When the Tide Turns - Casey Quirk The Ti… · · 2016-12-07When the Tide Turns: Building Next Generation Fixed Income Managers 4 • Clients are grossly unprepared to take losses

Leading fixed income investment managers have enjoyed the greatest success of all industry business models during the past decade. A long-term secular decline in interest rates globally has helped fixed income asset managers double revenue since 2000, and businesses that predominantly manage fixed income currently are more profitable than their equity counterparts.

But storm clouds, in the form of a zero or rising interest rate environment, are already here. Theupside/downside ratio on traditional fixed income products is unsustainably low. Individual and defined contribution investors are most exposed: they hold $5T in fixed income, and are not prepared for losses in this part of their portfolio.

U.S. investors facing uncertain bond markets will shift $1 trillion of assets — almost 15% their current allocation to fixed income — from traditional fixed income products (core, core-plus, government and benchmark-oriented strategies) to next generation debt strategies, including global and emerging market bonds, high-yield and loan portfolios, alternative fixed income products, and vehicles designed to defend investors from inflation and rising rates.

This shift will raise annual revenue from next generation debt strategies — especially those with opportunistic, active investment approaches to find alpha from multiple sources — more than 60% between 2012 and 2017. By 2017 next generation debt strategies will represent nearly 80% of the annual revenue created by fixed income mandates from U.S. investors.

Leading fixed income managers in the next decade will successfully execute four primary strategies to survive and prosper in this new environment:

• Define a next generation debt investment philosophy. Successful fixedincome asset managers will be highly active and benchmark-agnostic, offer broader capabilities, provide modern risk management, and rely onintegrated sector teams.

• Diversify the revenue base. The most successful fixed income firms willposition themselves as next generation fixed income managers, yieldmanagers, debt originators, and more diversified asset managers,potentially re-prioritizing their clients and prospects.

• Communicate with the market. Leading fixed income managers willmanage client expectations, transition clients to appropriate products, andestablish a thought leadership position around next generation debtmanagement.

• Shock-proof the P&L. Winning fixed income managers will prepare thealignment structure and exploit efficiency opportunities in order towithstand temporary revenue downturns.

When the Tide Turns:Building Next Generation Fixed Income Managers

CaseyQuirk by Deloitte.

When the Tide Turns: Building Next Generation Fixed Income Managers 1

1. Introduction:The Fixed Income Decade ...........................2

2. Challenge:A Zero Rate Environment and theUnprepared Investor ...................................3

3. Opportunity:Next Generation Fixed Income ..................6

4. Strategy:Evolving Into a Next GenerationFixed Income Business ................................8

5. Conclusion ..................................................16

Authorship

Authors:Yariv Itah, Casey Quirk Global Practice LeaderBenjamin F. Phillips, Investment Management Lead Strategist - ConsultingJeffrey B. Stakel, PrincipalMichael D. Chia, formerly a Manager at Casey Quirk

Contributors:John F. Casey, formerly Chairman at Casey QuirkKevin P. Quirk, PrincipalDaniel Celeghin, Head of Wealth Management Strategy Asia-PacificDavid J. Bauer, formerly a Partner at Casey QuirkJeffrey A. Levi, Principal

Supporting TeamMatthew J. Baker, Senior Consultant

Casey Quirk by Deloitte helps clients develop broad business growth strategies, improve investment/product appeal and growth prospects, evaluate new market and product opportunities, and enhance incentive alignment structures. Our unparalleled industry knowledge and experience, detailed proprietary data, and global network of relationships make Casey Quirk by Deloitte a leading advisor to the owners and senior executives of investment management firms in the world.

Table of Contents



1. Introduction: The Fixed Income Decade

U.S. fixed income managers have benefited from prolonged tailwinds in the capital markets.

A secular, three-decade decrease in interest rates attracted investors to the asset class, a trend

accelerated by demographics and a flight to perceived safety during the recent financial crisis.

Consequently, managers focused on fixed income grew dramatically, benefiting from both capital

gains and scale efficiencies, and outshining equity-oriented peers across all key business metrics.

