10 key trends changing investment management

*Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/qualified pursuant to FINRA regulations.
By Garry Evans
We are in an unusual investment world of ultra-low interest rates, swings between risk-on and
risk-off, and investors demanding yield, low fees and limited risk
This raises big challenges for the investment management industry. We identify 10 trends that
are shaping the industry – from the decline of hedge funds and the growth of multi-asset
funds, to the relentless rise of ETFs and the stirring interest in ESG
These trends should be positive for credit, high-yielding equities and alternative assets (such as
long-term debt financing and structured derivatives products)
Disclosures and Disclaimer This report must be read with the disclosures and analyst
certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it
The 10 key trends changing
investment management
…and how they will affect asset prices
Multi Asset Strategy
September 2012
Garry Evans*
Global Head of Equity Strategy
The Hongkong and Shanghai Banking Corporation Limited
+852 2996 6916
garryevans@hsbc.com.hk
Garry heads HSBC's equity strategy team worldwide. His previous roles at HSBC include Asia Pacific Equity Strategist, Head of
Pan-Asian Equity Research, and Japan Strategist. Garry began his career as a financial journalist and was editor of Euromoney
magazine for eight years before joining HSBC inTokyo in 1998. Garry is based in Hong Kong.

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The 10 trends shaping the investment world
We are in a very unusual investment world. Interest rates are at historical lows, equities more volatile
than normal, different assets classes abnormally correlated and demographics are altering savings patterns
in rich countries.
These developments have already caused big shifts in investment flows over the past five years. Investors
have switched massively from equities into bonds, moved their money into index funds and ETFs, and
searched for new ways to achieve return without too much risk.
In this report we look at how investor behaviour is changing and what this means for investment
management businesses. We identify 10 themes that we believe will shape the future of the industry over
the coming years. Not only is an understanding of these important for strategy planners at investment
management firms (and we held discussions with many CEOs and CIOs of investment firms in the
preparation of this report), we think these trends will affect asset prices too. Will the search for income
push down yields on credit to ridiculous levels? Will investors completely abandon equities because of
their volatility? Will demand for alternative assets (infrastructure financing, distressed debt, derivative
structures) push up their prices?
We believe that understanding these sorts of deep underlying trends in investment is important for asset
allocation. It is too easy to get caught up in the day-to-day movements of the economic cycle. Thinking
about long-term drivers, such as demographics, changes in wealth or market micro-dynamics, can help
improve investment decision-making. We believe the ideas and copious data in this report will prove
thought-provoking for anyone interested in understanding these shifts.
After an introductory section, which analyses the macro background and describes the state of the
investment management industry today – including projections for its future growth – each chapter of this
report details one of the trends, with our assessment of its implications of each for asset prices.
There are some common threads running through the trends. In brief, these are: the struggle to produce
income in a low interest-rate world (via credit, high dividend yield equities or illiquid investments); the
desire to tailor risk (though risk-minimising products and absolute return multi-asset funds); and the shift
to passive investments such as index funds and ETFs, which has begun to hurt hedge funds too.
Summary
How is a world of low interest rates, risk aversion and unusually high
correlations affecting the investment management industry? We
identify 10 trends changing how investors invest, and assess their
impact on the price of assets

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Our 10 trends are:
1. Average US BBB-rated five-year corporate bond
0
2
4
6
8
10
03 04 05 06 07 08 09 10 11 12
Yield
Spread
 The search for yield. With risk-free rates so
low, investors are desperate for income. They
have already piled into bonds. Credit remains
in a sweet spot, though issuers are attracted
by the low interest rates but, for investors,
spreads over government bonds remain
decent (Chart 1). We think dividend yield
stocks remain attractive, too. Many investors
argue it’s too late to buy them but in the US,
in particular, income funds still comprise only
3% of equity mutual funds. Page 13
Source: Bloomberg
2. Total return indexes* (log scale) since 1988
4.5
5.0
5.5
6.0
6.5
88 90 92 94 96 98 00 02 04 06 08 10 12
Equity
Bond
Cash
 The death – or rebirth – of equities. Bill
Gross of Pimco says the cult of equity is
dead. But equities have actually outperformed
bonds over the past 10 years, although
admittedly with high volatility (Chart 2).
Perhaps a bigger risk – which bond houses
are worrying about – is the bursting of the
bond bubble: could 2014 be another 1994? At
the very least, with cash yielding zero and
high-quality government bonds 1.5%, it
seems likely that equity returns will beat
these over the next 10 years. Page 17
Source: Bloomberg, MSCI (*Equity=MSCI ACWI TR Gross, Bonds=JP Morgan
Aggregate Bond Index TR Unhedged USD, Cash=3-month T-bills)
 Risk minimising strategies. Investors ideally would like equity-style returns with bond-like
volatility. That’s rarely possible. But fund managers are developing products that offer different
combinations of risk and return. Such strategies include: multi-asset funds, long/short equity
strategies, risk parity products, minimum volatility equity funds and using options to target a level of
risk. Page 20
 The growth of multi-asset. The fastest growing type of risk minimising strategy, especially in the
UK, is the absolute return fund, most famously Standard Life’s GARS. Such funds target Libor-plus
absolute returns, with bond-like volatility and costs lower than hedge funds. They have their
detractors (do they really create alpha, or are they just leveraged bond funds?) but look likely to grow
further, even in the US where they have yet to take off. Page 22

