COMMERCIAL AND INDUSTRIAL MATHEMATICS
|May 24, 2015|
Seminar Series on Quantitative Finance - January 30, 2003
Don Lindsey, President and Chief Executive
Officer of the University of Toronto Asset Management Corporation
The two decade-long bull market that ended in early 2000 created the status quo of investment management. The lucrative consulting business convinced institutional investors of the need for equity diversification across value and growth styles, capitalization sectors, and top-down and bottom-up stock selection. Then the hot debate became active management versus inexpensive indexation. By the end of the run, it did not matter because there was enough flow of funds into the equity markets to forgive mediocrity and unrewarded tracking error. Only those who were willing to compromise assets under management in order to pursue undervalued and unrecognized opportunities were penalized.
If a low equity risk premium environment persists over the next several years, the hedge fund structure is likely to eclipse the current mutual fund and investment advisor model. The owner-agency conflict can only persist in a bull market. The traditional business model rewards assets under management rather than risk-adjusted performance and does not appropriately align the interest of investors and firm management.
The pension industry has been obsessed with manager performance at the expense of diversification. The problem today is that it is virtually impossible to obtain the appropriate degree of diversification in a three-asset world of stocks, bonds and cash.
The traditional hedge fund model developed decades ago by Alfred Jones goes a long way in eradicating the owner-agency problems faced by investors. Hedge fund managers are expected to invest the majority of their liquid net worth in their fund. They seek absolute returns, which alleviates the tying of benchmark risk to business risk. Freedom from benchmark risk gives them the flexibility to exploit a wide range of opportunities. This requires, however, that plan sponsors and institutional investors develop a complete and thorough understanding of risk that goes beyond traditional mean-variance analysis.
As in any new industry, there has been a rush of participants trying
to play survival of the fittest. This means more frequent hedge fund
catastrophes are likely to happen, but the evolution of the investment
management business is firmly in place.