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Black-owned asset management landscape: Diversification in asset managers matters. We know that when assets become too concentrated and unwieldy, alpha generation suffers. We know that the more diverse the views are that are reflected in the market, the less volatile and more robust the market. We also know that if we want costs to be contained, we need as much competition as possible. We know all this, and yet, still, it remains particularly difficult for new entrants into the asset management industry to gain a foothold in the South African market. The real opportunity loss here is for transformation. And we know that for transformation in the industry ownership and skills development is essential if we are going to tackle the issues of opportunity and access which did not necessarily exist before 1994.
Opportunities for transformation and practical steps for incubation programmes
Diversification in asset managers matters. We know that when assets become too concentrated and unwieldy, alpha generation suffers. We know that the more diverse the views are that are reflected in the market, the less volatile and more robust the market. We also know that if we want costs to be contained, we need as much competition as possible. We know all this, and yet, still, it remains particularly difficult for new entrants into the asset management industry to gain a foothold in the South African market. The real opportunity loss here is for transformation. And we know that for transformation in the industry ownership and skills development is essential if we are going to tackle the issues of opportunity and access which did not necessarily exist before 1994.
There are well over 100 institutional asset managers in South Africa of which more than 40 are black-owned businesses. The South African industry remains highly concentrated with the five largest asset managers managing 50% of industry assets1. The number of black-owned asset managers has grown significantly over time and continues to do so. We have seen a number of black-owned firms performing extremely well and becoming established players in their respective areas of specialisation. The graph below shows the assets under management (AUM) of the black-owned managers in the industry at 30 June 2016. The graph also shows that there are a number of managers that have grown to be large in their respective specialisations. For example, Taquanta is the largest manager of third-party money market mandates.
Despite the growth in the number of black-owned asset managers and the success stories, the proportion of assets managed by black managers remains stubbornly low. Depending on how the numbers are calculated, between 4% and 8% of total industry assets are managed by black-owned asset managers. (Note that the 8% figure excludes insurance company assets.) This is clearly not sustainable and a concerted effort is needed to make a meaningful change. Asset owners, consultants and indeed the asset managers themselves all have a role to play in driving this change.
There are a few reasons why the pace of transformation has been slow. One issue is how it has been difficult to differentiate among managers based on B-BBEE ratings. The chart below from the 2015 Alexander Forbes Annual Retirement Fund Survey shows the B-BBEE ratings for all participants in the survey.
From the chart it is clear that managers have generally scored well with most managers achieving a Level 2 or Level 3 score. Under the revised B-BBEE scorecards, this picture is likely to change materially since it may be difficult for some companies to maintain their ratings at current levels. The Draft Amended Financial Sector Code aims to introduce a voluntary disclosure programme for the top 100 retirement funds whereby funds will be required to measure themselves against certain aspects. The proposed elements that funds will need to measure themselves against are:
We expect to see an increased interest by large funds, but particularly private pension funds and umbrella funds, to support black-owned asset managers and other service providers.
Incubation programmes can play an important starting point for transformation. This is a trend in South Africa as well as internationally, where we have seen many large institutional investors, like CalPERS, make a significant effort to find and support smaller managers. This is typically an effort to capture additional returns in the current lower-return environment.
In South Africa, we have seen incubation in various forms over time, most notably in the hedge fund space and by large retirement funds. We have also seen start-up firms play a vital role in the transformation of the industry, especially when it comes to training and mentoring of young investment professionals.
Every fund will have a slightly different interpretation around what incubation means to them and that is something that trustees will need to debate and agree on. Trustees should ideally incorporate the incubation discussion into their ultimate investment beliefs. Trustees should set clear policies and it is important that all stakeholders buy into the idea and support the programme. The policy should state how much should be allocated to these managers, what types of managers will be eligible for incubation as well as set out how decisions will be made and reviewed from time to time.