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3. Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USDbn
Passive Active
 The shift to passive. A third of active equity
money has shifted into passive funds in the
past 10 years (Chart 3). We think passive
encroachment is likely to continue, since
active funds empirically underperform on
average (with higher costs). But indexing
strategies are likely to get smarter: some
indexes outperform others, for example the
equal-weighted S&P500 has beaten the
regular (market cap weighted) S&P500 by
37% in the past decade. Page 24 Source: EPFR
4. Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1,000
1,200
1,400
1,600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012*
US Europe Other
 The relentless rise of ETFs. ETFs have
reached USD1.5trn (up from USD105bn in
2001 – Chart 4). But there are issues with
these, too. Are ETFs suitable for bonds?
Some overly sophisticated ETFs have blown
up spectacularly: will this invite the
regulators’ attention? The two keys for future
growth are (1) whether active ETFs take off,
and (2) the trend of retail financial advisors
being remunerated by fees rather than
commissions on the products they sell (ETFs
don’t pay a commission). Page 28 Source: Blackrock (*end-Jun)
5. Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF index
L/S equity
Macro HFs
 The decline of the hedge fund? Hedge funds
have struggled to perform recently (Chart 5).
The average hedge fund is up only 2.5% so
far this year. The underlying problem is that
the hedge fund community has become so big
that it has arbitraged out most of the alpha.
Like active equity funds, hedge funds in
aggregate cannot by definition outperform.
Moreover “traditional” fund managers are
increasingly converging with large hedge
funds – and they don’t charge fees of 2% and
20%. Page 31 Source: Bloomberg, EurekaHedge

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6. Illiquidity premium estimate, by asset class
0
100
200
300
400
500
Equity Corporate
bonds
Government
bonds
Covered
bonds
bp
 Harvesting the illiquidity premium. Most
investors have a strong preference for
liquidity. But some – notably pension funds
and insurers – don’t always need it and may
be overpaying for it. Amid the desperate
search for income, they may see the attraction
of the extra yield available in illiquid assets
(Chart 6) such as infrastructure, real estate
finance and “private debt” (structured like
private equity, but providing debt financing).
Page 34 Source: Adapted from Barrie & Hibbert
(www.barrhibb.com/documents/downloads/Liquidity_Premium_Literature_REview.pdf)
7. Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
 Where will the money come from? Defined
benefit pensions are dwindling (Chart 7). The
growth areas for investment management
companies in the next few years will be
personal pensions, Asian high net worth
individuals and sovereign wealth funds. But
each of these will demand more sophisticated
products and solution-based services. Page 36
Source: OECD
8. SRI assets under management (USDtrn)
0
2
4
6
8
10
2005 2007 2010
US SRI AUM ($tn) Europe SRI AUM ($tn)
 The challenge of ESG. Plan sponsors,
particularly public pension funds in Europe,
are increasingly focusing on environmental,
social and governance issues. So far, most
fund managers pay only lip-service to this.
But momentum is building (Chart 8) and
companies with superior ESG policies and
disclosure might start to outperform. After
all, who wants to buy a company with poor
corporate governance, which pollutes or treats
its staff badly? Page 42
Source: US SIF, Eurosif (definitions differ slightly)

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Implications for asset prices
The search for yield should be positive for credit and for high dividend yield stocks, both of which remain
attractive in our view. Equities in general may struggle for a few more years as global economic growth
remains low, but the basic concept that equities have a risk premium – and therefore generate greater
returns in the long run – will not disappear. If investors become more willing to buy illiquid assets to
boost yield, the pricing of long-term loans, commercial real estate and infrastructure finance should be
positively affected. The development of multi-asset funds should aid the development and liquidity of
more esoteric asset classes and derivatives products. We believe the further growth of passive funds and
ETFs will keep inter-market and intra-market correlations high.

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Introduction: an unusual world 7
Cyclical or evolutionary? 7
The search for yield 13
…in credit and dividends 13
The death – or rebirth – of
equities 17
Problem is volatility, not return 17
Risk-minimising strategies 20
Tailoring risk, not return 20
The growth of multi-asset 22
GARS and all its friends 22
The shift to passive 24
It’s hard to beat an index 24
The relentless rise of ETFs 28
Attractive – but problems too 28
The decline of the hedge fund? 31
Is there any alpha left? 31
Harvesting the illiquidity
premium 34
Do you really need liquidity? 34
Where will the money come
from? 36
The sources of growth 36
The challenge of ESG 42
Unavoidable momentum 42
Disclosure appendix 46
Disclaimer 48
Contents

