U.S. Investment Management Industry Takes a Look in the Mirror

Greenwich Associates’ 2008 U.S. Investment Management Study found that many American institutions have been frustrated by the failure of their diversification strategies to protect their portfolios from the market downturn. However, most institutions appear committed to diversified investment portfolios — including hedge funds and other alternative asset classes — clinging to the belief that it is the global financial system that is broken, not their portfolio management policies. In any event, hedge fund performance in 2008 has reinforced the importance of institutional due diligence capabilities.

Noting that proper due diligence can only be attained with sufficient staff, the study outlines how the typical U.S. institution employed only two professionals to select and supervise external investment managers over the past two years, down from an average of 2.5 professionals across all institutions in 2006.

“It is impossible to identify those managers with the skill and consistent, repeatable processes needed for investment success without sophisticated due diligence capabilities,” says Greenwich Associates consultant Dev Clifford. “The real lesson of 2008 is that institutions need to either build up these capabilities in-house, or acquire them externally. Doing without is not an option.”

Rebalancing and liquidity are also pressing issues, as the study notes that while three-quarters of institutions rebalanced their investment portfolios last year, doing so in 2009 will pose some unique challenges. First, there is the question of whether portfolio managers are willing to take the step amidst depressed asset values and an uncertain economic climate. Second, even if institutions do decide to stick with their rebalancing policies, some funds might not have the liquidity needed to fully rebalance.

“Large volumes of fixed-income assets are essentially still untradable, and many assets that are tradable can be moved only at a painfully deep discount,” says Greenwich Associates consultant Chris McNickle.

One of the important lessons drawn from the current crisis, according to the study, may well be the value of liquidity, or at least the dangers of undervaluing it. Prior to August 2008, most institutions minimized the proportion of their assets held in cash, which was seen as a drag on long-term investment performance. Allocations to money market funds and other “cash” investments were typically around 0.5% of assets.

“The rapid plunge in asset values quickly demonstrated the value of liquidity, which provides flexibility needed to prevent institutions from having to sell undervalued assets into falling markets in order to fund operations or other needs,” says Greenwich Associates consultant Rodger Smith.

The study also found that U.S. endowments and foundations have adopted asset allocation models that, in addition to being diversified away from U.S. equities, are also quite aggressive in terms of risk. These organizations had the lowest allocations to fixed income of any U.S. institutions in 2008, and much lower allocations than those found among not-for-profits in other countries.

“At a strategic level, many U.S. endowments and foundations have adopted portfolio strategies that favor the maximization of long-term investment returns over the preservation of capital as a defining goal,” says Greenwich Associates consultant William Wechsler. “This is not the case in other markets. In Canada, for example, endowments and foundations had approximately half their assets invested in fixed income in 2008; among U.S. endowments and foundations, that share was closer to 20%.”

To comment on this story, email jody.white@rci.rogers.com.