Norges Bank Investment Management view of exchanges - a call for change

The Norges Bank Investment Management (NBIM) company which runs the Norway SWF has written a provocative piece on the role of exchanges in current capital  markets which asks for a significant change in focus. Provocative may seem like a strong word, but on most finance issues SWF's try to keep a low profile. There are two key points that I believe NBIM want to make in the their piece "The Role of Exchanges in Well Functioning Markets: An Asset Manager Perspective".

One, the equity markets are more fragmented than what many may think. There are fewer exchanges, but more mechanisms for accessing liquidity which makes for a less well-functioing markets. Asset managers have to search for liquidity and develop and access multiple systems to find this liquidity. This search for liquidity comes at a cost.

Second, the limits to speed have been reached and this technological drive may not meet the needs of large institutional investors. High frequency and support for this smaller size trading is not consistent with the structural changes in the asset management area over the decade. Pension funds have gotten larger. SWF are larger and generally the size of asset managers around the global have increased significantly over the last two decades. Money management has become a game of scale. Asset managers need liquidity to trade size not speed. The exchanges have to come to grips with the size needs of institutional money managers who actually represent many small investors.

Continual markets that focus on speed do not help the manager who wants to trade blocks at fair prices. This is a fair comment from one of the big guys. The questions is how to find the right mix between size, speed, and price discovery. It is not clear that exchanges or regulators will be able to handle these issues.

State Street Asset Management survey - Big changes and risks

• 70% of asset managers interviewed said they are having to rethink their business strategy around demand for multi-asset strategies
• 64% say that heightened risk and compliance demands threaten to divert resources from the critical business areas
• 96% of asset managers say they are under pressure to reduce costs
• 77% say they now offer clients more transparency on risk and return compared to a year ago
• 61% say clients are demanding a more personalized approach to help them understand their risks compared to a year ago
• 72% of asset managers say their conversations with clients has evolved to focus more heavily on risk compared to a year ago

The above bullets are just a few of the highlights in the latest State Street survey of the asset management industry. This is an industry that may not have lost its way but is certainly thinking about a new course. Cost pressures are present. Prices are going down and the fixed cost of managing risk and compliance are going up. The scale necessary to be a successful manager is rising so the small guy may not have a chance for success. This is no different than many industries as economies of scale start to kick-in and costs rise. The AUM break-even for success is higher. The manager in the "garage" trying to build a better investment process is going to just be the stuff of folklore. 

What is a point of hope for the medium sized firms is the idea that clients are demanding a more personalized approach to money management and a sense of customization for  premium pricing. Economies of scale are great and the one size liquid alts approach plays to the strengths of larger money managers, but personalized service means small and high touch. The owner operator who takes the time to know his clients and provide services that are tailored to those needs will be successful. 

I have always thought of hedge funds as a mechanisms to provide unique money management services to a core group of selected clients that have a close relationship with the manager. Transparency is through the manager knowing the client and the client knowing the manager. Transparency of integrity and knowledge of the goals and objectives of both manager and client is a core risk management skill.

The State Street survey points out what may be the biggest change in the asset management - the new focus on objective oriented asset management. Providing management that meets the goals of each client. 

Global themes for August on one page

Low risk premiums - watch out

History has not dealt kindly with the aftermath of protracted periods of low risk premiums.
- Alan Greenspan, 2005

Risk premia and volatilities are unusually low precisely when risk is highest. What looks like low risk is, in fact, a sign of aggressive risk-taking.
-Claudio Borio

Risk premiums are low and that should be a concern for anyone who invests in financial markets. For that matter, Main Street will also be affected by low risk premiums because we know that declines in financial markets will have spill-over wealth effects on the rest of the economy. The one thing that has been clear since the Financial Crisis is that liquidity and market frictions will hit the real economy. The financial channel affects real growth. The assumptions of most macro models prior to the Financial Crisis were that banking and finance constraints did not play a strong role. We now know differently.

Risk premiums are time varying and mean reverting. Greater risk premium will only be received through prices adjusting downward to make assets more attractive. Risk premiums will rise in response to higher volatility and bad consumption states. As the lower volatility state moves higher, price will react. Of course, we cannot predict when this will happen or what will be the catalyst. We do know that transitions in states are painful.