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Cyclical or evolutionary?
We are in a very unusual investment world.
Interest rates are at historical lows, equities more
volatile than normal, different assets classes
abnormally correlated (the “risk on-risk off”
phenomenon) and demographics are altering
savings patterns in rich countries.
These developments have already caused a big
shift in investment flows over the past five years.
Investors have:
 Sold equities and bought bonds in huge
volumes: in the US since end-2007 bond
mutual funds have seen inflows of USD920bn
and equity funds outflows of USD430bn.
 Loaded up on risk-free assets. But the supply
of these has shrunk (according to the BIS,
AAA-rated government paper now totals only
USD12trn, compared to USD26trn in early
2011 – Chart 1). This has pushed down their
nominal yields to below zero in some cases.
 Increasingly understood that active equity
fund managers in aggregate underperform
benchmarks (even before fees) and so moved
heavily into index funds and ETFs.
 Searched for new ways, other than equities, to
achieve a decent return without too much risk.
This has led to the development of absolute
return (or diversified beta) funds and risk-
minimising strategies.
1. Credit risk of pool of government debt
0
5
10
15
20
25
30
35
40
01 02 03 04 05 06 07 08 09 10 11
AA to below AA+
AA+ to below AAA
AAA
Source: BIS (Ratings used are the simple averages of the long-term foreign currency
sovereign ratings from Fitch, Moody’s and S&P.)
Is this a permanent structural change, or will we
eventually go back to the old normal? Probably a
bit of both. The side-effects of the 2007-9 Global
Financial Crisis will eventually wear off (though
Introduction: an unusual
world
 Low rates, high volatility, high correlation – the world has changed
 Fund managers are struggling to cope: how to find returns without
too much risk, and provide solutions to investors with new needs
 We indentify three threads: the search for income, tailoring risk,
and the continuing shift from active to passive
Garry Evans*
Strategist
The Hongkong and Shanghai
Banking Corporation Limited
+852 2996 6916
garryevans@hsbc.com.hk
*Employed by a non-US affiliate
of HSBC Securities (USA) Inc,
and is not registered/ qualified
pursuant to FINRA regulations

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this may take a few more years), with interest
rates, volatility and correlations returning to their
historical norms.
But there has been some evolution too. Investors’
behaviour is likely to have changed permanently:
 Investors will increasingly question whether
hedge funds can generate alpha and whether
they deserve fees of 2% and 20% even if
they can.
 Retail investors will demand access to the sort
of absolute return strategies that hedge
funds previously specialised in – and at a
reasonable cost.
 There will be more demand for solutions:
whether liability-matched investments for a
defined benefit (DB) pension fund that is
winding down, or a “to-and-through”
personal pension plan for an individual due
to retire in five years who wants to fix
post-retirement income.
 Interest in buying stocks in companies with a
strong ESG (environmental, social and
governance) record will increase. This is not
idealistic green talk – after all, who wants to
own a company with poor corporate
governance or which treats its staff badly?
Many of these themes are fairly obvious, and have
been under way for a number of years. But how
the fund management industry will be affected by
them is not yet at all obvious. Like any business,
an investment management firm has to pick a
strategy: should it rush into all these new areas
(ETFs, absolute return funds, pension solutions,
ESG) or should it decide to focus? Is it better to
be a large global investment house or a focused
boutique – or hedge one’s bets by becoming a
multi-boutique umbrella organisation?
These trends will affect asset prices too. If
investors abandon equities for a generation, PE
multiples would contract further, as they did in the
1970s or after the Great Depression. Further
growth in ETFs and index products could push
correlations up further. A rise in demand for
alternative assets (infrastructure financing,
distressed debt, derivative structures) could shift
the prices of these assets. As banks in Europe
deleverage, infrastructure lending, leasing and
other forms of long-term finance could pass to
institutional investors, in a form of
disintermediation, which could bring down
borrowing costs.
2. Demographic trends: % of population aged 35-54 in DM 3. Demographic trends: % of population aged 35-54 in EM
20%
22%
24%
26%
28%
30%
1990 2000 2010 2020 2030 2040 2050
Developed markets
20%
21%
22%
23%
24%
25%
26%
27%
28%
29%
1990 2010 2030 2050
Emerging
Source: HSBC, UN Population Division. NB: MSCI World markets Source: HSBC, UN Population Division.

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Why this matters
This is a topic that HSBC’s strategy team has
tackled before. We believe that understanding the
deep underlying trends in investment are
important for asset allocation. It is too easy to get
caught up in the day-to-day vicissitudes of the
economic cycle. Thinking about long-term
drivers, such as demographics, changes in wealth
or market micro-dynamics, can help improve
investment decision-making.
Earlier this year, for example, we published a
report (Who will buy by Daniel Grosvenor, 3
February 2012) which argued that demand for
equities is likely to remain structurally weak due
to prolonged risk aversion, regulatory changes and
deteriorating demographics. In particular, ageing
populations in the developed world (Chart 2) will
tend to own fewer equities. This, the report
argued, could keep DM valuations depressed, but
EM should be immune (partly because of its
better demographics – Chart 3).
We also described the growing importance of
emerging markets investors in Asia buys Asia by
Herald van der Linde and Devendra Joshi , June
2012. Asian equity markets have traditionally been
dominated by foreign investors or speculative local
individuals. But this is changing, as Asians diversify
their wealth into financial assets, and pension
systems develop across the region.
Our colleagues in quantitative strategy have also
looked at the risk on-risk off phenomenon (their
latest report is Risk On – Risk Off: Fixing a
broken investment process, by Stacy Williams,
Daniel Fenn and Mark McDonald, April 2012).
They suggest ways in which fund managers can
adapt their investment process to cope with the
phenomenon and take advantage of it.
For this present report, we met with CEOs, chief
investment officers and senior business managers
at almost 20 investment firms in the US and
Europe. These ranged from niche long-only equity
specialists to opportunistic macro hedge funds,
from major ETF providers to large global multi-
asset investment managers. Naturally most of the
senior managers had a bias based on what they
specialised in: equity houses tend to believe that
actively managed equity will come back, and
passive specialists argue that in future everything
will be indexed.
But our conversations gave us a good idea of the
sort of concerns investment managers have when
they are being candid. Bond houses worry about
how to cope with the crash in bond prices that we
believe is inevitable in the future. Active
managers worry whether it’s too late to enter the
index ETF business – or whether they should try
to structure their active funds as ETFs. Many
managers are struggling to create innovative
products – risk-hedged funds, absolute return
strategies, pension-friendly structures – in a world
where their revenues have stagnated and so R&D
budgets have been cut.
The global investment industry today
Before we try to draw out some threads from the
10 trends in investment management we have
identified, some background.
4. Assets under management (USDtrn, end-2010)
Insurance
funds, 24.6
Pension
funds, 29.9
HFs, 1.8
SWFs, 4.2
ETFs, 1.3
Mutual
funds, 24.7
PE, 2.6
Source: TheCityUK estimates
How big is the global investment industry?
Conventional assets (pension funds, mutual funds

