“Intuitive people have a hightolerance for ambiguity. They knowthat there are several ways oflooking at the same thing.”

14

Theme 9: 	Emerging markets will be the new frontier where mind space
is more important than shelf space
In this decade, emerging markets
are expected to be the principal
sources of new funds as well as
their destination. For them, theWest will be a safe haven during
periodic turmoil; not an investment
magnet. China is a nascent fundsuperpower. It faces two challenges,
like its neighbours.
First, its institutional investors
are ultra-cautious, trading quality
for simplicity. Second, in contrast,
its retail investors are
momentum-driven: buying high,selling low. Investment invokes
gambling undertones.

Hence, most jurisdictions aretaking baby steps towards
incremental diversification forpension investors, and financial
education for retail investors.
In the process, they want to involve
asset managers from the Westprovided they create manufacturing
capability on the ground, instead of
distribution alliances, as happenedin the last decade.
For example, the US-domiciled
managers went global largely
by exporting their domestic
funds (north east box in thechart) or importing foreign
funds (south west box).

As the decade progresses,
Asia increasingly will shape theglobal economic dynamics. Its
governments are creating an
indigenous industry for top-down
and bottom-up strategies topromote cross border trade in funds
across the emerging markets (south
east box). Those who venture into
this box are likely to do well.
Client visibility will become evermore important in the Asianmarkets, as they promote financial
literacy directly and a buy-and-holdculture indirectly.
For non-Asian asset managers,
proximity will differentiate ‘pricemakers’ from ‘price takers’.

Figure 1.9 Why do emerging markets want asset managers from the West to create manufacturing
presence on the ground? (a stylised version of how US asset managers have globalised their businessvia imports and exports)

US clients

Non US clients

Produced in US

Localisation
driven by history

Internalisation via exports
driven by scale

Produced outside US

Products

Clients

Internationalisation via imports
driven by scope

Emerging markets
driven by search for clientsand alpha

Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“Asia is a treasure trove ofinvestment opportunity. It requires
boots on the ground and a lotof patience.”

15“Across Asia, losses are frowned
upon. Asset managers have a big
educational task in promoting a
buy-and-hold mentality. ”“Now, innovations flow from Westto East. Soon that may go theother way as well.”Theme 10: Persistency of good returns needs operational excellence
Independent attribution analysis
shows that the persistency of good
returns depends upon a numberof factors - operational excellence
being one of them.
Not only does it create the rightenvironment, it also reduces costs.
As a result, it now featuresstrongly when pension plans
award fresh mandates.
In response, asset managers
continue to outsource many ofthe middle and back officeactivities, while encouraging their
third party administrators to
improve the six core functionalities
that feed into the innovation engine
of asset managers.

These are: data warehouses thatgive real-time information on
trades; simulation models thatstress test new products; risk
analytics that give second opinions;fund structuring that extends global
footprints; independent valuationof illiquid assets that gives ‘fairvalue’ estimates; and performance
attribution analysis that ensures
product integrity.

20% expect them to develop stateof-the–art data warehouses.
27% expect them to develop
technology to enhance client
engagement via online inter-active
decision support tools.
26% expect them to develop
more robust analytics for
product development.
If performance is the target,
focus is its silver bullet. By
taking over non-core activities,
administrators are emerging as
innovation partners.

Over the next three years,
asset managers expect theiradministrators to continue an
upward advance in the investment
value chain (see chart below).

Asset managers have barely
scratched the surface of Web 2.0.
Via alliances, they will before long.

34% expect them to improvethe ease of fund structuring inseparate jurisdictions.

Figure 1.10 In order to deliver operational excellence, what will be different about third party
administrators’ approaches to innovation over the next three years?
% of respondents from the asset managers’ survey
0

5

10

15 20 25 30 35 40

Improve the ease of structuring funds in different jurisdictions
Develop state-of-the-art data warehouses
Develop new technology to revolutionise end-client engagement
Develop the analytics for robust product development
Adopt new tools of derivative pricing and collateral management
Have checks and balances that deliver zero-error in financial reporting
Create innovation hubs by integrating front-middle-back office activities
Capture new ideas as part of daily routine
Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“Service providers are helping us
create currency funds in the
Ucits structure.”“70% of Australian supers haveoutsourced their back office.”“Everything in our data warehouseis real time: information capture
and its analytics. It’s a reliable
decision-support tool.”16

3 An open mind
“The world ofinvestment is cyclical,
fashionable andself correcting.
Only intrinsic value
triumphs in the end.”

IssuesKey findings

This section presents the resultsfrom the pension plans’ survey andthe follow-up interviews. It covers
the following questions:• Many investment innovations
were first introduced in the 1980s
and 1990s. But their substantive
adoption by DB plans came in
the wake of the losses inflictedby the 2000-02 bear market. It
shifted attention from relative touncorrelated absolute returns.

• which innovations that applied
to pension plans delivered thebest value for money and which
delivered the least value in thelast decade?
• what factors influenced theoutcomes?
• how have asset managers andpension consultants fared inhelping their clients to achieve
their goals since the crisis brokein 2008?
• going forward, what challenges
do pension plans face?
• what actions do they requirefrom asset managers andpension consultants?

• The 2008 credit crisis hit all
innovations indiscriminately. Only
emerging market equities are
singled out by more than 50% of
pension plans as delivering mostvalue in the last decade.
• The four that came after themare: emerging market bonds, highyield bonds, LDI and ETFs.
• Strong beliefs in their intrinsic
worth, the right timing, and prime
mover advantage contributed totheir relative success.

• The ones that delivered theleast value are: leverage,
structured products, portablealpha, currency funds andglobal equities.
• Absence of intrinsic value,systemic risks, low client
engagement and herd
instincts contributed to theirrelative failure.
• The crisis exposed the design
faults of the new suite of
DC products and inspired
improvements.
• It also marked a defining moment
for asset managers and pension
consultants. Their value-add
has been variable since then:managers score better. But scopefor improvement remains.
• The size of current plan deficits
and the returns required to fix
them are daunting in today’s low
nominal return environment.
• Pension plans are left with two
actions: trim benefits and seek
more bang for their buck.
• For the majority of them, risk
failed to generate return in thelast decade.

• Some are unsure whether thatwould improve in this decade, due
to the recurring bursts of risk-off/risk-on activity that has ignored
fundamentals since 2009. Others
believe that active managers
should have a field day.
• Both camps want asset
managers and pension
consultants to develop deeper
insights into the dynamic natureof risk. Current risk models tend
to rely on the rear-view mirror
even though investment has
become heavily nuanced.
• Both camps want significant
improvements in two productfeatures that impact on theirbottom line: the risk-return
trade-offs (i.e. how much
returns per unit of risk), andfees and charges. They perceive
high watermark fees as one ofthe disruptive innovations of
this decade.

• The message is simple: theirservice providers should improve
what they currently offer. A new
asset class won’t help while thebulk of money remains locked in
the old.
• Notably, before long, pension
plans in the East aim to diversify
into new asset classes andgeographies in ways that would
help managers in the West. But
they see past innovations ascosting too much and delivering
too little.
• They also want their managers
to have a strong local orregional presence for top down
as well as bottom up strategies,
especially while Asia reshapes
the global economy.

• They also want moretransparency and simplicity,so that the intrinsic worth oftheir assets is not concealed
by devices such as derivatives,shorting and leverage. Theseshould complement, not conceal,
product integrity.

“Chance favours only the prepared mind.”Louis PasteurMost innovations were overwhelmed by the credit crisis
The 2008 crisis hit all innovationsindiscriminately.
Even so, more than one in fourplans who responded to our survey
singled out five innovations as
having delivered most value overthe last decade.
These are: emerging market
equities, emerging market bonds,
high yield bonds, LDI and ETFs.

Three factors contributed to theirrelative success, according to ourpost-survey interviews.
First, they had the skill sets andgovernance structures to capture
intrinsic value created by uniqueconditions: e.g. rise of BRIC
economies, the acceptance of non
investment grade debt, availabilityof de-risking tools, and theappearance of low cost means to
get market exposure.
Second, the timing of their moves
was broadly right. From pastexperience, DB plans had learnt thatthe success of their investment calls
had as much to do with timing aswith inherent quality, especially soin a decade that experienced two
fat-tailed events.

In the last decade, which innovations in the three subsets delivered most value to DB clients andwhich delivered least value? Which ones will experience further innovation that will benefit clients overthe next three years?
% of respondents from the pension plans’ survey
40 30 20 10 0 10 20 30 40 50 60

Experience
furtherinnovation
24

NEW ASSET CLASSES:
Emerging market equities
Emerging market bonds
High yield bonds
Global equities
Private equity (including infrastructure)
Real estate (including REITs)
Commodity funds
Convertible bonds‘Covered’ bonds
Currency funds

23
11
19
26
23
29
11
11
14

NEW ASSET ALLOCATION TECHNIQUES:ETFs
Global tactical asset allocation
Unconstrained mandates (benchmark agnostic)
Hedge funds
Index-plus equities
Distressed debt
Structured products

13
20
36
17
20
11
11

NEW HEDGING & RETURNS-ENHANCING TOOLS:
Liability driven investments
Derivatives for hedging unrewarded risks
Portable alpha
Shorting
Leverage

33
30
19
16
7

Delivered least value

Delivered most value

Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“There’s no free lunch indiversification. You need clear
beliefs rather than blind faith in
ex ante numbers.”

19“ETFs allow you dynamic asset
allocation at low cost and fullliquidity.”“Correct timing has turned highyield into a great hit. From here on,
it’ll do no better than coupon.”

58%

32%

40%

put emerging market equities
at the top

put emerging market
bonds second

put leverage at the bottom

Third, they chased opportunities
that chimed with their gut beliefs(see box below). These were
instrumental in giving themprime mover advantage before
opportunities were arbitraged away
by newcomers.

currency – came unhinged. Theiridiosyncratic risks were crushed by
the systemic ones.

they were less awareof the limitations of theirinvestment choices.

Likewise, after a brilliant decade,global equities lost their bloom withthe 2000-02 bear market. For some
pension plans in Australia, they
worked well. For their peers in the
US and the UK, they did not.

Looking ahead, DB plans want
their asset managers to improvethe design features of theirofferings, not invent new ones.

At the other extreme, fiveinnovations delivered least value,according to one in every four plans.
These are: leverage, structured
products (guaranteed equity bonds),
portable alpha, currency funds
and global equities. Three different
factors were at work.
To start with, leverage andstructured products tried tosqueeze value from their underlying
assets - where there wasn’t much.
Nor was there much alpha to port.
Strategies that were meant to thriveon volatility – e.g. hedge funds andAnother factor was herd instinct
on the part of pension plans. New
asset classes and tools either
reinforced their behavioural biases
in some cases or countered themin others. Many plans went into
alternatives when their peak returns
were history. Nor did they have thegovernance and skills to monitor theuse of complex tools like leverage,
shorting and derivatives.
Finally, their engagement with asset
managers was low to the extent that

They want asset managers to
do a few specific things: seek
governance improvements inemerging markets where corporates
are seen as being run mainly forthe benefit of the country rather
than their shareholders; develop
deeper insights into the risk-return
features of all asset classes at amore granular level and the intercorrelation between them; andcreate a distinct overlay of humanjudgement on all risk models so as
to manage systemic risks.

A view from the top…
Two bear markets in a short span of a decade destroyeda large chunk of pension assets worldwide. The market
recovery since then has helped.
Our most important lesson was that, unlike physicalinnovations, investment innovations are at the mercyof the prevailing market conditions. They do not deliver
predictable outcomes; they cannot be pre-tested in a lab;they do not carry a fit-for-purpose certificate.
We use internal and external managers. Some of ourinnovations have been very successful. They aimed
to identify price anomalies prevailing at various times
and exploited them by buying low and selling high.
The resulting success has relied on intuiting how otherinvestors are likely to respond to new developments in thelight of their well-known behavioural biases.