The eligibility discussion is a particularly important one. Trustees will need to decide whether incubation is used as a means of supporting transformation or small managers generally. Either way, we do not believe that efforts to support transformation should be limited to incubation programmes, nor that it should be a requirement that black-owned asset managers should start off in incubation programmes. In fact, many start-up black-owned asset managers are started by seasoned investment professionals that can hold their own against the larger houses. However, starting an asset management business is not easy and it’s often difficult to gain traction if you don’t have a track record. This is where incubation programmes can be useful.
There is often a misconception attached to the idea of incubation, from the perspectives of both the investor and asset manager. Often the perception is that one will need to accept lower investment returns for supporting certain managers. This is certainly not the case and international research shows that managers often produce their best performance when they are small. In theory, there are many reasons why smaller firms should be able to provide compelling investment outcomes, including greater alignment of interests, greater opportunity sets and the ability to trade in and out of positions quickly without affecting the market.
In South Africa, a number of criteria can be used to decide whether a manager is eligible for an incubation programme:
Ultimately one hopes the manager does well and will make way for other start-up managers in the incubation programme, so you will need to set ‘graduation’ criteria. You will also need to decide on the maximum length that a manager can stay on the programme since these types of programmes are not meant to provide indefinite support. The idea of graduation is contentious. There is a risk that successful managers lose assets from incubation programmes at a crucial stage in their development. This process needs to be responsibly managed.
Deciding to invest in small managers affects how manager research is conducted. To understand the business prospects as well as the background and experience of key investment professionals, deep due diligence needs to be applied to potential asset managers. The ability to run a business and having a sound operational infrastructure are as important as investment skill to an asset management business. A consequence of this is that the due diligence process on managers may take more time and be more in-depth than with more established asset managers.
Not many consultants cover the full spectrum of managers and therefore trustees sometimes need to question and nudge consultants to bring new ideas on managers. Alternatively, trustees could consider using a specialist adviser for incubation, one who covers the full spectrum of managers available. There are also packaged products available to invest in for those who don’t want to make the ultimate decision on manager selection. The governance budget of funds will ultimately dictate which structure is appropriate.
Ultimately an allocation to any asset manager or strategy should be aligned with the investment beliefs and the investment strategy of the investor. One of the current obstacles in doing this is the shortage of multi-asset-class portfolios from black-owned asset managers for inclusion in balanced portfolios. Most black-owned asset managers, particularly newly established managers, specialise in managing a particular asset class. That said, we have seen encouraging signs of managers expanding their product offerings to include multi-asset-class portfolios as they grow. Within a specialist structure, there are many highly rated black-owned asset managers that could be considered for inclusion within portfolios.
Trustees may have the misconception that investing in small managers is unnecessarily risky. All asset management businesses are exposed to operational risks, but these can be monitored over time and corrective measures taken if necessary. The major investment risk is the chance of underperformance relative to a specific objective or benchmark, which is a risk trustees face when appointing any asset manager. This risk can be mitigated in various ways, including providing detailed and prescriptive mandates to managers. One needs to be careful not to change the nature of an asset manager with overly restrictive mandates.
If fiduciaries want to include asset managers with limited performance histories, it is a relatively easy and straightforward process to create reasonably controlled mandates that capitalise on a manager’s articulated skill set, while controlling the degree of variability the manager is allowed to introduce into portfolio construction process. This is of course provided that the consultant or asset manager is employing a multi-asset, multi-factor risk model. Typically, around 95% to 99% of the performance outcome will be a function of this portfolio construction and risk management process.
We recognise that not all managers will survive and it is therefore important to identify managers that have a high probability of building successful, sustainable businesses. Given the business risk faced by small businesses, it’s important to monitor the progress of the managers in building a sustainable, stand-alone business. This could include monitoring business metrics as well as team dynamics which requires more regular and more detailed interactions with the managers by the multi-manager or consultant.
In summary, a more meaningful and concerted effort is required by all to support black-owned asset managers to foster transformation in the investment industry. Incubation can play a meaningful role in this but support of blackowned asset managers should in no way be limited to incubation. The landscape continues to evolve and there are skilled black-owned asset managers who have built, or are in the process of building, credible, sustainable businesses. This should ultimately lead to a more competitive industry which in turn should hopefully lead to better net-of-fee returns for investors.;
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