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and insurance) total about USD80trn, split
roughly evenly between the three (Chart 4). The
AUM of these institutions has doubled since
2000. Hedge funds manage around USD2trn, and
private equity funds a little more than that. Add to
this sovereign wealth funds which, in their pure
form, have assets of about USD5trn; include FX
reserve managers and other sovereign institutions
(such as national pensions or development funds)
and the total reaches about USD20trn. ETFs
comprise another USD1.5trn or so. Private wealth
is harder to figure out: various estimates put it at
between USD26trn and USD120trn. At the top
end of estimates, the total amount of money
available for investment firms to manage exceeds
USD200trn – almost 3x global GDP.
The US is still the largest source of funds, with
USD35trn out of the USD79trn in conventional
assets globally (Chart 5). That is 224% of US GDP.
The UK, though much smaller in absolute terms, at
USD6.5trn, is the biggest in proportion to GDP, with
conventional funds representing 257% of GDP
(although some of that comes from money
domiciled in the UK but not from UK nationals).
5. Source of conventional assets, by country (USDtrn)
0
5
10
15
20
25
30
35
40
US
UK
Japan
France
Germany
NL
Switz.
Other
Pension funds Insurance assets Mutual funds
Source: TheCityUK estimates based on OECD, Investment Company, SwissRe and UBS
data. (Figures are for domestically sourced funds regardless of where they are managed.
No reliable comparisons are available for total funds under management buy country.)
…and the chances of it growing
There is no reason to suppose that the rate of
growth of institutional assets will slow over the
coming years. Over the past decade, conventional
assets have grown at a compound annual rate of
7.1%. While it is likely, in our view, that global
economic growth will be lacklustre in coming
years as the after-effects of the Global Financial
Crisis are worked off, this does not mean that
global savings will be stagnant. Indeed, quite the
opposite. Households and companies are likely to
increase their savings as they stay risk averse (and
governments are likely to reduce fiscal deficits,
albeit slowly).
The IMF projects that US and UK gross national
savings, which have already improved modestly
since 2009 (to 12.9% of GDP from 11.5% in the
case of the US), will continue to increase over the
next five years, with the US reaching 17.8% by 2017
(Chart 6). China, meanwhile, is unlikely to reduce its
savings rate much, despite efforts to get households
to spend. Australia has already made some headway
in raising its savings rate since its bubble in the early
2000s. Japan is the only major economy where the
ratio may fall, as retirees start to eat into their
savings. All this suggests that the savings glut, which
drove the fall in interest rates and strong equity
performance in 2003-7, will not disappear.
6. Gross national savings rate, selected countries (% of GDP)
0
10
20
30
40
50
60
80 85 90 95 00 05 10 15
UK US AU CH JP
F
Source: IMF
And, at the same time as savings grow, companies in
the developed world are unlikely to need to raise
much money for the next few years. Corporate cash
holdings are at record highs, especially in the US,
and companies are being cautious about capex.

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Dividend payout ratios are very low (31% in the US
last year, for instance). This suggests that large listed
companies, at least, will not need to raise much
capital, either debt or equity, for the next few years –
although capital-hungry emerging markets
companies, of course, will.
As countries get richer, they tend to increase the
amount of institutional assets under management
and increase the amount invested in equities and
bonds (rather than placed in bank deposits), as
shown in Charts 7 and 8.
7. Increasing wealth brings growth in institutional assets
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
1970 1980 1990 2000 2010 2020
UK US Germany
% of household w ealth in institutional assets
Bubble size = per capita GDP (PPP)
Source: HSBC, CEIC
8. …amid withdrawals from bank deposits
0%
10%
20%
30%
40%
50%
60%
70%
1970 1980 1990 2000 2010 2020
UK US Germany
% of household w ealth in bank deposits
Bubble size = per capita GDP (PPP)
Source: HSBC, CEIC
This suggests that, as long as emerging markets
continue to develop (which in most cases we think
likely), then not only should the pool of potential
savings grow, but the proportion of the pool
available for international investment institutions
to manage should grow even faster. Not that this
will be without challenges: how do London or
New York-based investment managers get access
to wealth held in China or India, which is still
highly restricted in where it can invest and mostly
off limits to them?
Indeed, a well-read report by the McKinsey
Global Institute The emerging equity gap: Growth
and stability in the new investors landscape,
December 2011, argued that the growth of
international securities ownership by emerging
market investors will be essential if the role of
equities in the global financial system is not to be
reduced in the coming decades. In particular,
emerging market investors will need to triple their
allocation to equities if companies in these
countries are not to be starved of equity capital.
Common threads
In this report, we highlight the 10 trends that we
think will drive the investment management industry
over the next few years. Understanding these trends
– and considering their implications – will be
important both for investment institutions in
planning their strategies, and for investors interested
in the impact of these trends on asset prices.