Exhibit 1

Key Business Metrics: Equity Vs. Fixed Income Managers

Note: Firms classified as fixed income if at least 70% of revenue is generated from either fixed income or equity assets under management, sample of managers is global in nature.Sources: Casey Quirk by Deloitte/McLagan/Institutional Investor Performance Intelligence, eVestment, Cerulli, and Casey Quirk by Deloitte analysis

Global Growth in Revenue From 2000-2012

Revenue / Full-time Equivalent As of 2012

Operating Margins As of 2012

Revenue109%

73%

34%

32%

67%

53%Efficiency

Profitability■ Fixed Income

■ Equity

0% 20% 40% 60% 80% 100% 120%

{{{


2. Challenge: A Zero-Rate Environment and the Unprepared Investor

The market reality that fueled fixed income managers’ growth in the past decade has changed

dramatically — while the managers have not. Even a partial return to long-term nominal interest

rates will trigger substantial losses to investors in traditional fixed income products. These clients,

mostly retail fund shareholders and defined contribution plan participants, are unprepared for

fixed income losses. The challenge for fixed income managers is, therefore, three layers deep:

• The upside/downside ratio on traditional fixed income products is unsustainably

low, regardless of when (or if) interest rates rise. Rising rates create an obvious

downside, but even if rates remain low, upside potential is too low to help many

investors, especially older ones, reach required objectives.

Exhibit 2

Simulated Capital Gains (Losses) Within U.S. Traditional Fixed Income Portfolios fromChanging Interest Rates

Note: Historical average rate (8.2%) = 1970-2000 of 10-year Treasury bond. A 6.5% increase in nominal rates is required to reach historical averages. Simulated losses are fully marked to market. Sources: eVestment, Casey Quirk by Deloitte Analysis

Short Duration

High Yield

Government

Core-Plus

Core

Long Duration

-70 -60 -50 -40 -30 20 30-20 -10 0 10

-9% -11%

-12% -14%

-12% -15%

-13% -15%

-23% -40%

3%

6%

8%

8%

9%

24%

■ Rates Increase to Historical Average

■ Rates Increase to Half of

Historical Average

■ Rates Fall to 0%

% Change in Value

-6% -6%


• Clients are grossly unprepared to take losses in fixed income. Individual

investors and defined contribution plan participants hold $5T in bonds, the majority

of U.S. investor exposure to fixed income.

Exhibit 3

U.S. Fixed Income Exposure by Client Segment, 2012

Retail

2,105

AU

M ($

B)

HNW PublicPension

1,700

1,232

$0

$500

$1,000

$1,500

$2,000

$2,500

1,230

811

282

DefinedContribution

CorporatePension

Non-Profit

Total AUM: $7.4T

Source: Casey Quirk by Deloitte Analysis

Because sustained interest rate hikes haven’t occurred since the 1980s, most individual investors

under 50 years of age probably never have experienced a negative return on their fixed income

portfolios. Advisors often position traditional fixed income as safe-haven assets, and investors,

consequently, have accepted very low recent returns. Older investors, many of whom have been

encouraged to increase their fixed income exposure immediately before or during retirement, are

particularly exposed. Rising rates will disproportionately impact them, triggering a set of political

and public relations challenges for the industry that will compound fixed income managers’

problems with capital markets.


Exhibit 4

Simulated Fixed Income AUM Loss

60+-$500

$0

$500

$1,500

$2,000

50s 40s

Note: Simulates rate increase of 3.25%, half the long-term historical average. Simulated losses are fully marked to market. Sources: ICI, Cerulli, and Casey Quirk by Deloitte Analysis

$1,000

30s

67% of all losses

20s

■ Retail Fl AUM

■ DC FI AUM

■ HNW FI AUM

■ FI AUM Loss

Age Cohort

• Many fixed income managers are not structured to deal with these challenges.

Having benefited from a long grace period, most fixed income managers have felt no

need to evolve their products, distribution, or business model. They are not fully

prepared to communicate the challenging news to clients, deal with sudden political

pressure, and make painful organizational changes that a zero rate environment

requires. Making necessary changes now, while short-term rates remain somewhat clear

and low, will be much easier than it will be in more volatile conditions.