Accordingly, we rely on our seven time-honoured
beliefs: timing is everything; risk generates returns;
diversification works; new asset classes and tools create
prime mover advantages; liquidity erodes the risk premia;
active management works; and, above all, asset allocationis the alpha behind alpha.
Arguably, many innovations have come when these basics
have been ignored: new fixes for old foibles. No wonder;some worked, others didn’t work.
For us, emerging market equities and high yield bonds
have delivered great value, as have catastrophe bonds,
infrastructure and private equity. Apart from the righttiming, we followed four guiding principles: invest only
if you know when to exit; control costs as they are a key
source of out-performance; chase only a small numberof risk premia at any time; and avoid fads.
~ A Dutch pension planInterview quotes:“Sentiments drive mostinvestments. Wishing forpredictable outcomes is an
ideal dream.”“Herd mentality often ignores
investment basics. Common sense
has not been that common.”“Far from amassing the predicted
US$3 trillion by 2010, the 130-30
funds flopped due to ill timing
and limited capacity.”

20

The latest generation of DC products will morph for the better after
the crisis
As background, worldwide, thechallenges faced by DB plans
multiplied over the past decade
accelerating two trends: closures
to new members and the switch
towards DC plans. This switch willcontinue in this decade. Ever moreprivate sector DB plans– especiallyin Canada, Ireland, the UK, andthe US – will close completely, withbalances switched into DC productsof members’ choice. DC plans will
come of age.
Currently, however, there aremarked differences ininvestment choices both within
and between countries.
In some countries, DC plans are
privatised: members make thechoices and bear all the risks.
Australia, Hong Kong, Ireland,

Japan, Sweden, the UK and the US
fall into this group.

The latest innovations in the DC
space are nascent. Currently, theytarget investors in the first group
and, to some extent, the second.
They embed advice andtarget solutions.

The second group covers countries
where plans are run by trustees,
who mostly target relative
returns, with members bearing
all the risks. Examples include
Australia, Brazil, Chile, Denmark,the Netherlands, Singapore,
South Africa and Sweden.

So far, four innovations havebeen notable (chart below):
diversified growth funds, blending
different asset classes withperiodic rebalancing towards
new opportunities; target dateretirement funds, following an
age-based glide path that replaces
aggressive equities with cautious
bonds over time; target risk funds,
following a pre-agreed risk profile;and customised plans, offering
advice and a dynamic risk profile.

The third group comprises
countries where plans are run byemployers, who not only makeinvestment choices, but are also
legally obliged to protect the valueof contributions against major
market events. Examples include
Denmark, Germany, Switzerlandand France. They mainly use
insurance contracts.

In the last decade, which innovations delivered most value to DC clients and which delivered least
value? Which ones will experience further innovation that will benefit clients over the next three years?
% of respondents from the pension plans’ survey
25

20

15

10

5

0

5

10

15

20
Experience
furtherinnovation

NEW ASSET ALLOCATION APPROACHESDiversified growth funds

13

Target date retirement funds

27

Target risk retirement funds

27

Customised investment plans

30

Delivered least value

Delivered most value

Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“Trustee-run plans are either
overly cautious or overly reliant onbull markets. Neither adds value
over time.”

21“There’s a detailed scrutiny ofwaterfall strategies when some2010 target date funds lost 40%
in 2008.”“By exposing their design faults,
the credit crisis has acted as acatalyst for improvements in theexisting DC products”.

16%

14%

10%

put diversified growth funds
at the top

put target date funds second

put customised plans at
the bottom

As yet, none have proved especiallysuccessful, as the chart shows.
The collateral damage from the2008 meltdown is the main reason.
None have design features that canwithstand major market events.
That does not detract from theirintrinsic worth.

accumulation and decumulation
options in order to attract evermore assets from trust-based plans.

a bad press due to their all-ornothing nature. After the crisis,
they have become even lessattractive: counter party risks haveinflated the re-insurance rates.

After all, left to their own devices
in the past, members made wrong
choices; chasing the fads; often
buying high and selling low. Greater
choice ended in causing confusion.
However, the DC product pipeline islikely to improve in this decade with

The ageing population will be
another contributory factor. Overthe next 10 years, ranks of retirees
will swell by some 80 million in
America, some 75 million in Europe,some 20 million in Japan andsome 3 million in Australia: with acollective pot in excess of a mouthwatering US$15 trillion.
Yet, there is a dearth of decent
retirement products. Even before
the credit crunch, annuities had

Now only three countries in
the world have compulsory
annuitisation: Chile, Switzerland
and the UK. The last plans todiscontinue it in 2012.
Many OECD countries arecontemplating a form of compulsion.
But not much action is likely overthe next three years. We return to its
implications on pp.33-34.

A view from the top…
Just how good are Australian superannuation funds? How
many of them have the ability to attract funds as a resultof what they offer and not just as a result of compulsion?
My answer is ‘not many’.

design; reduce fees and increase alignment; go passive
when appropriate; take different investment bets; get abetter measure for risk; improve currency and cash flow
management; and introduce life cycle investing.

In fact, despite the absolute amount of money in industry
funds and retail funds growing each year, the market
share of both these funds has been falling. So much sothat now there is more money in self-managed super thanin industry funds and retail master trusts combined.

This desire for life cycle investing is universal. For
example, Hong Kong has followed the US in letting
members of its Mandatory Provident Fund makeinvestment choices under the so-called Employee ChoiceArrangement; this is in the belief that the bigger the
choice, the lower the cost. Costs have not come down.
Members continue to chase the latest fads.

This is because the supers are paralysed by perceived
business risks and the mediocrity that results froma desire to be average. There is a morbid fear ofunderperforming the next guy and losing AuM or
members. That’s why there is so little switching between
funds even after the great financial crash. Isn’t itinteresting that in a low switch environment, selfmanaged funds are flourishing? Clearly, in theory, supers
are a good tax-efficient way of achieving a retirement
outcome. But they have lost their primary aim: to deliver
decent retirement incomes.
Going forward, therefore, they need to do nine things
to counter the criticisms in the recent Cooper Review:de-emphasise peer-risk; use dynamic asset allocation andportfolio insurance to align time horizons; enhance fundIn contrast, the trust-based DC plans on the Continent
offer minimal choice to their members. But in the handsof inexperienced lay trustees, choices have involved
insurance contracts (Germany and Switzerland) or
deferred annuities (Denmark and France).
There and elsewhere, DC plans suffer from design faults
and excessive charges. For example, the Dutch DC plansdeliver 50% higher retirement benefits than their UK
peers due to lower charges and more risk sharing. In
the US and UK, poor asset allocation choices have costinvestors dear in the last decade. Plan balances arepathetically low, even after two decades of investing.
~ Australian pension consultants

Interview quotes:“Unless DC plans embody someof the attractive features of DBplans, they will follow the same
death road.”“Like the internet, retirement
products will morph for the better,
after a messy start.”“Today’s US$9 trillion global DC
market will have 10% CAGR in
this decade.”22

Since the crisis, asset managers score relatively well
We asked pension plans to assess
the value added by managers
and consultants in their 10 core
activities. Taken as line items, asset
managers are rated as ‘good’ or‘excellent’ in five of them by atleast 50% of respondents. The
corresponding figure for pension
consultant is only one. Assetmanagers out-score consultant
in 8 out of 10 categories. In the
top 6 value added activities –strategic asset allocation, manager
selection, portfolio construction,
stock selection, risk management
and investment returns - asset
managers do better as well. Notably,the ‘excellent’ rating is awarded by
no more than 12% of respondents toany single item in the chart below.
The scope for improvement is big.
These numbers are symptomaticof the problems that pension plans
have experienced as they haveprogressively switched to liabilitiesmatching in the wake of past losses
and subsequent accounting rules.
In the bull market of 1986-2000,
DB plans had targeted equity risk
premium – typically 5% – as an end
in itself in the hope that it would
meet their future liabilities. In thelast decade, as the risk premium
dried up, there was a reversal:
liabilities became the ends andinvestment the means.

As a pension plan, how would you rate the contribution of your asset managers and pension
consultants in helping to meet your investment goals over the past three years?
Cumulative % of respondents from the pension plans’ survey
90 80 70 60 50 40 30 20 10 0 10 20 30 40 50 60
CONTRIBUTION BY ASSET MANGERS:
Portfolio construction and stock selection
Manager selection
Strategic asset allocation
Risk management
Access to new investment insights
Returns on your investments net of fees & charges
Listening and understanding each client’s unique needs
Tactical asset allocation
Fiduciary management/strategic partnership
Asset-liability modelling
CONTRIBUTION BY PENSION CONSULTANTS:
Listening and understanding each client’s unique needs
Asset-liability modellingManager selection
Strategic asset allocation
Access to new investment insights
Risk management
Returns on your investments net of fees & charges
Portfolio construction and stock selection
Fiduciary management/strategic partnership
Tactical asset allocation

1

44

16

51

4

30 53

1

9

37 48

6

14

33 47

6

7

43 47

7

3

48 37

8

46 33

11

10

47 35

13
27

5

42 27

39

45

4

4
12

38 48

4

10

38 45

13

4

39 48

12

1

45 43

12

0

49 37

13
18

55 26

17

58 25

1
1

0

17

60 23

0

18

60 20

2

59

24

Poor

Mediocre

16

1

Good

Excellent

Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“In 2005, most of alpha wasleveraged beta. Why couldn’t ouradvisors see that?”23“Successful innovations must
reinforce investment basics, notignore them”“How many pension consultants
have ever managed money?
There’s the world of ideas and theworld of practice.”

58%

55%

83%

give highest acceptable rating topension consultants for any one item

give highest acceptable rating toasset managers for any one item

give lowest rating to pension
consultants for any one item

This switch towards goals-oriented
investing has also been evident
in DC plans where solutions haveemerged in different guises in thelast decade (see case study below).

asset classes. As the risk universe
expanded, asset allocation had togo dynamic. Paradoxically, factorsthat caused it are also the ones
making it hard to implement.

different asset classes. In thiscontext, two points were repeatedly
made by pension plans involved in
our interviews, especially in Asia.

It became inevitable as two
traditional pillars of asset allocation
were weakened by systemic forces:
the buy–and-hold strategy was
not working, as equities were
outperformed by bonds; nor was
the core satellite model, as actual
returns diverged markedly fromexpected returns for mostAsset managers and pension
consultants need fresh insights into
three factors on which successful
dynamic asset allocation now
depends: the causes, symptoms andconsequences of systemic risks;
the risk-return features of different
investments at granular level; andchanging correlation between

First, the current generation ofrisk models used by managers andconsultants overly relies on therear view mirror. They can neither
predict risks nor help mitigate
them. Second, if they are to develop
the necessary insights, asset
managers need to focus on theircore capabilities and not stray too
far in their innovation efforts.

A view from the top…
Our funding ratio has dropped from 104% to 89% since2007. One lesson we’ve learnt is that everything in thename of innovation carries a ‘health warning’.
Ten years ago, our DB plan was closed to new members.
Lately, we have launched a programme of dynamic LDI
which immunises risk in distinct tranches as and when
our funding ratio recovers. We have cast off the slaveryof market benchmarks and focused on liability matching.
The returns-seeking portfolio is a blend of equities, bonds
and alternatives. Risk is back on the table. It’s the only
remaining way of attacking the deficit, after having raised
the retirement age and the contribution rate.
On the DC side, we’ve have moved towards solutionsdriven investing by offering four options: capitalpreservation, excess over cash, wealth accumulation via
diversified growth funds and balanced funds.
As a result, we’ve had extensive contacts with asset
managers and pension consultants in the past 3 years.
In their separate ways, they have been constructive andhelpful. But history teaches us that, in the globalised
world of investing, the unexpected often happens. By
definition, Black Swans are impossible to predict. The
least that asset managers and consultants can do is tostress test their ideas under extreme economic, politicaland physical scenarios. They also need to go back inhistory and understand the intricate interplay between

three variables that have longed moved markets indifferent periods: growth, inflation and interest rates.
The models currently in use are overly backward-looking
and do not capture subtle nuances of the evolving
investment landscape where systemic risks are springing
up from unexpected quarters: e.g. the sovereign debt
crisis and political upheavals in the Middle East. The
models need a strong overlay of human judgment.
Finally, our move towards a solutions-driven world isunderpinned by a variety of investment approaches thatcan be classified into distinct buckets such as hedge
funds, infrastructure, absolute returns, total returns,
illiquid assets, ETFs and so on.
On their part, asset managers and consultants need todevelop distinct capabilities in each bucket. Many don’t
have USPs other than a physical market presence.
Hitherto, the tendency has been to shift effortlessly
between some of these buckets, as if they were fads thatneeded the same skill sets. That’s untrue.
During 2004-07, the convergence between mainstream
and alternative strategies lost us money. All innovationsin the mainstream area have been derivatives of equities
and bonds. A new asset class will not solve anything.
~ A UK pension planInterview quotes:“Those who present numbers are
rarely without bias. Besides, thepast rarely foretells the future.”“After paying layers of fees,
investors don’t know what they will
get and when they will get it.”“Nothing short of a gold standard
in client engagement will restore
trust. We need clarity on returns
and charges.”

