The Research Foundation of CFA Institute announced the launch of a new monograph which looks at how the financial crisis has affected and will continue to affect the investment management industry. The publication brings together a review of literature, conversations with industry players, industry observers, executive recruiters, and academics in a single volume that provides insight into the lessons to be learned and changes that need to be made to improve investment and business practice in the industry.
Domluke Da Silva, an executive committee member and Chair-Advocacy for the local CFA Emirates society said: “This new study is very important for the investment management industry and in particularly relevant to the finance sector in the UAE as we continue to become more and more integrated into the global financial & investment community. There are valuable lessons to be learnt as well for investors in the region as many were affected by the crisis. Pertinent issues such as the dynamics of asset allocation, diversification and correlations, the importance of having a global view on the investment environment, marketing of structured derivatives products and ethics all have significant ramifications for investors, whether investing out of or into the region. â€
Focusing on what the industry has identified as challenges in the post-crisis period, such as asset allocation, risk management, management fees and the redistribution of roles in investment management, as well as ethics and regaining the trust of the investor, the monograph highlights ten key considerations:
1. For effective diversification, consider correlations at the relevant time horizons. Instantaneous correlation between the returns of different assets and asset classes does not fully reflect the behaviour of the returns of assets or asset classes in times of crisis, when there can be shifts in medium-term trends or an increase in correlation at long time horizons.
2. Review asset allocation more frequently. Today’s markets experience more large swings in market valuations and change behaviour in fundamental ways that affect the forecasts of entire asset classes and require dynamic asset allocation. However, while dynamic asset allocation holds the promise of higher returns, it is a source of risk given that it shifts assets dynamically from entire asset classes, leaving little margin for mistakes in timing.
3. Consider extreme events as they do occur more frequently than today’s risk models forecast. Empirically, we know that returns distributions are fat-tailed. In addition, there are hidden sources of extreme risk that have to be accounted for. These facts need to be incorporated into financial decision-making.
4. Consider carefully the magnitude of losses should one need to unwind positions rapidly. Recent events have demonstrated that a sudden withdrawal of liquidity from markets might occur, leading to potentially very large losses on leveraged strategies.
5. Consider the complexity of the web of relationships between agents and between investment products. The structure of market links has come to the forefront as a source of risk as complex derivative products might propagate losses throughout the economy well beyond what was believed realistic before the 2007-2009 crisis.
6. Look at macroeconomic quantities as the real economy does matter. Though macroeconomic variables move slowly, they are important insofar as they can signal the building up of situations that might lead to large losses.
7. Consider the risk that hedging strategies can fail given that apparently solid counterparties can and do fail (Lehman Brothers). With the crisis that started in 2007, hedging has acquired a new dimension as the possibility of failure of counterparties such as major banks and insurance firms has increased beyond what was considered likely before the crisis.
8. Build up multi-asset and multinational capability: markets are global and investors increasingly expect those who manage their money to have a global view on the investment environment.
9. Build up the quantitative capability to address the size and complexity of markets, and the fact that optimal execution increasingly calls for automation and quantitative capabilities.
10. Align the promise with what the investment management industry can deliver. Investors have been stunned by large swings in market valuations three times in the past 10 years (1997-1998, 2000-2002, 2007-2009) years. The industry needs to regain investors’ confidence.
Sergio Focardi, co-author of the monograph and professor of finance at EDHEC Business School (Nice, France) said, “From mid-2007 through the first quarter of 2009, financial markets were shaken by a series of shocks. It is important that the investment management industry learns lessons from this crisis to understand what needs to be done differently going forward. Everyone in the industry will need more ‘science’, a more systematic consideration of the true risks that lie ahead, be they the risk of extreme events, liquidity risk, counterparty risk or systemic risk. At the same time, investors are asking for more transparency in products and processes and are increasingly reluctant to pay high fees for low returns. The industry needs to propose strategies and a fee structure more aligned with today’s reality. We hope that the monograph’s findings can help impart valuable lessons on today’s industry players.â€
The monograph is free to download and available to the public. It was researched and authored by Frank Fabozzi, CFA, Sergio Focardi, and Caroline Jonas on behalf of the Research Foundation of CFA Institute. The Research Foundation is a not-for-profit organisation established to promote the development and dissemination of relevant research for investment practitioners worldwide.