3. Opportunity: Next Generation Fixed Income

Investors are not waiting for rates to rise and are already beginning to react to the zero rate

environment. A rising rate environment, when it arrives, will merely accelerate trends that

are occurring anyway. Overall exposure to fixed income should remain somewhat constant — in

fact, over the long term, fixed income exposure should increase. However, the types of

fixed income instruments investors will use and demand will change substantially. U.S. investors

will reallocate $1 trillion of assets from traditional fixed income strategies — core, core-plus,

government, and benchmark-oriented fixed income strategies — into next generation fixed

income products such as global and emerging market bonds, high-yield and loan portfolios,

alternative fixed income strategies, inflation and rising-rate defense strategies, and opportunistic

mandates, particularly dynamic and multi-sector varieties.

Exhibit 5

Projected Fixed Income Asset Management Net New Revenue by Client Type, 2013-2017E

WinningStrategies

Net

New

Rev

enue

($B

)

-$3

-$2

-$1

$1

$4

$5

$6

$7

ChallengedStrategies

Note: Simulates $1 trillion of reallocation flows; net new revenue represents fees on inflows/outflows. Source: Casey Quirk by Deloitte Global Demand Model

$3

$2

$0

$6.4

$2.5

$3.9

-$2.2

-$0.7-$2.9

Individual

Institutional

Winning Strategies:• Global and emerging

market debt• High-yield and

loan portfolios• Structured products• Inflation and rate-rise

protection strategies• Opportunistic mandates• Alternative fixed

income strategies

Challenged Strategies:• Core• Core-plus • Government bonds• Benchmark-oriented fixed income strategies

Next generation fixed income products will share the following characteristics:

• Benchmark-agnostic: already, 57% of U.S. fixed income flows in the past three years

have targeted products with the top-quartile tracking error, as investors seek highly

differentiated exposures.

• Focused on non-duration return levers, particularly credit and global macro drivers,

to deliver returns not directly correlated with any potential rate increases.


• Invested broadly across the capital structure, for both risk management and

yield extraction purposes.

• Employing modern, sophisticated risk management for more complex

downside protection.

Next generation fixed income will be one of the most significant catalysts encouraging

convergence of traditional active and alternative investments, with both long-only and alternative

asset managers developing a variety of innovative fixed income products. The line between

traditional forms of fixed income — bonds, for the most part — and debt exposure held in

alternative investments, such as credit hedge funds, CLOs/CDOs, derivatives, and private market

strategies, will blur as managers increasingly combine such securities and instruments.

Such innovation will reflect the broader investment frameworks that institutions and inter-

mediaries already are applying when allocating assets. Rather than segmented allocations built

around instrument types — again, such as fixed income and alternatives — investors will talk

about exposure to debt and credit: employing multiple types of vehicles, held both long and

short, across a wider band of the capital structure. These tools will play key roles in portfolio

allocations with growth, liability, and volatility management objectives.

Exhibit 6

Emerging Investment Frameworks

Legacy Allocation Framework

Traditional Equity •Global•Domestic •Regional•Index

Traditional Fixed Income •Government/Credit•Core/Core-plus•Municipals•Corporate Credit•Structured

Alternatives •Hedge Funds•Private Equity•Real Estate

Emerging Allocation Framework

Equity •Traditional•Smart Beta•Equity Hedge•Private Equity

Debt •Traditional, Smart Beta•Credit and Credit Hedge•Floating Rate and Direct Lending•EMD, Global, Regional•Infrastructure

Real Assets •Real Estate•Timber and Agriculture

Trading Strategies

(Uncorrelated Hedging, Comm

odities Trading, CTA,Overlay M

anagement, Tail Risk Hedging)


4. Strategy: Evolving Into a Next Generation Fixed Income Business

Fixed income managers must prepare for the next phase in fixed income management by

employing strategies that are both defensive and offensive. Regardless of a change in rates,

the following strategic initiatives will not only help defend a firm’s current business, but also

will propel its growth.

Exhibit 7

Preparing the Fixed Income Business

1Define Next Gen DebtInvestment Philosophy

2 3 4Diversify theRevenue Base

Communicatewith the Market

Shock-Proofthe P&L

Strategy 1: Define a Next Generation Debt Investment Philosophy

The first and perhaps hardest step in preparing a business for the new fixed income environment requires re-examining the firm’s investment philosophy. The investment philosophy determines the manager’s identity, and investors often cite it as the primary reason for selecting and retaining an asset manager. Successful managers will not shy away from challenging their long-held ideas, given that capital market realities today are fundamentally different from those of the past 30 years.