24

The current deficits of DB are large enough to force a raft of non
investment as well as investment solutions
Roughly two out of every five
respondents to our survey currently
have funding levels above thestatutory watermark. The rest are
below it. Around 20% are below
80% - some as low as 50% (charton the left below). At the surface
level, therefore, three out of fiveplans are under funded.
The figure is an underestimate,
however, since many of the largest
plans are below the watermark.
Furthermore, in jurisdictions likethe Netherlands, the watermark is105% and rises with the riskiness ofassets in the portfolio.

are worse than indicated bysimple averages.
The same observation applies to theannual average returns targeted byour respondents in order to meettheir long term liabilities (chart on
the right).
Around a third target up to 5%;
a further third between 5.1 and
6.5%, and another third target
6.6 to 8.0%. Only 2% target in
excess of 8%.
These numbers are optimistic,
too. For only the private sector
pension plans in Europe are
obliged to follow the mark-tomarket rules which enjoin themHence on an asset-weighted basis
or risk-adjusted basis, the deficits

to use a conservative discountrate to calculate the present valueof their future liabilities. The rest
use rates that are less cautious.
They inadvertently understate theliabilities as well as the projected
investment returns to cover them.
These observations serve tounderline the important point:
numbers don’t tell the full story.
Be that as it may, pension
plans have been forced to act
on two fronts: investment andnon-investment.

If you offer a DB plan, what is your current funding level? What annual total returns on yourinvestments would meet your long term funding needs?
Funding levels

Target returns
2%
20%
30%

40%

36%
18%

32%

22%
Below 80%

91—100%Up to 5%

6.6—8.0%

81—90%

Over 100%

5.1—6.5%

Over 8%Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“Corporate DB plans in the US
are going into LDI-lite by using
Libor bonds: swap spreads are not
attractive.”

25“Endowments invested in illiquid
alternatives are setting up credit
lines to avoid forced selling, if
markets tumble.”“The Dodd-Frank Act will not
reduce systemic risks: chances ofpolicy mistakes are high with thecurrent debt mountain.”

40%

20%

38%

of DB plans have funding
ratio of over 100%of DB plans have funding
ratio below 80%

of DB plans need annual
returns in excess of 6.5%

On the investment front, more andmore of them are adopting assetliability optimisation. This means
giving up the tyranny of benchmark
hugging – both peer and market– and using liability as the coretarget. It means putting money
into buckets that encompass a
range of distinct approaches. These
single out liquid from illiquid funds;
capital preservation from capital
growth; and market-returns fromexcess-returns.

and investment experts on totrustee boards.

the cash balances route (casestudy below).

On the non-investment front, aseries of small changes have also
been implemented since 2005, on
top of the closure of DB plans to
new members.

These changes have been more
pronounced in the US, the UK,
Canada and Ireland. However,changing old entitlements is proving
hard. Piecemeal changes and messy
lawsuits will be the norm.

To cope with the resulting
governance needs, more and moreplans are recruiting in-house CIOs

These include raising the retirement
age and member contribution rates.
Benefits based on final year salary
are being replaced by ones based on
career average salary. Discretionary
indexation has been introduced.

In contrast, in other big DB markets
like Japan and South Korea, nonotable revisions are anticipatedto the benefits structure pending
adoption of mark-to-market rules.

Before long, many plans will close
to existing members, too, by using

A view from the top…
A pension promise is easy to make but expensive todeliver. Nowhere is this more evident than in the US
where the state and municipal pension plans are currently
nursing unfunded deficits well in excess of $2.5 trillion.
Some have 50 year recovery plans.
Four key items are on the negotiating table: later
retirement age, higher employee contribution, no
automatic indexation, and a pension based on theemployee’s career average, rather than final year,
salary. These changes are easier said than done at atime when pension entitlements have been hardwired
into employment contracts for over half a century andan ever higher proportion of people’s lives are spent inretirement. Lawsuits have been frequent, especially wherea significant minority have already retired on terms thatare being denied to those who follow them. Pension plans
are left with two actions: prune the benefits and maketheir assets sweat harder. In line with national trends, via
small steps, we have negotiated an employee contribution
where there was none before; dispensed with indexation
altogether which provided a 3% protection; and raised theretirement age by two years. Welcome though they are,these changes will improve our funding rates by only 8%
when they bite in earnest over the next 10 years.
In the meantime, we’re changing our investment
approaches. Our sponsor covenant risk is at its all timehigh, after making a series of one-off cash injectionsof over $3 billion over the past ten years. Recently, thesponsor decided to switch to mark-to-market rules inadvance of their implementation in the US in 2012, so as
to write off past losses in one go, as a prelude to starting
an LDI programme.
The sponsor is also investigating the possibility of turning
the DB plan into ‘cash balances’ for individuals, following theprecedent set by a US-based global IT giant. The idea is to doa big one-off cash top-up, distribute the fund to its members,
encourage them to re-invest in 401k vehicles of their choice,and thereby transfer all risks – especially investment,
inflation and mortality. What was unthinkable five years ago
may well become common five years from now.
~ A US pension planInterview quotes:“Without reduced benefits andincreased retirement age, few DB
plans have any future.”“More and more DB plans arerecruiting in-house CIOs andexperienced investors on
the board.”“No major regulations are plannedin the US. But there is a lot of
reinterpretation of the old rules.”26

Pension plans want to see significant improvements in product featuresthat impact directly on their bottom line
As we saw on p.20, pension planswant improvements in a numberof investment strategies and tools.
Four features have been citedby at least one in every three
respondents: risk return tradeoff (60%); fees and charges(52%); transparency (44%);and simplicity (32%).

economy remains vulnerable tofrequent systemic shocks: e.g.
rapid deleveraging and currency
wars. They will create frequent
bursts of risk-off/risk-on activity
that ignore fundamentals, as
witnessed since the middle of2009. Investors can only makemoney by taking big risks.

Monday in 1987; the collapse ofcommunism in 1989; the collapseof LTCM in 1998; the collapse of
Enron in 2001; and the Iraq war in
2003. Many plan sponsors missed
these opportunities because they
were unable to act on the pricing
dislocation due to capital calls,
fears and queues.

If there was one recurring message
in our post-survey interviews, it wasthat risk failed to generate return inthe 2000s, giving rise to two camps.

The glass-half-full group holds
that the periodic shocks canalso be a blessing in disguise formanagers with instincts to exploit
them. Some of the best returns
in the past came in periods ofmajor upheaval: e.g. meltdown

Asset managers with trained
intuition should be able toextract higher returns per unitof risk in today’s environment.
This should be the golden ageof active management.

The glass-half-empty group holds
that investment returns will follow
a random walk while the global

In which areas do asset managers and pension consultants need to make significant improvements,
if they are to receive mandates from your plan in future?
% of respondents from the pension plans’ survey
0

10

20

30

40

50

60

ASSET MANAGERS:
Risk-return trade off
Fees and charges
Transparency
Simplicity
Client communication and engagement
Customisation
Volatility
Liquidity
PENSION CONSULTANTS:
Fees and charges
Plan design (with respect to DC plans)Manager selection
Asset allocation
Governance expertise
Client communication and engagement
Transparency
Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“Asian plans demand a strongrisk overlay as a pre-condition
for diversification out ofgovernment bonds.”

27“A rise of each 1% point in interest
rates improves our funding ratioby 14%, so unreal are the pension
accounting rules.”“Consultants are forcing the paceon fee compression on behalf of
their clients.”

60%

51%

44%

want improvements in therisk-return features

want improvements in fees
and charges

want improvements intransparency

Additionally, pension plans wantmore transparency in investment
products, so that their intrinsic
worth is not obscured by devices likederivatives, shorting and leverage.

Indeed, the glass-half-fullschool also holds that their highwatermark variant will be a key
disruptive innovation of this decade.
It will force managers to be distinct
by exploiting their core capabilities.

as geographies in ways that could
potentially benefit asset managers
in the West. Once they embark on
a more realistic valuation of their
liabilities, diversification will follow.

As for fees and charges, pension
plans see them as a key source ofout-performance over time. The
current heads-I-win, tails-you-lose
fee structure is coming underincreasing pressure from pension
plans and their consultants alike,as reported in our 2010 report.
Performance-related fees are dulyon the rise.

This was especially emphasised by
Asian pension plans, noted for theirhome bias and conservative choices(case study below). In South Korea,
for example, the largest pension
plans already own a large chunkof domestic equities and bonds.
They and their regional peers want
to diversify by asset class as well

However, as pre-conditions, theywant to see improvements in theexisting products and their pricetags. They also want Western
managers to have amanufacturing presence in Asia
to improve their client proximity
and market understanding.

A view from the top…
Institutional investors in Asia Pacific are very risk averse.
For example, hedge funds have yet to score in thisregion, outside Japan. Even in a sophisticated market like
Australia, equities and bonds predominate. Elsewhere,
tools like derivatives, leverage and shorting are eitherbanned or shunned. Behavioural biases play a part, too.
For example, pension plans in Japan prefer passives overETFs, being cheaper.
Overall, Asia Pacific significantly trails behind the US
and Europe in three major areas: diversification into
alternatives, adoption of new asset allocation tools, anddeployment of returns-enhancing techniques like shorting
and leverage. Local pension plans have yet to adopt themark-to-market rules that have forced their peers in theWest to be more innovative. In China, Japan, South Korea
and Taiwan, asset allocation is governed mostly by local
regulations or peer pressures.
There is a lot of talk about reforms across Asia. But it issafe to assume that changes will be slow and measured.
In the meantime, we shall continue to diversify. But it will
not be radical until we see improvements in the integrityof the products manufactured in the West. Looking
through the prism of the East, innovations in the Westhave not worked with the degree of consistency that we
expect. They seem to have favoured asset managers morethan their clients.
Our diversification will continue to progress along two
distinct tracks: strategic stakes and portfolio investments.
The first will focus on long-term assets in Africa, Europe,
Latam, and North America that can deliver stable cash
flows over 20-30 years on the one hand, and continuityof raw material supplies on the other. The second track
will focus on emerging markets. Asia will be the sourceof alpha as well as assets. But attempts to gather assets
here are more likely to succeed if asset managers have
manufacturing capability on the ground, especially if theywant to be ‘price makers’ more than ‘price takers’.
Even for top down investment strategies, we would likeour asset managers to be in our time zone. As Asia’s
growth re-shapes the dynamics of the world economy, it
will also influence the top down macro strategies now run
from centres like London, Paris and New York.
Client proximity is essential as we promote financial
literacy directly and a buy-and-hold culture indirectly.
~ A Chinese institutional investor

Interview quotes:“We have small allocations totimber, catastrophe bonds andmusic rights: good opportunities
are rare.”“Success will go to those withinsights into how to apply
investment basics in an age of
fat-tailed risks.”“Hedge funds will become
bigger, safer, duller and cheaper,
after their near-death experiencein 2008.”28

4 Room for improvement“Unlike computersor cars, asset
products do not have
replicable outcomes
and definable shelflife, irrespectiveof their external
environment.”

IssuesIn a separate survey, asset managers
and other service providers suchas pension consultants, third party
administrators and distributors wereasked the following questions:• which innovations delivered
best/least value to the endclients in different segments inthe last decade?
• which factors influenced
the outcomes?
• what is the current thrust ofinnovation and what factors
are inhibiting it?
• what actions are being taken
to deliver better innovation in
the future?

• Responses to the first twoquestions were classified by threeclient segments: DB plans, DC
plans and retail clients.