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Inevitably, there are some overlaps between the
10 trends. Broadly, we see three threads running
between them.
 The search for income. With interest rates so
low, investors are desperate to generate
income. This has triggered demand for credit
and high dividend yield equities, which we
expect to continue. It is also forcing investors
to consider whether they are overpaying for
liquidity, and to look at harvesting a premium
for investing in illiquid instruments such as
infrastructure and “private debt” funds.
 Tailoring risk. Modern derivative techniques
make it possible to tailor risk to an extent.
Investors scared of drawdowns can hedge fat-
tail risk. Fixing a return is not possible (except
for a very low return); tailoring a level of risk
may be easier. This concept has spawned the
development of risk parity funds and a boom in
multi-asset absolute return funds.
 A continuing shift from active to passive.
Academic evidence strongly suggests that
active equity fund managers in aggregate
underperform their benchmarks. That has
pushed investors over the past decade from
active to passive funds, especially ETFs – a
trend we expect to continue. It is also forcing
a rethink of the role of hedge funds, which
have grown so large that in aggregate they no
longer seem to be able to produce superior
performance either.
In the following sections, we describe in detail the
10 trends we have identified and analyse their
implications for asset prices.

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…in credit and dividends
With cash yielding zero and top-quality
government bonds little more than 1.5%, it is
unsurprising that investors are scrambling to pick
up yield. Indeed, one could even say that the
market has become obsessed with income.
1. Cumulative net flows to bond funds worldwide, by type
-100
-50
0
50
100
150
200
250
300
07 08 09 10 11 12
USDbn
Govt
Credit
Other
Source: EPFR (“Other” includes muni funds, MBS funds, total return bonds, and funds
able to invest in a mix of bond types)
Look at flows into bond mutual funds recently. It
is well known that these have been very healthy,
totalling USD580bn over the past three years
according to EPFR. But, for the past 12 months at
least, bonds flows have been predominantly into
credit funds (for example, corporate, high yield or
EM bond funds) with even a small net outflow
from government bond funds (Chart 1).
The sort of funds selling well is clear from the list
of the largest fund launches year-to-date. The top
20 new US-based funds, ranked by assets under
management now (Table 2 overleaf), include 10
bond funds, two asset allocation funds and only
eight with an equity focus (remember, this is for
the heavily equity-centric US market). Three of
the best-selling funds include the word “income”
in their names.
Credit is in a sweet spot. Interest rates at which
corporates can issue are at historic lows. But, at
the same time, spreads over US Treasuries are
quite high, making the bonds attractive for
investors too.
In the US, for example, BBB-rated five-year
corporate bonds currently yield only about 2.8% –
the lowest for decades – but that represents a spread
over Treasuries of around 200bp, well above the
average of 130bp from the 2003-7 period (Chart 3).
The same is true in emerging markets. The HSBC
Asian Dollar Bond Index (Chart 4) currently has a
record low yield of 3.7% but the spread over
Treasuries is a still attractive 300bp.
This is why lots of bonds have been issued this
year: August, for example, with over USD120bn
of issuance according to Dealogic, was the highest
August on record and more than double the
USD58bn average for August. Sub investment
The search for yield
 With risk-free rates so low, investors are desperate for income
 Credit is in a sweet spot, with issuers enjoying record low
borrowing costs, but investors finding decent spreads
 We think dividend yield stocks remain attractive too