Exhibit 8

Shifting the Fixed Income Framework

Benchmarks

Duration

Legacy Fixed Income Management

Sensitive

Benchmark-driven management

Reporting and forecasting

For diversification

Macro views

Sector allocations

Defined by tracking errorRisk management

Investment teams

Research focus

Siloed

Ratings underwriting

Positioning

CapabilityBreadth

Risk

Team Structure

The Next Generation ofFixed Income

Agnostic

Aggressive, dynamic management

Actionable trading strategies

To capture alpha

Dynamic factor management

Cross-sector skill sets and disciplines

Capital structure mispricing

Successful managers can carefully innovate their investment philosophy in four ways:

• Dump the benchmarks. Investors already favor investing in benchmark-agnostic

funds and products. In the future, this trend will accelerate as both asset managers

and investors realize that these benchmarks are not portfolio construction tools.

• Expand the capability set. Asset managers will look to further develop non-duration

drivers of returns. This likely will involve expanding macro capabilities from simply

reporting and forecasting key macro indicators to executing actionable trading strategies.

Successful fixed income managers will develop the capacity to work across multiple

geographies and currencies, and approach asset allocation and smart beta as tools to

drive alpha, not just manage or mitigate risk.

• Shift to dynamic factor risk management. Risk management at many benchmark-

driven managers is insufficiently developed to manage today’s fixed income portfolios, let

alone next generation products. Risk management needs to evolve from a reporting

system based on tracking error, volatility, and value at risk into a dynamic factor system

integrated with the investment process in real time. Modern risk management monitors

exposure to broad factors (such as the price of oil, regional trade balances, and monetary

policy) at the security, portfolio, strategy, and firm levels, and directly integrates this data

to decision making at the strategy and portfolio level.


• Restructure the investment team. In most traditional fixed income investment teams,

analysts determine a view at the sector level, and portfolio managers allocate across

sectors. Next generation fixed income managers will break down the silos to exploit capital

structure mispricing at the issuer level and improve communication to enhance relative

value decisions. That will require not only organizational changes (reporting lines,

compensation) and investment process modifications (research inputs, data and

information, decision making), but also could include physical changes to trading and

research desks, as well as communication protocols.

All of these changes imply challenging structural modifications that must be conducted with

minimal disruption to team cohesiveness and current portfolio performance. Making these

changes is risky and delicate, but successful managers will embrace them as necessary to remain

competitively relevant.

Strategy 2: Diversify the Revenue Base

Shifting demand within fixed income allocations will allow some fixed income managers to

reposition themselves by redefining their vision and value proposition as a firm. Depending on the

size, global reach, organizational ability to expand, balance sheet, and growth requirements of the

specific firm, expansion and diversification could be both strategically and tactically beneficial.

Exhibit 9

Strategic Options for Diversifying Traditional Fixed Income Revenue

Provide Next Generation

Fixed Income

Description

• Global and EMD• High yield and loans• Structured products• Inflation and rate-rise protection• Opportunistic mandates

• Infrastructure• Real estate• Dividend equity

• Private lending• Sourcing and packaging

unlisted opportunities• RE loan origination

• Equity• MACS• Alternatives

Reposition as Yield Manager

OriginateLoans

Execute Broad

Diversification

Opportunity

❏ Demand already exists in both retail and institutional markets

❏ Remain close to the corebusiness and client base

❏ Expand beyond debt instrumentsand leverage credibility incore business

❏ Diversify into higher-fee products

❏ Very large opportunity, untappedby traditional asset managers

❏ Leverages core credit analysis skills

❏ Expand beyond the asset class

❏ Timing might be right to acquire equity teams

1

2

3

4

✓

✓

✓

✓

✓

✓

✓

✓


Fixed income managers can typically pursue one, or more, of four options to diversify their

revenues away from traditional fixed income products:

• Provide next generation fixed income. Managers can upgrade their fixed income skill

set by offering multi-sector, multi-currency, and multi-region products, as well as strategies

based on sophisticated inflation protection, negative rate exposure, and floating-rate

instruments. Additionally, expanding packaging will help. Successful fixed income

managers will offer their capabilities in a variety of vehicles, including closed-end funds

that address liquidity challenges, structured products designed around specific outcomes,

and separate accounts that permit more buy-and-hold strategies.