Key findings• For DB plans, innovationsdelivering most value are
emerging market equities, ETFs,
emerging market bonds, highyield bonds, and LDI.
• The list is similar to the one
identified by pension plans in thelast section. The contributory
factors are: timing of investments
and the negative perceptions oflong only actives• Those delivering least value
include: structured products,
leverage, portable alpha, private
equity and currency funds.
The list is similar to the one
compiled by pension plans in
Section 2; the only missing item
is global equities.
• Contributory factors are alsosimilar: lack of intrinsic value,poor timing and herd instinct
on the part of investors.
The only one missing is low
client engagement.
• Asset managers recognisethat their pension clients want
better returns, lower costs
and more transparency formany of their products.
• However, they doubt whether
these can be delivered over the
next three years.
• Returns come from the market
environment as much as
managerial ingenuity; cost
reductions are hard in a fixedcost people business that cannot
be leveraged in a flat market;
and too much transparency risks
dumbing down returns.
• However, as we shall see below,
asset managers are attempting
to improve their innovative
capability in response to
demands that directly impact
on their clients’ bottom line.
• Moving on to DC products, noneof the new ones that first cameon line in the last decade is rated
highly. Given their long-term
nature, however, it is too early
to judge, especially after such amajor market event.
• But they will morph, due tochanges now in the works anddeliver probably one of the mostdisruptive innovations of thisdecade – in the sense of changing
the existing models for the better.
• Retail innovations are mainly
perceived as copycats. None is
rated particularly highly, withstructured products perceived
as delivering the least value. But
there is a caveat.

• These are caused by: growing
product commoditisation;
mounting uncertainty in the
global economy; continuing
behavioural biases on the partof clients; a growing scarcity
of talent that can cope withthe random bumps in today’s
markets; and regulatory creep
powered by new rules as well as
the re-interpretation of the old.
• Asset managers are respondingby re-engineering theirinnovation approaches; adopting
new tools for generating ideas,organising talent in small groups;
and using their service providers
as innovation partners.
• In the process, product deepening
ranks higher on the agenda than
product widening: improving theold, before creating the new.

• New theme funds – like ESG, SRI
and Shari’ah as considered here
- also deliver psychological valuethat is difficult to assess.
• Fresh headwinds are shifting
the focus of innovation fromcreating new things to doing old
things better.

“Everything that can be invented has been invented”
Charles H. Duell, US Commissioner of Patents, 1899

Like their clients, asset managers caution against throwing theinnovation baby out with the bath water
In a separate survey, when asked
which innovations delivered most/least value in the last decade totheir DB clients, asset managers’
choices are roughly similar to
those identified by pension plans(Section 3). According to one infour respondents, the following
delivered most value: emerging
market equities (39%); ETFs (28%);
emerging market bonds (26%);high yield bonds (24%); LDI(24%); hedge funds (24%);and unconstrained mandates(24%). Two contributory factors
were singled out.
The first was timing of investments.
For example, the legendary
dynamics of emerging markets
sparked a momentum that
attracted over US$1 trillion. Roughly
three-quarters was opportunistic;

and one-quarter buy-and-hold;causing frequent big corrections.
Similarly, the right timing also
helped high yield bonds, when the
much-predicted spike in default
rates did not materialise in thewake of the Lehman collapse.
The second contributory factor was
the negative perception of long only
active management, in the face ofrising pension plan deficits.

In the last decade, which innovations in the three subsets below delivered most value to DB clients
and which delivered least value? Which ones will experience further innovation that will benefit clientsover the next three years?
% of respondents from the asset managers’ survey
30 25 20 15 10 5 0 5 10 15 20 25 30 35 40
Experience
furtherinnovation
29

NEW ASSET CLASSES:
Emerging market equities
Emerging market bonds
High yield bonds
Commodity funds
Global equities
Private equity (including infrastructure)
Real estate (including REITs)
Currency funds
Convertible bonds‘Covered’ bonds

21
10
24
18
18
13
11
4
6

NEW ASSET ALLOCATION TECHNIQUES:
ETFs
Hedge funds
Unconstrained mandates (benchmark agnostic)
Global tactical asset allocation
Distressed debt
Index-plus equities
Structured products

23
21
27
22
8
10
10

NEW HEDGING AND RETURNS-ENHANCING TOOLS:
Liability driven investments
Derivatives for hedging unrewarded risks
Shorting
Leverage
Portable alpha

26
25
10
5
13

Not delivered value

Delivered value

Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“Most products add value at one
time or another – even derivatives.
It’s all a matter of where you are in
the market cycle.”

31“Leverage was the prime source ofout-performance while the going
was good. It worked until it didn’t.”“High yield bonds sparkled
while the default rates declined.
Now what?”

39%

28%

26%

put emerging market equities
at the top

put ETFs second

put structured product atthe bottom

Turning to the innovations thatdelivered least value, five topped
the list: structured products (26%);
leverage (22%); portable alpha(18%); private equity (17%); andcurrency funds (17%). The list issimilar to the one identified bypension plans (Section 3), with
global equities missing.

As for improvements, asset
managers recognise that clientswant better risk-return tradeoffs, lower costs and greatertransparency for many of theirproducts. There are doubts whether
these can be delivered over the
next three years: the trade-off isa matter of market environment
as much as managerial ingenuity;
cost reductions are hard in what isa fixed cost people business; andmore transparency may undermine
the competitive edge. Even so,
managers are improving theirinnovation processes (pp.39-40).

They are responding in otherways, too: e.g. emerging markets
are segmented by size, economic
development and risk profiles; theReits structure is being applied toreal estate and infrastructure to
improve their liquidity; hedge funds
are being revamped to improveliquidity, charges and fees. Overall,
the focus is on improving the oldrather than creating anew.

Notably, the contributory factors
cited by asset managers werealso similar to those singled out
by pension plans: lack of intrinsic
value, poor timing and herd instinct
on the part of DB clients.

A view from the top…
We have invested in long only as well as alternatives, inevery asset allocation technique and every risk enhancing
tool. We’ve used external managers as well as in-house
ones. You name it, we’ve done it. Some of our innovations
have worked well, some haven’t. Overall, we could havedone better.

asset values and asset correlations alike. When it dried up
in late 2008, few innovations could weather the storm.
So, a charitable view would be that innovations in the last
decade were inadvertently adopted in an environment
alien to their inherent features. They were at the rightplace at the wrong time.

To start with, investment is more nuanced now than ever:opportunities disappear only as fast they appear. We
implemented the Yale model only to discover in hindsightthat its peak returns were history by the time we moved
in. With alpha, he who dares first, wins; or so it seems.
It involves real time investments that only work within
nimble governance structures with a lot of delegatedauthority to full time professionals.

Most of all, we have discovered that it is inadvisable tojudge the success of innovations on the basis of theirmarket-beating abilities. The cap weighted indices – thede facto judge and jury of active strategies - sufferfrom momentum and concentration risks to the point
where they no longer represent the intrinsic value of
their component stocks. On the bond side, too, indicesrepresent neither the vast fixed income universe nor the
regular turnover forced by the differing maturity profileof the constituents.

In contrast, today’s governance structures remain
suited to the world of long only investing. In any case, a20-year bull market since 1981 lulled us into a sense ofcomplacency that any bear market will be brief, mean
reversion is the norm, and innovations the saving grace.
You can’t blame us for believing that, since even the thenGovernor of the Federal Reserve repeatedly played down
any threat of systemic risks, at the time, when the global
economy was awash with cash that severely distorted

Accordingly, we use the traditional 4-factor risk model
to construct the true value of beta and use it as abenchmark for assessing the value added (or detracted)
by our innovations. The results are not spectacular. But
they caution against throwing the innovation baby out
with the bath water.
~ A Scandinavian pension planInterview quotes:“How do you price an ETF whenliquidating a whole index? What isthe price discovery mechanism?”“LDI has not taken off in the US
due to low funding levels andreluctance to use long-dated
swaps with counter-party risks.”“Clients want liquid products from
illiquid assets. It is like sprinkling
magic dust to create a liquid fairy.”32

DC products will undergo significant improvements
In the last decade, substantive
innovations in the DC space came
via four new products: diversified
growth funds, customised
investment plans, target dateretirement funds and target risk
retirement funds, as describedin Section 3. Originating in theUS, each sought to embed asset
allocation advice, in the light ofclients’ pre-stated risk appetite andretirement preferences.
Before their arrival, the two key
private DC markets – the US andthe UK – were beset by two
daunting problems.
First, as employers switched fromDB to DC plans, there was no auto
enrolment for new members:
participation rates fluctuated from
50% to 70%.
In the US, this has been correctedby auto enrolment under thePension Protection Act 2006, which
also endorsed target date funds.
The UK will follow suit in 2012 via
the new state sponsored National
Employment Savings Trust.
Second, before then, most buyersof 401k funds in the US made wrong
asset allocation choices by opting
for top Morningstar funds – in initialinvestments and their periodic
rebalancing. For example, many
ended up overweight in tech stocks.
In the 2000s, the pursuit of thenext rainbow was just as prevalent:
the lessons from the tech debacle
were soon forgotten.
Much the same behaviours
were evident in the UK, where asignificant minority also went to theother extreme and invested in ultra
safe assets like bonds, insurance
contracts and cash plus products –with low returns and high charges.

The reforms have gone a long
way towards countering thesetendencies. In the process, the four
products in the chart below havebeen in the ascendancy. At thisstage of their evolution, however,
only around 15% of asset managers
rate them highly; and just as manyrate them lowly. The vast majority
in between reckon that, given
their relative newness, it is too
soon judge.
Those who rated them highly gave
two reasons. First, their inherent‘buy-it/forget-it’ feature prevents
ill-informed choices on the partof clients - both at the outset andover time. The buy-high/sell-low
mentality is increasingly a thingof the past; as is the urge to chasethe latest ‘hot’ stocks. Second, via
these funds, large 401k providers
have been able to mount effective
education campaigns on raising the

In the last decade, which innovations delivered most value to DC clients and which delivered least
value? Which ones will experience further innovation that will benefit clients over the next three years?
% of respondents from the asset managers’ survey
20

16

12

8

4

0

4

8

12

16

20
Experience
furtherinnovation

NEW ASSET ALLOCATION TECHNIQUES:Diversified growth funds

19

Customised investment plans

22

Target date retirement funds

24

Target risk retirement funds

20

Not delivered value

Delivered value

Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“German DC plans guarantee thevalue of contributions. Employers
remain liable for losses. So, capital
growth is tiny.”

33“DC plans using 60:40 structures
went for risk parity portfolios.
They’ve loaded up on fixed income
after its best run in history.”“Across Europe, DC results range
from a car crash to a walk in thepark, depending on your timeframe.”

16%

15%

14%

put diversified growth funds
at the top

put customised plans second

put target date funds thirdlevel of financial literacy on the partof private investors.

end. But it was over influenced by
the investor’s age.

Those who rated these products
poorly focused on theirmechanical nature.

Furthermore, it embodied few
tactical tilts in the belief that risk
premia were bound to accrue overtime; notwithstanding its history
over the past 10 years.

havoc on plan balances. For
example, in late 2008, certain 2010
target date funds were down by
40%. Some even had toxic credit
products dressed up as bonds.

Citing the target date fund as an
example, it was stressed that its
glide path was fine in principle: withaggressive equities at the outset
and cautious bonds towards theMost of all, it has no overt
mechanism to protect against
major market events that wreak

By general account, the DC
revolution is at a nascent stage.
New flows, new jurisdictions andnew regulations are already driving
improvements (case study below).