14
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grade issuance in August totalled USD27bn, up
from USD1.3bn the same month in 2011.
3. Average US BBB-rated five-year corporate bond
0
2
4
6
8
10
03 04 05 06 07 08 09 10 11 12
Yield
Spread
Source: Bloomberg
Investors are clearly now having to take more risk
to get yield. Fund houses report that investors who
20 years ago would not have touched BBB credits
will now buy almost anything for yield. One
example is bonds from riskier emerging markets.
Ten-year paper from the Philippines, a BB-rated
issuer, now yields only 2.5%. Investors have been
buying bonds from countries such as Gabon,
Belarus, Nigeria and Vietnam. But five-year
bonds even from Gabon (BB-rated) now yield
only 3.8%. You have to stretch to Belarus (B-) to
get a decent yield, just over 10%.
4. HSBC Asian US Dollar Bond Index
0
2
4
6
8
10
12
00 01 02 03 04 05 06 07 08 09 10 11 12
Yield Spread
Source: HSBC
This could all go very wrong. Credit spreads are
supposed to compensate investors for the
probability of default. At the investment grade
part of the credit spectrum, defaults are rare, but at
the sub-investment grade end they are less so. At
present, the combination of low rates on high
quality government bonds and relatively wider
credit spreads, combined with very low default
rates, places credit in a sweet spot; compared to
some other assets classes. However, in an
2. Largest mutual funds launched in the US this year
Ticker Name Manager Inception
date
Asset class Objective AUM
(USDbn)
TGIRX US Int'l Value Fund Thornburg 5/1/2012 Equity International Equity 26.5
OIBIX US Int'l Bond Fund Oppenheimer 1/27/2012 Debt International Debt 12.6
WAPRX US Core Plus Fund Western Asset 5/1/2012 Debt Govt/Corp Intermediate 9.6
OSIIX US Global Strategic Income Fund Oppenheimer 1/27/2012 Debt Government/Corporate 8.6
OGLIX US Global Fund Oppenheimer 1/27/2012 Equity Global Equity 8.3
PSTQX US Short Term Corp Bond Fnd Pridential 3/2/2012 Debt Corporate/Preferred-Inv Grade 8.0
AEMSX US Emerging Markets Fund Aberdeen 2/27/2012 Equity Emerging Market-Equity 7.5
OIGIX US Int'l Growth Fund Oppenheimer 4/27/2012 Equity International Equity 6.2
MSKHX US Mid Cap Growth Portfolio Morgan Stanley 6/15/2012 Equity Growth-Mid Cap 6.0
MSFKX US Total Return Fund MFS 6/1/2012 Asset Allocation Balanced 5.8
PEFAX US EM Fundamental IndexPLUS Pimco 5/31/2012 Debt Index Fund-Debt 5.4
CMCPX US Active Portfolios Multi-Manager Core
Plus Bond Fund
Columbia 4/20/2012 Debt Government/Corporate 4.7
OBBCX US Mortgage Backed Securities Fund JP Morgan 7/2/2012 Debt Asset Backed Securities 4.1
JQLAX US Life Aggressive Fund John Hancock 3/1/2012 Asset Allocation Flexible Portfolio 3.7
OEIIX US Equity Income Fund Oppenheimer 4/27/2012 Equity Value-Large Cap 3.3
MIDLX US Int'l New Discovery Fund MFS 6/1/2012 Equity International Equity 3.2
JIPPX US Strategic Income Opportunities Fund John Hancock 3/1/2012 Debt Global Debt 3.1
WABRX US Core Bond Fund Western Asset 5/1/2012 Debt Govt/Corp Intermediate 3.0
MFBKX US Bond Fund MFS 6/1/2012 Debt Government/Corporate 2.8
JDVPX US Disciplined Value Fund John Hancock 2/29/2012 Equity Value-Large Cap 2.8
Source: Bloomberg

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environment of low growth rates, credit quality is
at risk of deterioration and, if default rates begin
to rise, the credit spreads sought by investors
could widen significantly.
Income from equities
The other obvious place to turn for yield is
equities. With the dividend yield on global
equities currently averaging 3.2%, the spread over
government bonds is the highest since the 1950s.
Investors have been buying into this theme
enthusiastically over the past two years. There
have been almost USD80bn of flows into
dividend funds over this time (Chart 5), making it
the most popular of the themes tracked by EPFR.
Oddly, the theme has not been so popular in the
US. Maybe there are definitional differences but
US income funds tracked by ICI have seen net
outflows of about USD11bn over the past two
years (Chart 6). Income funds comprise only 3%
of outstanding US equity mutual funds (compared
to 33% for growth and aggressive growth funds).
5. Cumulative net flows into mutual funds by theme
-20
0
20
40
60
80
00 01 02 03 04 05 06 07 08 09 10 11
USDbn
Dividend
Balanced/multi asset
Gold
Commodity
Source: EPFR
There are a number of explanations for the lack of
interest in dividend funds in the US. The dividend
yield in the domestic market is quite low (2.6%
compared to, for example, 4.3% in Europe), since
companies prefer buy-backs which are more tax
efficient. The tax on dividends (currently 15%) is
due to rise next year as part of the “fiscal cliff” to
an investor’s marginal tax rate, i.e. as high as
40%; this is causing uncertainty. It may be simply
that investors are just too nervous of equities to
touch even ones with good income.
6. Cumulative net flows into US equity mutual funds, by type
0
100
200
300
400
500
600
700
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
USDbn
International
Growth
Balanced
Agg growth
Global
EM
Sector
Income
Source: ICI

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Many CIOs argue that it is just too late to buy
dividend stocks, since they have already
performed well. We disagree. The global dividend
yield has not fallen much: it peaked at 4.4% in
early 2009 at the market trough, but has been
fairly steadily around 3% for the past three years.
High dividend stocks have not outperformed that
much yet either. For example, the global MSCI
High Dividend Yield Index has beaten MSCI
World by only 7% over the past three years
(ignoring the dividends paid). And the MSCI
USA High Dividend Yield Index (launched in
January this year) has performed just in line with
the headline MSCI US year-to-date.
The search for yield will continue if, as we expect,
risk-free government bond yields remain low for
some time to come. That suggests to us that both
credit and high dividend equities will see further
inflows, and therefore a contraction in bond
spreads and rise in equity prices.