• Reposition as a yield manager. Demand for yield and income is an important driver

of investor demand, as individual investors search for income replacement products in an

era of declining defined benefit eligibility and access. Winning fixed income managers will

leverage existing skills, as well as potentially acquire new ones, to expand into other yield-

driven strategies such as real estate, agriculture, infrastructure, and perhaps even

dividend-yielding equity strategies.

• Originate loans. While revolutionary, loan origination and direct lending may represent

one of the asset management industry’s least tapped sources of future revenue.

Insurance companies and hedge funds already are well ahead of fixed income managers

in originating loans. Managers could and should seek to complement banks, particularly

as regulation and politics drive many traditional lenders away from riskier issues. Pursuing

this market position will require substantial investment, but asset management firms have

the economics to attract good talent and can focus on narrow parts of the market where

they can add value, serving investors who prefer taking on additional risk over the insured

safety of a bank deposit.

• Execute broad diversification. Some next generation fixed income managers will

expand their brand and product offering to include alternative, multi-asset, and even

equity products. For these managers, the timing is right to exploit their investments

leadership (and financial success) in the fixed income business by transforming

themselves into more multi-capability competitors. This is the most transformative and,

therefore, riskiest option: to date, fixed income managers have experienced mixed

success in expanding into other types of securities.


Across all of these positioning alternatives, managers will have another decision to make: their role

in the lengthening distribution value chain. A lengthening value chain across the industry will lead

all asset managers to continuously evaluate their highest-priority clients. Traditional fixed income

managers unable to quickly diversify into next generation products may elect to sell their existing

duration-focused products into the multi-asset portfolios of other asset managers and

intermediaries, rather than directly to individual investors. Conversely, firms with strong macro

and allocation capabilities may further invest in individual client relationships, opening

architecture to component providers where necessary.

Strategy 3: Communicating with the Market

Having a well-planned and executed market communication strategy is critical, for both defensive

and offensive purposes.

Exhibit 10

Communicating with the Market

Provide Next Generation

Fixed Income

Def

ensi

veG

row

th-D

rive

n

Proactively transition clients

❏ Review client guidelines and increase flexibility, if needed

❏ Identify allocation or product changes to enhance client positioning

❏ Nudge clients to next generation products

Prepare clients

❏ Map out clients’ sophistication and expectations

❏ Communicate potential risks and portfolio impact of a rising rate environment

❏ Communicate how the firm is preparing to protect its clients and its team

Educate the market

❏ Launch a planned campaign to share thought leadership with the market

❏ Leverage capital market challenges to establish a long term competitve advantage


Managers who turn the challenge into an opportunity will employ all of the following steps to

communicate with the market:

• Prepare investors. To defend the franchise, successful fixed income managers will take

steps to fully understand their client base, including its composition and

broader investment objectives. Successful managers will tier clients by objective and

sophistication, and communicate how the current environment impacts the risk

investors are taking and return expectations they should have.

• Proactively transition clients. As managers develop a next generation fixed income

investment philosophy, winning firms will proactively transition their clients to it.

At first, managers will modify the way existing portfolios are run. Then, as new

next generation products are developed, managers will encourage clients to make

allocations to these products.

• Educate the market. In this final step, successful managers will launch an appropriate

thought leadership campaign and establish a market position as an investment leader in

next generation fixed income investing. This position and branding will become

invaluable if and when the tide does turn, and investors look for firms that already have

formulated a credible strategy and response.


Strategy 4: Shock-Proof the P&L

Successful fixed income managers will not only prepare portfolios and clients for rising rates,

but also will prepare their own employees and shareholders. Taking a page from equity-focused

investment firms during the recent financial crisis, asset managers with high exposure to

traditional fixed income strategies can modify incentive alignment and efficiency initiatives to

prepare for a temporary, but potentially sharp, decline in revenues that would result from

investors fleeing capital losses triggered by rate increases.