A view from the top…
DC products have come a long way in the US in the past
decade. But they still have a long way to go. As a leading
401k player, it is clear to us that clients want holistic
solutions at two distinct phases in their retirement
planning - accumulation and decumulation – to be rolled
into a single product.
In the accumulation phase, clients want a flexible variant of
the existing target date funds that sequentially provides:
advice on how to identify their own risk profile; choice togo cautious at the outset in the light of early loss aversion
and other commitments like marriage and mortgage;
choice to go aggressive once the plan balances build up
to a reasonable amount; choice to go cautious in theapproach to retirement; and, above all, an inbuilt stop-loss
mechanism – via physical limits, tactical tilts or deferredannuities - to counter major adverse market events. The
suggested product differs from the currently available
life style or life cycle funds by: providing a dynamic risk
profile as well as a dynamic glide path; and offering
protection against fat-tail risks as well as eschewing the
one-size-fits-all approach based on mechanical, age-based
or risk-based algorithms.
Then in the decumulation phase, retirees want a blended
solution embracing annuity income, income drawdown, insurance cover, spouse benefits and residual
wealth transfer on death. Specifically, they want theiraccumulated assets rolled over into a single ‘cafeteria
plan’ where benefits are available on a pick ‘n’ mix basis;
and where certain benefits are negatively correlated, sothat their total cost is less than the sum of the parts (e.g.
annuity and life insurance).
The product envisages part of the retirement pot to beinvested in an annuity to provide regular income andlongevity hedge; with the rest invested (or re-invested)
to generate income upside and some capital growth toaugment the annuity income. Alongside annuity, thepot should also be used to buy life and health cover, if
required. The cost of insurance cover should allow for thenegative correlation between annuity and the targeted
insurance cover.
This proposed product should mark improvementson the existing arrangement. It will counter the threenegative features of annuities, as perceived by clients:
their expense, their ‘all-or-nothing nature’ and theirzero balances for intergenerational wealth transfer.
Furthermore, it will provide an opportunity to grow theasset pot even after one has retired. Finally, it will be acost-effective way to enjoy insurance-oriented retirement
benefits by targeting scale economies in their delivery.
Asset managers have the tools to provide most of thecomponents needed in the two identified phases. The
biggest drawback, however, is that no insurance company
in the world today has the balance sheet to underwrite
the volume of annuities envisaged under such a product.
But that should not stop us providing other benefits. And
we will before long.
~ A US asset manager

Interview quotes:“DC products must embed advice.
If you want to see what lack offinancial acumen costs investors,come to Hong Kong.”“Today’s DC product will morphover time into something
more holistic. Most of the corecomponents are there in the US.”

“Given their long term nature, it’sunwise to make a judgement on
the latest DC products so soonafter the 2008 meltdown.”

34

Retail innovations are widely seen as copycats
Worldwide, the retail scene
witnessed rapid productproliferation in the last decade.
For example, the number of shareclasses more than doubled inEurope. Freshly minted products
were churned out at record speed
in an elaborate leapfrogging
exercise fuelled by distributors.

and mutual funds that deployedhedge fund type tools - both citedby around 15% of asset managers.
Tax efficiency and stable cash flows
were contributory factors behindthe modest success of the first; andbetter returns behind the second.

Elsewhere, the story was much thesame. Warren Buffett became therole model in places like Hong Kong,
India and Singapore, where daytrading had been the norm.
Not much was new apart fromseven mostly minor innovations,embracing new asset allocation
techniques and distinct themes(figure below).

However, at least as many managers
singled out five innovations thatdelivered least value: structured
products, social funds, religious
funds, environmental funds andmutual funds that used hedge fundtype tools.
Either way, there are no standouts.
Our post-survey interviews exploredthe reasons.
First, as the decade progressed,
the underlying weaknesses ofthe mutual fund model became
glaringly obvious. On top of its

The two that delivered most value
were income-in- retirement funds

hidden charges, it rarely closed
funds, despite the limited scalabilityof many of the underlying
strategies; nor did it generate ‘sell’signals or rebalance in favour ofcash beyond the 10% threshold.
These limitations forced hugeredemptions in the down market.
Accordingly, innovations in themutual fund space have admirers
and detractors in equal measure.
Newcits have gained traction lately
but it is too soon to assess theirimpact due to their newness.
Second, structured products
experienced an explosive growth,thanks to a strong productpush from banks, using theirown distribution channels. The
guarantees on offer were dubious
and the charges high. Currently,
they are being re-branded as income

In the last decade, which innovations delivered most value to retail clients and which delivered least
value? Which ones will experience further innovation that will benefit clients over the next three years?
% of respondents from the asset managers’ survey
25 20 15 10

5

0

5

10 15 20
Experience
furtherinnovation

NEW ASSET ALLOCATION TECHNIQUES:
Mutual funds using hedges to enhance returns (e.g. ‘Newcits’)
Income / capital protection funds (e.g. structured products)

29

Enhanced / variable annuities

16

18

NEW PRODUCT WRAPPERS:
Income-in-retirement funds (e.g. IRAs in the USA)

25

Social funds (e.g. SRI)

22

Water / environmental funds

19

Religious funds (e.g. Shari’ah )12

Not delivered value

Delivered value

Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“Shari’ah products deliver good
relative returns and ethicalinvestments; but are hard tomarket outside the Islamic world.”

35“The savings culture is so powerfulin Asia: people want quarterly
dividends at the expense of capital
losses: a Ponzi scheme.”“In Europe, labour unions favour
SRIs for their members. Since
2007, investments have doubled
to US$7 trillion.”

16%

15%

22%

put income in retirement
funds first

put mutual funds withhedging tools second

put structured products
at the bottom

bonds or equity bonds, commanding
hefty charges. Many only guarantee
capital, if the benchmark index falls
more than 50% in a 5-year period.
There are also issues about counterparty risks, in view of their relianceon derivatives.

construction and stock selection.
But they can guarantee outcomesno more than other approaches.
Worldwide, some 10% of assets are
currently held in SRI and ESG funds,
for example.

Yet, theme funds retain powerfulappeal. Their real worth is inproviding benefits that arehighly subjective.

Third, theme products arefundamentally designed to deliver
psychological benefits. In theprocess, they influence portfolio

Their performance has been
variable: Shari’ah funds havedone well since the crisis (seecase study below).

Finally, annuities are viewed asa mixed blessing: a good hedge
against the longevity risk; but
an expensive means to secure amodest income stream in the faceof low interest rates.

A view from the top…
One innovation that has delivered good relative returns is
Shari’ah funds. But their popularity has been held back by
their religious image.

However, due to their three distinctly ethical undertones,
such funds are also attracting interest from non-Islamic
institutional clients keen on SRI.

Over the past 5 years, they have delivered average excess
returns over the Dow Jones World Index of 1.97%, plus
lower volatility.

First, these funds focus on businesses founded on realand productive activities that generate fair and legitimate
profit. Exotic instruments like derivatives, unrelated
to underlying assets, are shunned; as are excessively
leveraged and speculative activities.

Whether by AuM, client base, product mix or geography,
their growth has been strong, albeit from a low base.
Some $50 billion is now invested by clients in the Islamic
world, in places such as Egypt, Gulf Co-operation Council
States, Malaysia, Indonesia and Pakistan.
Worldwide, there is a growing interest in themed funds:
ones that are anchored in the personal values andreligious beliefs of investors. The end of the last decade,for example, saw the emergence of SRIs. This wasfollowed by new interest in ESG (environmental, socialand governance) funds. Nearly 10% of global assets are
now held by these funds.
Interest in Shari’ah funds is part of a wider trend underwhich clients in distinct segments are looking for decent
returns within a value-for-money fee structure in linewith other competitive products on the shelf; andpsychological benefits in line with their values or beliefs.
It is not hard to see why interest in Shari’ah funds has
been so strong in this decade. Their clear emphasis on
Koranic principles of interest, speculation, uncertainty,
fairness and ethics has obviously enhanced their appeal
in the Islamic world.

Second, these funds have high standards of disclosurethat enforces market discipline and minimises
informational asymmetries.
Finally, Shari’ah-compliant investments are not restricted
to investors of the Islamic faith, nor limited to Islamic
companies. Investors of all stripes are drawn into avalues-based approach that filters out businesses
engaging in activities deemed unacceptable: e.g. alcohol,
tobacco, pornography and gambling.
However, their underlying investment engine has todeliver returns at least as good as the ones from theconventional funds, if not better. In sum, their image has
set a high hurdle.
Before long, they will be re-branded under a different
theme (e.g. ethical funds) outside the Islamic market,
duly highlighting their intrinsic merits and performancetrack record.
~ A Malaysian asset manager

Interview quotes:“Product customisation requires
intuiting customer emotions. Few
asset managers can do that.”“For most funds, themes willremain add-ons; not a driver ofclient choices.”“Themes must connect with theirunderlying investment engines.
Many SRI funds do not.”36

Headwinds are shifting the focus of innovation from creating new things
to doing old things better
Since 2008, the pace ofinvestment innovations has not
only slowed markedly. Its scope isalso being redefined.
Faced with the need for fresh capital
under the latest clutch of regulation(case study on the opposite page),banks and insurance companies
are stepping up their product push.
They are also switching towards
low-touch commoditised productsthat can be sold on-line without acostly advice interface.
Just under 50% of asset managers
cite this as a factor limiting thescope of their current innovations.
The second factor cited by 42%
is the uncertainty in the global

economy, due to rising inflationin the East and mounting
unemployment in the West: a far
cry from the synchronised global
expansion of the 2000s.
The third factor is clients’behavioural biases, as cited by 38%.
This is causing them to agonise
about every good investmentidea, in case it’s a bad idea. Due
diligences are prolonged, stringent
and thorough. Clients know thatdaily liquidity comes at a price.
They also know that volatility
is a concealed opportunity. Yet,some of them act as if the 2008
market crash was a foretaste ofthings to come. Some are bothrational and irrational at different

and unpredictable times. For asset
managers, reputational risk is high.
32% of managers cite regulation
as an inhibitor. The worry stems
from the indirect impact of the newbanking and insurance rules rather
than the direct impact of the newfund industry rules; and from thetighter enforcement of the existing
rules rather than creation of the
new ones.
As if the external inhibitors ofinnovation are not enough, there
are two internal ones as well thatare worthy of note.
43% of asset managers cite scarcity
of investment talent as one of them.
This is not to say the industry has

What external and internal factors are conspiring to inhibit asset managers’ scope of innovation
currently?
% of respondents from the asset managers’ survey
0

10

20

30

40

50

EXTERNAL INHIBITORS:
Banks and insurance companies keen to sell commoditised products
Growing uncertainty in the global economy
Behavioural biases on the part of clients
Growing regulatory burden sapping creativity
Market uncertainty favouring simple capital protection products‘Bad press’ for financial innovation created by the credit crisis
Competitive landscape favouring players with big bureaucracies
INTERNAL INHIBITORS:
Scarcity of investment talent that could make a difference
Inadequate tools for encouraging and capturing new ideas
Legacy systems or legacy thinking
Silo working
Unsupportive business culture and work environmentNo ‘white space’ for free thinkers or internal bureaucracy
Lack of urgency fostered by existing high net profit margins
Mergers and acquisitions diverting attention from clients
Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“Across Asia, regulators willtighten the rules on front load, exit
load and hidden charges to avoid
big mutual funds churn.”

37“Regulators in Europe and the US
are getting more hands-on withtighter enforcement.”“Banks’ crazy compensation
models need a big product push in
the mass market, flogging savings
products as investments.”

47%

43%

42%

cite commoditised products firstcite talent shortage second

cite economic uncertainty as third

suffered a talent drain post 2008.
With the time-honoured practices
in asset allocation, manager
selection, portfolio construction,
stock selection and above all risk
management coming under attack,personal insights and gut instincts
have become major differentiators.

changing dynamic of the global
economy and its impact onfinancial markets.

encourage the generation of new
ideas and their robust evaluation.
38% of asset managers cite thelack of such processes as yet
another inhibitor.

Worldwide, there is a shortageof people who understand the

Finally, few asset houses have had
innovation processes that remotely
resemble what prevails in innovative
companies in other knowledgeintensive sectors like IT, pharma andengineering. Such processes overtly

The implications are clear: improve
what you have rather than search
for the new.