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Problem is volatility, not return
Bill Gross, Co-CIO of Pimco, famously
announced this August that “the cult of equity
is dead”.
But the truth is not that simple. Indeed, many
bond fund managers are worrying more about the
crash in the bond market that we believe is
coming, and thinking about how to position
themselves for it.
Certainly over the past few years, investors have
switched massively away from equities and into
bonds. Since the end of 2007, USD920bn has
flowed into bond mutual funds in the US and
USD430bn out of equity funds (Chart 1).
This is not only because of the equity bear market
of 2007-9. The trend has been accelerated by
demographics in developed economies (older
people hold fewer equities) and by regulation, as
regulators, especially in Europe, pushed pension
funds and insurers to derisk their portfolios.
1. Cumulative net flows into US mutual funds (USDtrn)
0.0
0.5
1.0
1.5
98 99 00 01 02 03 04 05 06 07 08 09 10 11 12
Equity funds
Bond funds
Source: ICI
But have equity returns really been that bad?
Many investors talk about the past 10 years as
having been a “structural bear market” for
equities. But the fact is that over that period the
total return from global equities (a compound
annual rate of 8.0%) has been better than the
return from global bonds (5.2%).
Of course, the picture is a little more complicated
than that. The return depends greatly on the
starting-point: the 10-year return for equities is
flattered by the fact that August 2002 was close to
the bottom of a bear market.
The death – or rebirth – of
equities
 Bill Gross says the cult of equity is dead
 But equities have actually outperformed bonds over the past 10
years, although admittedly with high volatility
 A bigger risk is the bursting of the bond bubble: could 2014 be
another 1994?

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And equities have been particularly volatile over
the past decade or so (Chart 2). In the bull market
of 1992-9, equities produced a much smoother
annual return of 16% with volatility of 13%,
compared to a 6% return for bonds with a
volatility of 5%. Over the past 10 years, the
volatility of bonds has been pretty steady, at 6%,
but the volatility of global equities has risen to
19% (Tables 3 and 4).
2. Total return indexes* (log scale) since 1988
4.5
5.0
5.5
6.0
6.5
88 90 92 94 96 98 00 02 04 06 08 10 12
Equity
Bond
Cash
Source: Bloomberg, MSCI (*Equity=MSCI ACWI TR Gross, Bonds=JP Morgan
Aggregate Bond Index TR Unhedged USD, Cash=3-month T-bills)
3. Compound return from different asset classes
Equity Bond Cash
1 year 9.8% 1.4% 0.2%
2 years 8.1% 5.2% 0.2%
5 years -0.9% 6.4% 1.1%
10 years 8.0% 6.7% 2.1%
20 years 7.1% 6.4% 3.5%
1992-1999 16% 6% 5%
Since 1988 7.2% 7.1% 4.3%
Source: Bloomberg, MSCI
4. Annaulised volatility of different asset classes
Equity Bond Cash
1 year 20% 4% 0%
2 years 18% 5% 0%
5 years 24% 6% 0%
10 years 19% 6% 0%
20 years 17% 6% 0%
1992-1999 13% 5% 0%
Since 1988 17% 6% 0%
That volatility explains a lot. Retail investors and
regulators have been made very nervous by the
big swings in stock prices. It will take a lot for
them to get confident in equities again. Many
equity fund managers worry that one more crisis
or another nasty bear market in the near future
would put investors off equities for a generation,
as happened after the 1929 stock market crash.
The high volatility also explains the big flows into
passive funds in recent years (discussed in a later
section): volatility makes it hard for active or
thematic fund managers to perform well.
But there are issues for bond markets too,
valuations for a start. The interest rates on top-
rated government bonds are at unprecedently low
levels: the 10-year US Treasury yield, for
example, fell below 1.4% this summer, the lowest
since at least the late 19th century (Chart 5).
5. 10-year US Treasury bond yield (%)
0
2
4
6
8
10
12
14
16
1880 1900 1920 1940 1960 1980 2000
Source: Robert Shiller
Meanwhile, equity valuations, while not
exceptionally low, are certainly well below long-
run averages: the forward PE on the S&P500, for
instance, is currently about 12.5x, compared to a
140-year average of 13.6x (Chart 6).