Exhibit 11

Shock-Proofing the P&L

Preparing the Alignment Structure

CompensationVariability

FranchiseAlignment

LongerHorizons

Investments

Distribution

CorporateResources

Pursuing Reasonable Efficiency

Shock-Proof

the P&L


Compensation and incentives represent the largest part — between 63% and 82% on average —of

an asset manager’s middle line. Aligning next generation fixed income teams and operations

around the business success of the entire franchise is always important (and always sought by

professional buyers), but it will be crucial to help execute the change management required in

transitioning to next generation fixed income management. Winning fixed income managers will

align incentive structures in three ways:

• Increase compensation variability. When revenues fluctuate, variable compensation

structures allow the firm to keep a large part, or the entirety, of their team employed.

Firms with high fixed compensation costs often conduct massive layoffs at exactly the

moment when they need talent to deal with external pressures.

• Ensure franchise alignment. Many fixed income managers have compensation

structures that align key personnel with narrow individual-level objectives, often focused

on product performance, rather than with the financial success of the entire enterprise.

Traditional fixed income teams could suffer as a result, leading them to make decisions

that may be best for their individual compensation, but not for clients or the firm as a

whole. Ownership and pseudo ownership programs built on franchise value are effective

solutions for such issues.

• Prolong bonus horizons. Too many firms still have very short-term compensation

structures. Longer-term and deferred compensation vehicles help smooth the potential

negative effects of short-term revenue volatility.

Additionally, given their long-term historical growth in revenues and earnings, many fixed income

managers have not focused on efficiency. True efficiency is not solely about cost cutting, but

rather ensuring that the firm’s best resources are positioned against its greatest opportunities.

Successful fixed income managers will seek efficiencies in three key areas:

• Investment team. The structural changes required to develop next generation fixed

income products also will provide a longer-term opportunity for streamlining processes

and eliminating redundancies. Firms should stomach temporary inefficiency to underwrite

change management, but plan to optimize resources against the best opportunities for the

long term.

• Sales and client service. Most fixed income managers leveraged historically high levels of

cash flow to sustain sales and client service infrastructure across a wide range of client

segments. The changing operating environment will force fixed income firms to deploy

resources only against the opportunities with the highest likelihood of success.


• Corporate resources. As next generation products are developed and new markets

pursued, successful managers will recognize the need to add operational and managerial

resources to manage the flow of activity. In the past, many managers have had the

tendency to assume more scalability in their business than there really was, and stifled

growth by not investing enough in these functions.

5. Conclusion

Institutional and individual investors already are demanding next generation fixed income;

successful fixed income firms will implement it regardless of the timing and magnitude of

interest rate changes. Most importantly, next generation fixed income will likely be the largest

intersection to date between the traditional and alternative worlds of active asset management,

as changes in the yield curve will make a previously theoretical discussion highly tangible and

necessary. Transitioning a fixed income business requires a multi-pronged approach requiring

investment and organizational changes. Successful fixed income managers will find this

transformation challenging, but necessary, and invest time and resources accordingly.

Supporting Team: Michael D. Chia, Matthew Baker

When the Tide Turns:Building Next Generation Fixed Income Managers

Kevin P. Quirk, PrincipalYariv Itah, Casey Quirk Global Practice LeaderDaniel Celeghin, Head of Wealth Management Strategy Asia-PacificGrace Cicero, Chief of StaffJeb B. Doggett, DirectorJonathan L. Doolan, PrincipalJeffrey A. Levi, PrincipalBenjamin F. Phillips, Investment Management Lead Strategist - ConsultingJeffrey B. Stakel, PrincipalJustin R. White, Principal

Casey Quirk by Deloitte helps clients develop broad business growth strategies, improve investment/product appeal and growth prospects, evaluate new market and product opportunities, and enhance incentive alignment structures. Our unparalleled industry knowledge and experience, detailed proprietary data, and global network of relationships make Casey Quirk by Deloitte a leading advisor to the owners and senior executives of investment management firms in the world.

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Benjamin F. Phillips Investment Management Lead Strategist - Consulting New [email protected] +1 347 269 1324

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When the Tide Turns - Casey Quirk The Ti… · · 2016-12-07When the Tide Turns: Building Next Generation Fixed Income Managers 4 • Clients are grossly unprepared to take losses