A view from the top…
There’s a switch in our innovation effort: from creating
new offerings to improving the existing ones. Re-invention
rather than new inventions is what we do now.
In the last decade, we created a number of new products
for global clients. We introduced an LDI propositionin the US. We were active in the Ucits arena. We took
alternatives to places like Singapore and Japan. We
became active in Islamic products. We adopted the multiboutique model.
But, as I reflect back, my overriding thought is thatnew doesn’t necessarily mean better. Nor does it imply
big strides. Nor does it mean immediate impacts fromeverything we have done. Everything is work-in-progress,
nothing is finished. Don’t forget, change management
is not exactly a forte of asset managers! Going forward,
softly-softly will be the name of the game. Three big
concerns figure high on our agenda.
The first and the most worrying is the deteriorating global
economic outlook. Although unprecedented, the recent
S&P warning on the US economy was hardly unexpected.
Public finances in most OECD countries remain dire in
the face of loose policy responses to the credit crunch.
Some continental banks remain shaky. Markets remain
turbulent. Deleveraging remains on the back burner. So,
it’s best to stick to knitting.
Another external inhibitor is regulation: indirect as well
as direct. When transposed into rules, the Dodd-FrankAct in the US will require more compliance oversight andoperational capital for bank-owned asset managers likeus. Solvency II will force Europe’s insurance companies
to offload equities and corporate debt in sizeable chunks
in favour of government bonds. This is at the time whensome sovereign debt faces big downgrades. Who will
be buying equities five years from now? How many
sovereigns can avoid default?
Regulators are also re-interpreting the old rules for ourclients. For example, in the Netherlands, pension plans are
obliged to value their illiquid assets very cautiously anddeclassify gold as a monetary asset. In Scandinavia, largeplans are dissuaded from investing in emerging markets
beyond an arbitrary limit. In the US, the Volcker rule
prevents fund seeding beyond a year.
There is also direct regulation in the pipeline. In the US,
asset managers have to cope with the Fair and Accurate
Credit Transactions Act on top of the Dodd-Frank Act.
In Europe, the AIFM Directive, the updated Ucits rules,
revised MiFid prospectus, and Target-2 Securities will
preoccupy us for a while. Regulatory creep is in overdrive.
Will it cause more pain than gain?
Finally, we have an internal challenge with our multiboutique model. The oversight role of the mother shipsits uncomfortably with the entrepreneurial spirit ofindividual boutiques. The model is experiencing teethingproblems.
While we tackle these questions, product-deepening,rather then product-widening will top our agenda for theforeseeable future.
~ A French asset manager

Interview quotes:“Talent is now defined by special
intuitions that deliver fresh
insights into new challenges
thrown up by today’s markets.”“Talent begets talent; and ideas
beget ideas. Work environment
and incentives are the key drivers.”“We rely on our talent pool togenerate ideas. But you also needrigorous tools to do the necessary
reality checks.”

38

Tools for generating new product ideas and escalating the good ones arebeing adopted by asset managers
In the aftermath of the crisis,business models came under
scrutiny. One area has received
particular attention: theinnovation process.

with the successful launches. The
aim is to weed out the ‘dogs’ fromthe ‘stars’.

This involves four distinct andsequential functions that are criticalto successful innovation. The firststage is ideas generation: inviting
individuals concerned to post
their ideas. The second stage isevaluation: doing a feasibility study
and crafting a business case. The
third stage is design: constructing
prototype products that can be
subject to a ‘wind tunnel test’ as
in cars, for example. This involves
paper- trading to provide ‘proof
of concept’. The fourth stage isdelivery: launching the productwith seed capital to road test before
going public. The robustness of theprocess is measured by the numberof kill-offs at each stage, comparedautonomous product teams– working as actual or virtual
boutiques – with autonomy and‘white space’ to generate highconviction ideas and implement
them with due accountability,

Around 40% of asset managers
are currently adopting such a
process, or variants of it. This is inmarked contrast to what happenedin the last decade where productinnovation was a matter of personalego or competitor leapfrogging.
Time-to-market mattered morethan robustness.

Around 20% are seeking ideas fromtheir third party administratorsthat provide additional insights into
areas as diverse as stress tests, risk
analytics, attribution analysis, andfund structuring. With the growthof data warehouses, administrators
are emerging as asset managers’
external thinking partners.

Around 35% are promoting
innovation as an integral part ofcorporate culture and businessstrategy. The key tool being usedis ‘provoked creativity’: framing
specific challenges around longstanding problems and inviting ateam of experts to craft workable
solutions within a set timeframe.

Around another 20% are setting
credible targets for new products,
as part of corporate strategy.
The aim is to go into new client
segments and new geographies via
better products.

Around 33% are changing
their operating model to create

A small but notable minority (8%)
are also setting up dedicated R&D

How is your business fostering innovation despite the identified constraints?
% of respondents from the asset managers’ survey
0

5

10

15 20 25 30 35 40

Adopting new processes for developing new ideas
Promoting innovation as everyone’s concern & everyone’s responsibility
Nurturing talent by creating autonomous product teams
Seeking new ideas and thought leadership from asset servicers
Setting ambitious revenue targets for new products
Seeking new ideas from clients
Creating dedicated R&D units
Awarding special incentives for fresh ideas
Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“Innovation often results whenpeople are frustrated with thestatus quo. We constantly
challenge it.”39

“Ideas generation only works
if there is a follow-up fast
track process.”“Asset servicers know a lot
about our products, clients andjurisdictions. We solicit ideas
from them.”

37%

35%

32%

put ideas generating processes
at the top

put innovation culture second

put talent thirdunits for generating breakthroughideas. So much for the tools forgenerating new ideas andescalating them. They target
the knowledge residing inside
individuals and leverage it to
expand ‘corporate memory’.

They emerge via frequent andintensive discussions in small
informal groups, with minimal
bureaucracy. Successful hedge fundmanagers, for example, attribute
their success more to their free
thinking environment than to theirinherent talent.

incentives and personal recognition
for successful ideas.

Experiences of innovative fundhouses in our interviews underline
the importance of three otherrelated factors.
One is work environment. The best
ideas often come from serendipity.

Another factor is the corporate
culture. It not only needs to haveinnovation as a line item inpersonal balanced scorecards.
It also needs to provide financial

The final one is a fast track
process that by-passes corporate
bureaucracy and encourages staff
to post new ideas on a dedicatedwebsite, thus creating a portfolio of
ideas. The good ones are escalated
through the five stage processdescribed on the previous page.
Technology thus helps to harness
latent creativity.

A view from the top…
Innovation appeared on our radar screen in the wake ofthe 2000-02 equity bear market when clients, saddled byhuge losses, started demanding better ways of investing,and forcing two ideas on to our agenda: one about ends,
the other about means.
The first centred on uncorrelated absolute returns,
irrespective of the market cycle. Its seductive emphasis
on skills of asset managers – rather than market
movements - captured the imagination of investors
who had hitherto relied on a raging bull market to do
the heavy lifting for them. The second set centred on
improving business models to create a competitive edge
via stellar performance and operational excellence that
could sustain it into the future. So, we did a benchmark
study and discovered that our peers were using – orplanning to use - one or more of five innovation tools.
Some set aggressive revenue targets under which staff
were mandated to create new products to penetrate newclient segments and geographies not already in their
existing portfolios.
Some used a fast track system that overtly encouraged
staff to post new ideas on our corporate intranet andescalate the good ones via a step by step process thatfiltered the likely winners from the rest.

Some created dedicated R&D labs that were enjoined
to come up with breakthrough discoveries, resulting
in offerings that didn’t exist anywhere before. Some
organised their front office people into virtual or
actual boutiques to give them autonomy to generatehigh conviction ideas as part of the day job. Some
overtly promoted a culture where ideas generation was
everyone’s concern and everyone’s responsibility.
Of course, these tools overlap. In our business, we haveblended most of them. Often, we also bring together
people from cross functional areas into virtual teams.
Each is framed a specific challenge around a longstanding problem – in front, middle or back office. They
are then invited to come up with ideas on fixing it. Eachteam has a top level executive sponsor with responsibility
to ensure that the team’s remit is clear and do-able within
the required time frame.
This eclectic approach works for us. It helps in creating
an ideas-seeking culture in which ideas breed new ideas.
However, it is hard to assess its direct or indirect impact
because asset products are not like physical products(e.g. car or a computer) that have consistent replicableoutcomes and a definable shelf life irrespective of theirexternal environment.
~ A UK asset manager

Interview quotes:“We seek ideas from clients. We
also use clients to road test what
we think.”“Bureaucracy is the kiss of deathfor talented individuals.”“Our multi-boutique model
gives people the ‘white space’ togenerate high conviction ideas.”40

5 Ideas beget ideas
How do asset managers aim to do betterin future?
“Most asset allocation
models and manager
selection tools aregood at forecasting
events that havealready occurred.
They need to lookbeyond history.”

Issues
Our survey of asset managers
and other service providers also
aimed to shed light on thefollowing questions:• how do they generate andcapture new ideas?
• what will they do differently inthe next three years?

Key findings• The changing nuances oftoday’s investment haveshifted the centre of gravity inideas generation among asset
managers: from product push toinvestment pull.

• Investment professionals andclients are in the driving seat,
unlike the last decade when sales
and product development teams
led the charge.
• It speaks to a new theme:
investment innovations work only
if we know their limits. Problems
arise from delusions that markets
can be tamed.
• Clients need to be more aware,
therefore, about what can andcan’t be delivered at a time when
pension liabilities are maturing
fast due to an ageing population.
• Client engagement is growing via
focus groups, pulse surveys andinformal contacts.

• On the other hand, the roleof consultants in the ideas
generation process is perceived
as invidious, on balance.
They walk a fine line between
client interests and personalconvictions.
• Looking ahead to the next three
years, many things will be done
differently.
• Asset managers aim to: improve
the quality of their products,
develop better alignment ofinterests with their clients; andimprove operational excellence.
• More likely, they will adopt morerobust processes for promoting
new ideas and stress-testing theresulting products.
• Improvements are being madein four sequential activities:
ideas generation, inviting people
to post their ideas; evaluation,
doing a feasibility study;
design, creating prototypes andsubjecting them through ‘mental
wind tunnels’; and delivery, using
seed capital before going public.

• Asset managers also aim to seek
better alignment by counteringclients’ behavioural biases andavoiding products that are not fit
for purpose.
• Finally, they will improve
operational excellence by seeking
new alliances with third party
administrators so as to focus on
their own core capabilities.
• Faced with the prospect offresh regulation on banning
front-end commissions,distributors face disruptivechanges. They will be obliged to
improve service standards andadvice infrastructure.
• As a result, they will segment
their service proposition byclient groups and merge theirchannels for retail, institutionaland HNWI clients in pursuit ofoperating leverage.

• Their recommendations have tobe evidence based. On the flipside, that will continue to limit
the scope for fresh thinking and
gut instincts that are so essential
when markets are moved moreby sentiment than by history.
• The brunt of their changes
will focus on their businessmodel. Large houses will moveever more into implemented
consultancy. Niche players willdevelop greater client proximity.
• The investment value chain will
be distinguished as much byintrospection as innovation.
• The projected changes constitutemodest steps. But they havethe potential to improve theretirement outcomes as thedecade progresses.

• Finally, caught between arock and a hard place,
consultants’ scope forinnovation will be limited.

“Brilliant spirits often encounter violent opposition
from mediocre minds”
Albert Einstein

The changing nuances of today’s investment landscape has shifted thecentre of gravity in ideas generation
When asked to cite the significant
sources of new ideas, at least one
in every three asset managers
identifies their investment
professionals and their clients asa key group.
The second notable group, citedby at least one in five managers,
includes: sales and CRM; productdevelopment teams; and senior
management. Other sources areless widely cited.
The 2008 crisis was a watershed. It
elevated the role of the first group,
according to our interviews. Before
then, the second group was in thedriving seat. The switch reflects a
subtle shift from product push toinvestment pull.

It speaks to a broad theme:
investment innovations work
only if we know their limits.
Nobody can guarantee outcomes:
all they can do is to minimise‘wrong-time’ risks. Few investments
are path-independent: theunexpected often happens.
Hence, future innovations shouldseek more balanced revenue
streams for asset managers andmore robust opportunity sets fortheir clients.
More than ever, innovation is about
applying intellectual rigour via
tools and techniques to manage
money within a defined rangeof outcomes. Every position in a

portfolio is a matter of conviction,
not guarantees. Fat-tailed risks
cannot be predicted. But one canhave conviction about them via
a high tolerance for ambiguity:
looking at the same picture throughdiverse lenses.
All this requires greater engagementwith clients in order to understand,anticipate and meet their needs.
Pension liabilities are likely tomature exponentially within next ten
years as the post-War baby boomers
head for retirement. Clients need
to be more aware about what canand can’t be delivered while theglobal economic outlook remains
uncertain. For example, as cash
continues to pile up in Asia, there

Which of the following are the most significant sources of new ideas in your business? Which are themost significant inhibitors of new ideas?
% of respondents from the asset managers’ survey
20

15

10

5

0

5

10

15

20

25

30

35

Investment professionals
Clients
Sales and client relationship managers
Product development teamSenior management
Distributors
Academia
Consultants
Asset Servicers
Risk & compliance team
Industry trade associations
Fund Boards
Inhibitor

SourceSource: Citi / Principal / CREATE Survey 2011

Interview quotes:“Hong Kong has experienced a big
talent inflow from the West lately.”43“We don’t believe in the wisdom of
the crowd. Being lonely is often aprecursor to being successful.”“As CEO, I attend all big client
events to know the complexity of
their challenges and subtleties of
their decisions.”

35%

34%

27%

put investment professionals
at the top

put clients second

put sales & CRM third

are worries about whether it canbe put to use responsibly. In China
and Japan, over 50% of household
assets are locked into low interestbank accounts.

focus groups, pulse surveys andinformal contacts to understand theheartbeat of their clients.

blame them after a decade in which
nearly 90% of active managers
failed to hit their benchmarks?
They have to walk a fine line
between client interests andpersonal convictions.

Before the crisis, asset managers
worldwide were increasingly
disintermediated by distributors in
the retail space and consultants in
the institutional space. Since then,the gulf has been narrowing, as
more and more asset managers use

Turning now to the sources that
inhibit the generation of new
ideas, two merit attention: external
consultants and internal risk &compliance teams, as cited by 15%.
Consultants’ roles remain invidious.
As advisors and guardians ofclients’ interests, they have tochallenge new thinking. Who can

As for the risk & complianceteams, their heightened role since
the crisis has created an extra
layer of oversight for investment
professionals. They are thelightning rod for regulatory creep.

A view from the top…
In the 1990s, we were like other large pension plansin North America: with a 60:40 equity-bond portfolio.
This worked so long as the markets powered ahead. The
crash in 2000 forced a major reappraisal. It showed that
equities had been over-valued for too long, thanks topump priming by the Federal Reserve at every whiff ofmarket correction. It also showed that the time profile of
our liabilities favoured assets with strong and stable cash
flows within a realistic fee structure.

In the past, mutual misunderstanding was rife: bosses
saw their investment professionals as greedy arrogant
individuals with a highly inflated sense of self worth. Inturn, professionals saw their bosses as glorified beancounters detached from the heart beat of investment.
For both groups, the regular parting of the ways was no
more than a futile chase for the next rainbow. With therebalancing of the portfolio, talent management shot up
on our business agenda.

We duly initiated incremental rebalancing that blended
buy-and-hold investing with opportunistic investing. It
favoured infrastructure, private equity and real estatealongside high yield, distressed debt and hedge funds.
Their overall weighting soared from 5% to nearly 35%
over the past decade. We cherry picked some prized
assets in Europe and the US in the down markets. Over
50% of our assets are managed internally, targeting
absolute returns by nurturing talent.

We motivate our talent pool via light touch management,a liberal dose of open honest communication, ameritocratic incentives system and peer recognition.

The experience of successful hedge fund managers hadtaught us that talent is only as good as the environment
in which it is deployed: having the right bench strength is
one thing; getting the best out of it quite another.
The latter requires three sets of benefits conducive
to a high performance culture: an employer brandthat generates personal pride; an interesting job that
stimulates personal commitment and a balance of hardand soft rewards that inspires self-motivated creativity.

We accept that they are more interested in managing
money than people. So we let them work in small teams
with minimal hassle that ensures that ideas breed new
ideas, following the law of increasing returns. Too many ofthem working together usually results in chaos, debates
and low performance. Above all, we offer them the twothings which they value most: autonomy and space withinwide parameters of discretion; and a boss they admire.
No hero worshippers, they prefer nuts & bolts leadershipabove visionary rhetoric.
This approach has worked well for us in achieving what is
widely admired as one of the most successful rebalancing
in the pension industry.
~ A Canadian pension planInterview quotes:“We seed new products with ourown money – occasionally withsmall support from our clients.”“We use quant tools andfundamental judgement within acareful marriage of the two.”“For consultants, there’s no
incentive to break ranks and sticktheir heads above the parapet toprotect client interests.”

44

Product quality, better alignment and operational excellence will dictate
the thrust of innovation in the near term
For asset managers, the crisishas been more a moment for
introspection, than the motherof invention.
Over the next three years, theirinnovation effort will build on thepast by doing old things better.
Their industry is not Darwinian
enough to cope with disruptivechanges. Likely improvements will
fall into three clusters.
The first cluster covers productquality. 42% of asset managers
expect to adopt a more robust
process for generating andevaluating new ideas, as describedat the end of the previous section.
37% aim to stress test their new
products before bringing them tothe market.

27% aim to have longer time-tomarket to create a track record fortheir new products.

fiduciary overlay that does one ormore of the following: it countersbehavioural biases that have costclients dear in the last decade;prevents asset managers fromselling products that are not fit
for purpose; offers symmetricalincentives in which gain and pain
are shared more equitably; develops
common investment beliefs andtime horizons.

At least 20% aim to use thesemeans to deliver three productoutcomes: upside protection while
limiting downside risks; lower
correlation between asset classes;
and less complexity.
Product quality may improve but
new killer products are unlikely. The
existing ones will be upgraded totarget better outcomes.
The second cluster of improvements
will cover alignment of interest withclients, as cited by 51% ofasset managers.

Progress will crucially hinge on
the extent to which pension plans,consultants and distributors areable to drive down the current
levels of fees and charges. The
pressure is building up, as we shallsee later in this section.

As our last year’s report showed,
this will be done by creating a

The third cluster covers operational
excellence. 20% expect to seek new

What will be different about asset managers’ approaches to innovation over the next three years?
% of respondents from the asset managers’ survey
0

10

20

30

40

50

NEW PRODUCTS WILL:
Have a more robust process for generating new ideas
Be stress tested against extreme scenarios before coming to the market
Aim to deliver upside participation while limiting downside risks
Have longer time-to-market to establish an early track record
Aim to reduce cross-correlation between asset classes
Minimise complexity
Eschew copycat mentality
BUSINESS MODELS WILL:
Aim to deliver better alignment of interest with clients
Seek new alliances with external partners in front-middle-back office
Aim to be more nimble via focus on core competency
Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“Investment products cannot
be tested in a lab. We put themthrough mental wind tunnels.”

45“Our innovations embrace honesty
in what can be delivered and rigour
in the way it is delivered.”“External administrators are nolonger peripheral; they’ve rapidly
progressed from the back to
middle office.”

51%

42%

37%

put alignment of interestat the top

put new ideas generatingprocess second

put extreme scenario stresstesting third

alliances with external partners infront-middle-back office. 19% aim
to become more nimble by focusing
on their core capabilities. Since
the middle of the last decade, anincreasing number of activities
have been outsourced to third
party administrators, starting in
the back office and then spreading
to the middle and front offices.
As asset managers have ventured
into new strategies, jurisdictions,channels, alliances and client

segments, business complexityand diseconomies of scale havebeen rife, due to too many moving
parts. Alliances and outsourcing
have been the principal means
for accessing expertise, improving
operational excellence andmaximising scale economies.

that comes with size. Run as
autonomous or semi-autonomous
units, these boutiques aim tobecome centres of investment
excellence around different productareas. They also provide inputs
into multi-asset class products. In
combination with outsourcing andalliances, they aim to sharpen thebusiness focus (case study below).

Indeed, more and more medium
and large managers have adopted
the multi-boutique model tominimise the bureaucracy

A view from the top…
Large asset houses are often perceived as creatures oflegacy systems and legacy thinking: bloated and flatfooted, always hell-bent on protecting their existing
revenue streams. As we have evolved into a global
house through organic and acquisition routes, we havegone out of our way to counter this popular caricatureby ensuring that our business model is more outwardlooking and more ideas-seeking. Our guiding ethos is that
innovation comes from learning-by-doing, learning by
experimentation and learning from others.
Over the past decade, we have earned numerous
innovation awards thanks to two factors.
The first is the way we blend our investment processes,
research engine, risk platform and human ingenuity.
We use vast amount of information in formulating ourinvestment thesis. We solicit new ideas and then subject
them to reality checks via quant models and intensive
small group discussions. Out of these normally emerges
what we term the ‘X-factor’: special insights and foresight.
These combine what people think in their brain with what
they feel in their gut.
The second success factor has been our alliances withthird party administrators. Initially, they minded ourback office. In the last five years, they have gone up thefood chain by delivering six core functionalities that feed
into our innovation engine: data warehouses that give
real time information on our trade positions; simulation

models that do the stress testing of putative products;
fund structuring that allows us to customise our products
for far-flung jurisdictions; risk analytics that give us asecond opinion on our risk profile; independent valuationof illiquid assets that gives our pension clients a realistic
measure of their funding levels; and performance
attribution analysis which enhances our credibility in theeyes of our current and prospective clients.
With globalisation and regulation, the asset industry has
too many moving parts and too many compartments.
If performance is the target, focus is the silver bullet.
So, we rely on asset servicers to provide operational
excellence that seamlessly aligns the front office withthe rest of the business via a professional overlay of thelatest expertise and physical infrastructure.
Based on their relationships with other asset managers,
the servicers have been a good sounding board: they
help us to learn from the mistakes of others rather than
pay the price for our own. Also, given their knowledge
about our clients, we can envisage the time when asset
servicers will design and host our websites, offering araft of DIY or educational tools to institutional and retailclients in areas like risk management, asset allocation,
portfolio construction and stock selection. Assetmanagers have barely scratched the power of Web 2.0.
~ A German asset manager

Interview quotes:“Being a multi-boutique houseenables us to assess crosscorrelations between credit,
equities and physical assets.”“As CIO, I often frame challenges
and invite new ideas around them.
I help escalate the ones thatare selected.”“Operational excellence gives
us an edge in costs, quality
and credibility.”46

Distributors face disruptive changes in this decadeWorldwide, distributors remain
conflicted: more so in Asia andEurope than in the US.
Dominated by banks in the nonEnglish speaking countries, they
typically channel their clients’money to asset managers that givethem the highest up-front, trail
or exit commissions; irrespectiveof client needs, managers’ trackrecord and scalability of theunderlying strategies.
In the English-speaking world,
independent financial advisors
predominate. Commissions drive
their decisions, according to ourinterviews. The US is the only majorcountry where independent advisors
have their prime oath of allegianceto their end clients, in return foradvice and transaction fees.
However in Australia, Europe
and India, regulatory pressures
are building up (see case study

on the facing page). The shapeof the regulation may be hazy at
this stage but its intent is clear: toattack conflicts of interest whichhave long thrived on high fees, highchurn and poor choices.

their service by classifying clients
into different segments, on thebasis of a number of criteria: e.g.
growth potential, family situations,asset size and risk appetite. Someare even classifying clients into four
segments: platinum, gold, silver andbronze. Each segment has a clear
service proposition.

Commissions may well be history
in this decade, according to
distributors participating in ourinterviews. In anticipation, fourdevelopments are likely over the
next three years, according to our
respondents.

For example, a platinum client will
have regular detailed investment
reviews and portfolio rebalancing.
Advice will be the main element. At
the other extreme, a bronze one will
have accurate timely information.
Mutual funds will be the main focus.

37% expect improvements inservice standards.
35% expect them to switch from‘products’ to ‘solutions’.

18% expect growth in embedded
advice products.

That apart, regular pulse surveys
and focus groups are increasingly
coming into vogue. Not only do they
provide a picture of client needs,
they also act as an external tool todrive internal change.

Emulating institutional managers,
large distributors are improving

As for the shift towards solutionsdriven products, its main thrust

20% expect improvements in theadvice infrastructure.

What will be different about distributors’ approaches to innovation over the next three years?
% of respondents from the asset managers’ survey
0

5

10

15

20

25

30

35

40

Raise the standards on client service
Move from ‘products’ towards ‘solutions’Improve the advice infrastructure
Embed advice in the products they sell
Minimise conflicts of interest
Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“The UK’s RDR will shift asset
allocation to distributors who willkeep the lion’s share of the walletby opting for ETFs.”

47“The changes in the global
distribution landscape are
evolutionary. But over time theirimpact will be revolutionary.”“Outside the US, retail investors
are not ready to pay for advice. But
they will, once they know about
the hidden commissions.”

37%

35%

20%

put service standards at the top

put solutions second

put infrastructure

is likely to be different on eitherside of the Atlantic. In Europe, theshift will be driven by ETFs, which
are increasingly marketed as asset
allocation products. In the USA, theshift also incorporates a range ofretirement funds like target date or
target risk funds.

to improve the advice infrastructureand sell embedded advice products.

design of the next generation of
DC plans. In the process, they areusing common asset allocation andmanager selection tools for both
retail and institutional clients.

As spin offs, segmentation andthe shift towards solutions-based
products are increasingly expected

Initially, private banks on both sidesof the Atlantic are likely to be thekey drivers of change.
The large European ones are
already venturing into theinstitutional market by offering
asset allocation advice, manager
selection and asset management.
Some are offering advice on

Their distribution channels
between client segments are also
converging.
Strong winds of change are evident,
especially in Europe

A view from the top…
Of all the areas in the investment value chain, distribution
will possibly experience the most disruptive changes overthis decade, especially in Europe and Asia Pacific.
As a background, there was too much choice. Today, forexample, there are 50,000 share classes on offer in theEU, nearly five times as much as in the US, but with half
as many assets. Most are copycats that look different
outwardly to attract higher fees.
Furthermore, conflicts of interest are rife. In places asdiverse as Australia, China, India, Japan, Singapore,
France and the UK, distributors have remained heavily
conflicted. They’ve poured money into funds that havegiven them highest front load, or trail commissions orexit load; irrespective of client needs, managerial trackrecord and strategy scalability. The charge sheet reads
the same whether distribution is done via banks as on theContinent and in Japan; or via IFAs as in Australia, Hong
Kong, Singapore and UK.
India has led with the new rules. UK will follow suit in 2012and probably the rest of Europe thereafter. Under them,old-style commissions will be disallowed for a wide rangeof retail funds. Instead, distributors are obliged to charge
advice and transaction fees to the end-client. The impact
in India has been swift in the past year: a collapse in net
inflows. Clients mistakenly thought that they were being
charged for a service which had long been ‘free’!
In Europe, distributors have wised up ahead of regulatoryintervention. On our part, to start with, we are moving

heavily into ETFs where fees are low and hidden
transaction costs high. We increasingly use ETFs in
our dynamic asset allocation products and earn goodcommissions on transaction fees, thereby protecting ourrevenue stream.
However, over time, the negative knock-on effecton active managers will be huge. Mediocre active
managers who have existed at the mercy of commissions
will struggle to survive in the face of the gathering
competition. Over time, our proposition for the massaffluent market will be commoditised.
Alongside that, we are strengthening our propositions for
HNWI and institutional clients – both DB and DC – offering
advice on asset allocation, plan design and manager
selection in Europe and the Far East. As a part of that,
we are segmenting clients into platinum, gold, silver andbronze categories, with distinct sets of services for eachcategory. The segmentation is done on the basis of various
objective and subjective criteria. The aim is to get closer
to our clients by anticipating and meeting their needs.
Lastly, the biggest change we have implemented lately
is to roll different sales silos into one. Retail, HNWI andinstitutional clients are served via the same channels,
partly due to convergence in their needs and partly due
to high operating leverage in our asset allocation andmanagerial selection capabilities.
~ A Swiss private bank

Interview quotes:“Poor asset allocation decisions
and opaque structures have costclients an average of 2.5% in lost
returns per year.”“Sales channels for retail,institutional and wholesale clients
will converge in order to reap theoperating leverage.”“Distribution will become
segmented by distinct
client groups.”48

Caught between a rock and a hard place, consultants’ scope forinnovation will remain limited
Pension consultants are in a Catch
22 situation.
Clients want predictability; markets
deliver uncertainty. Clients want
to be prime movers; but their
allocations demand track record.
No wonder consultants got more
flack than asset managers for muchthat went wrong in the last decade,as we saw in Section 2.
To compound the problem,
consultants also experienced atalent drain to asset managers,
investment banks and new start-ups
in every major financial centre inEurope and the US.
As advisors, their approaches areperceived as backward- looking,especially in asset allocation andmanager selection. Implicit in theirapproach is the assumption thatthe past is a good guide to the
future. Yet the last decade showedthat markets are moved more bysentiment than by history.

17% expect them to develop
expertise in implemented
consultancy, providing a one-stopshop solution to clients.

In defence, their recommendations
have to be evidenced based, inview of their independent role. As
we saw in the last two sections,investment innovations have hadvariable outcomes. So, consultants
are obliged to question their worth.
Besides, they also know all too wellthat most small and medium-sizedpension plans do not have theskills and governance structures toventure into anything new.

17% expect them to improve therisk tools that underpin theirinvestment advice.
Our post-survey interviews with
consultants drilled deeper into
these numbers, in the face ofcontradictory demands made on
their expertise.
While their advisory role limits thescope of innovations, consultants
are more likely to tinker with theirbusiness models.

Against this background, overthe next three years, our survey
respondents expect consultants tomake four improvements.

First, the consultancy model isalready bifurcating.

26% expect them to improvetheir expertise in dynamic
asset allocation.

Large houses are likely to venture
into implemented consultancy,
in order to fortify their market
position, in the face of competitive
threats posed by the rapid growth

17% expect them to rely more on
foresight than past performance inmanager selection.

What will be different about asset managers’ approaches to innovation over the next three years?
% of respondents from the asset managers’ survey
0

5

10

15

20

25

30

Asset allocation will be more dynamic
Manager selection will rely more on foresight than past performance
New expertise will be developed in implemented consultancy
New risk tools will underpin investment advice
New tools will explore asset class correlation at a more granular level
Source: Citi / Principal / CREATE Survey 2011

Interview quotes:“Our industry is not Darwinian.
Everybody has their place in theinvestment food chain; nobody
wants to rock the boat.”49“Consultants must understand the
big swings in asset classes. Few ofthem have worked at the coalface.”“Concepts like alpha and beta
should be thrown out. The
correct benchmark is clients’long term goals.”

26%

17%

17%

put asset allocation at the top

put manager selection

put implemented consultancy

of fiduciary management in the
Netherlands. They will be creating
centres of expertise in critical areas
like asset allocation, manager
selection, and portfolio construction.
It remains to be seen what conflictsof interest will arise in the face ofthe cross-selling it entails.

clients and minimal conflictsof interest.

companies divesting their asset
management function.

Second, talent will differentiate
winners from losers.

On their part, consultants recognisethat without breadth of knowledge
and depth of expertise, they will not
be able to compete with large asset
managers who are also targetingthese segments for their one-stopshop offerings.

Niche consulting will continue torise. Via its narrow specialisation,
it is developing closer proximity to

The demand for investment advice
is growing in every jurisdiction, as
new client segments emerge. The
weight of new money will comefrom four segments in the emerging
markets: SWFs, state social security
funds, new DC plans and insurance

A view from the top…
Let’s get one thing straight: pension deficits are eyepopping. Naturally, asset managers and we pension
consultants are cast as villains. It’s hard to dispute thatin the face of the appalling reality of numbers.
Some of our pension clients who operate municipal
funds in the US, for example, require up to 60-year
recovery periods.
The way they operate encourages bad behaviour: e.g.
arbitrary promotions or needless overtime in the last yearof retirement that inflate their entitlement in the finalyear schemes. But such abuses don’t explain the wholetruth. For, on the investment side, they have been victimsof too many unknown unknowns.
Few of us saw the two bear markets coming; few of us
detected the time bomb concealed in cheap money; few
of us understood the unintended consequences of themark-to-market rules; few of us expected the asset classcorrelation to go through the roof.
Quite simply, most asset allocation models and manager
selection tools make great PowerPoint slides. Their
predictive power is confined to forecasting events thathave already occurred. They can’t look beyond history.
After a turbulent decade, we have learnt five lessons.
Correlation between asset classes is asymmetrical;
low in the upturn, high in the downturn. Risk return
characteristics of asset classes are hard to ascertain
except over very long periods; in the meanwhile, they canbe ravaged by fat-tail events. Risk models based on past
events are more a therapy than a barometer: while thepast may be our best guide to the future, it is still a pretty
imperfect one. There is no free lunch with any asset class:systemic risks are increasing relative to idiosyncraticrisks. Finally, liquidity, for long incidental, has moved
centre stage as a direct result of the credit crunch.
These unpalatable facts are forcing us to raise our sights
by at least 30 degrees, in order to retain our relevance inan environment fraught with uncertainty.
No wonder clients are very suspicious of innovations.
They see them as con tricks to fleece them. The principalagency problem is as acute now as it has ever been. One
way to ease it – although it won’t be easy – is to play down
the role of our models and tools that have produced somany wrong calls.
It’s time to apply the greater insights to make sense of
the unusually high ‘noise’ levels in today’s markets. The
false rigour and spurious accuracy of some of the things
we do are fabulously effective in managing our careerrisks. But, inadvertently and over time, they raise client
expectations only to dash them.
We’re applying a far stronger overlay of humanjudgement to everything big that we do for ourpension clients.
~ A global pension consultancy

Interview quotes:“As advisors, it’s been very hardregaining our credibility after
2008. We were the first to be
blamed by clients.”“We are ratcheting up fee
pressures on behalf of our clients.
Our manager selection is far morejudgemental than before.

“We are becoming a key conduit
for private banks, DC plan sponsors
and SWFs.”

50

Other publications from CREATE-Research
The following reports and numerous articles and papers on the emerging trends in global
investments are available free at www.create-research.co.uk• Exploiting Uncertainty in Investment Markets (2010)• Future of Investments: the next move? (2009)• DB & DC plans: Strengthening their delivery (2008)• Global fund distribution: Bridging new frontiers (2008)• Globalisation of Funds: Challenges and opportunities (2007)• Convergence and divergence between alternatives and long only funds (2007)• Towards enhanced business governance (2006)• Tomorrow’s products for tomorrow’s clients (2006)• Comply and prosper: A risk-based approach to regulation (2006)• Hedge funds: a catalyst reshaping global investment (2005)• Raising the performance bar (2004)• Revolutionary shifts, evolutionary responses (2003)• Harnessing creativity to improve the bottom line (2001)• Tomorrow’s organisation: new mindsets, new skills (2001)• Fund management: new skills for a new age (2000)• Good practices in knowledge creation and exchange (1999)• Competing through skills (1999)• Leading People (1996)

Contact details:

Prof. Amin Rajan
amin.rajan@create-research.co.uk
Telephone: +44 (0) 1892 52 67 57
Mobile/Cell: +44 (0) 7703 44 47 70

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Citi, the leading global financial services company, has approximately 200 million customer accounts and does business inmore than 140 countries. Through its two operating units, Citicorp and Citi Holdings, Citi provides consumers, corporations,
governments and institutions with a broad range of financial products and services, including consumer banking and credit,
corporate and investment banking, securities brokerage, and wealth management. Additional information may be found atwww.citi.com.
Global Transaction Services, a business line of Citi, is a leading provider of integrated treasury and trade solutions, andsecurities and fund services to multinational corporations, financial institutions and the public sector around the world. With
the industry’s largest proprietary network, spanning 100 countries, we are uniquely qualified to serve your organization’s local
and cross-border interests.
Through its Securities and Fund Services business, Citi’s industry-focused experts provide investors worldwide with
tailored solutions delivered though proven global platforms that feature modular, open architecture. With over
US$11 trillion of assets under custody and the industry’s largest proprietary custody network, clients can leverage
Citi’s local market expertise and global reach to extract value across the entire investment value chain — including,global custody, fund administration (for traditional and alternative funds), securities finance and cash management.
For more information, please visit our website: www.transactionservices.citi.com

Principal Global Investors is a diversified asset management organization and a member of the Principal Financial Group.
Principal Global Investors manages $235.3 billion in assets primarily for retirement plans and other institutional clients inover 50 countries, and draws from the expertise of 435 investment professionals. The firm offers a broad range of investment
capabilities, including equity, fixed income and real estate investments as well as specialized expertise in currency management,
asset allocation, stable value management, and other structured investment strategies. Our multi-boutique strategy enables
us to provide an expanded range of diverse investment capabilities through our network of specialized groups and affiliates.
We serve our clients from locations in the U.S., London, Munich, Singapore, Tokyo, Sydney, Hong Kong and Kuala Lumpur.

CREATE-Research is an independent think tank specializing in strategic change and the newly emerging business models in
global asset management. It undertakes major research and advisory assignments from prominent financial institutions andglobal companies. It works closely with senior decision makers in reputable organizations across Europe and the U.S. Its work is
disseminated through high profile reports and events which attract wide attention in the media. Further information can be foundat www.create-research.co.uk.

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