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6. One-year forward PE, S&P500 (x)
0
5
10
15
20
25
30
35
1870 1890 1910 1930 1950 1970 1990 2010
Source: Robert Shiller, IBES, MSCI
Indeed, the best way for investors to regain
confidence in equities would be if bond prices were
to crash. This might be caused by a rise in inflation
or signs that the Fed and other central banks were
looking to begin unwinding their unothodox
monetary easing measures. Some CIOs have started
to worry whether 2014 could be another 1994 (when
the Fed raised rates unexpectedly and sent bonds
crashing). How could bond houses stay relevant in a
rising rate environment?
Indeed, several we spoke to have begun to prepare
for this eventuality, and started to consider how
they might enter the equity business. Gross’s
Pimco set up four equity funds for the first time in
2010, and others are starting to address this, also.
Other traditional bond houses told us they were
looking at specialising in equity tactical asset
allocation, using ETFs to execute country and
sector bets.
They key question, then, is whether the recent
volatility in equities and the shift in investors’
preferences to bonds are structural or cyclical.
The answer is that it is surely a bit of both. With
the debt overhang in the developed world likely to
hold down growth for a few more years, policy
uncertainty and low inflation will probably keep
interest rates low and equity markets on edge. But
this will not last forever.
And, in the meantime, investors will struggle to
make decent returns from bonds at current levels.
The financial textbooks may dictate that as an
individual nears retirement he or she should sell out
of equities and own only bonds. That might have
worked when interest rates on government bonds
were 7% and a 65-year-old could expect to live
only 10 years. But it certainly doesn’t work with
bond yields at 1.5% and life expectancy of 80-85.
Our conclusion is that equities are likely to
struggle for a few more years, with economic
growth in the developed world anaemic. But the
basic concept that equities have a risk premium
should not disappear. And we would have a high
degree of conviction that the total return from
equities over the next 10 years will be higher than
that from cash or government bonds (admittedly
not a big hurdle).
The problem to solve is investors’ perception that
equities are risky. But there might be ways to
reduce the riskiness of equities, without sacrificing
too much of their return. We examine the idea of
risk-minimising strategies in the next section.

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Tailoring risk, not return
What all investors would ideally like is a good
return with low risk. Of course that is impossible,
but fund managers are increasingly designing
products that give at least a decent return (or
income) with some downside protection or
reduced volatility.
The key insight here is that, while it is impossible
to fix return, it is possible to tailor risk to a
degree. One could, for example, buy an equity
index together with a put option, thus giving up
some income in return for a pre-determined limit
to drawdown. Investors have a reduced tolerance
for drawdown after the upheaval of 2008; fund
managers can structure their offerings with the
aim of avoiding an outlier outcome.
Such products are not new (private banks have for
at least 20 years sold capital guaranteed equity
indexes, where the dividend stream is used to buy
downside protection). But, in a world where
investors are hungry for yield but nervous of
equity risk (as we saw in the previous two trends)
they are increasingly popular. They are also
becoming more sophisticated and nuanced.
There are many such structures around.
 The fastest growing, especially in the UK, are
multi-asset funds (aka diversified beta or
diversified growth), which we discuss in
detail in the next section. These aim at
absolute returns in a range of assets, with a
targeted level of volatility. Essentially, they
intend to provide a nice return but with low
correlation to equities.
 “Risk aware equity services”, such as
long/short or market-neutral strategies,
have for long been the territory of hedge
funds, but are increasingly being used by
conventional fund managers.
 Balanced funds (with a mix of equity and
bonds, typically 60:40) have long been a
mainstream of retail fund management houses.
But they have often produced poor returns,
mainly because the vast proportion of the risk
lay in the equity portion. A recent
development is risk-parity products, where
risk between the asset classes is equalised, for
example by leveraging the bond portion.
Risk-minimising
strategies
 Investors want equity-style returns with bond-like volatility
 Fund houses are developing products that tailor a level of risk in
return for giving up or boosting return
 Strategies include diversified beta, risk parity, min vol, call writing

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 Minimum volatility equity funds focus on
low-beta stocks in an index, often using a
quants model. They are based on the finding
in some academic research that beta does not
produce the outperformance in the long-run
that it should. These funds, it is claimed, can
produce at least as good performance as a
major index, but with significantly reduced
volatility.
 Using options to target a level of risk. For
example, a fund could write calls and buy
puts to an equal value to specify acceptable
downside risk at the expense of upside. This
could also be done simply, and relatively
cheaply, to eliminate extreme tail risk.
 Similarly, a strategy of passive-plus with call
writing allows a fund to boost the return on
an index, in return for capping the upside.
Again, the level of the cap can be tailored.
 Some funds have experimented with the idea
of hanging a coupon off an equity fund.
This might look more attractive than a simple
dividend fund, since the coupon, as long as it
was relatively low (for example 2%) could be
fixed for a period, since shortfall is unlikely.
Any dividend payment in excess of that
would be reinvested. This hybrid of bond and
equity characteristics may be attractive to
some investors.
Not that such tailored products are without
problems. It may be hard to explain their
characteristics and attractiveness to retail
investors: as one CIO told us: “You can’t sell a
Sharpe ratio”.
The products can be quite expensive too. Some
highly risk-averse investors may end up giving
away too much upside to buy insurance. With
implied volatility for equities still high (though
lower this year than for a while), the cost of
options protection is high. The lack of
transparency on costs may leave some retail
investors wondering whether the investment bank
selling them the structured product is offering a
good deal.
But for both sophisticated retail investors, with
astute advisers to guide them through the
complications, and for institutions with strong risk
consciousness, for example insurance companies,
products that minimise – or at least tailor – risk
might be a wise investment.
If risk-minimising products grow further, this
should be positive for the growth of options
markets and for liquidity in the sort of assets that
multi-asset funds typically target.

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GARS and all its friends
Standard Life’s Global Absolute Return Strategies
(GARS) Fund has been causing a stir in the UK.
Since its inception in 2008, it has gathered assets
of GBP11.7bn. It aims to produce an annual
return of cash plus 5% with an investment time-
horizon of three years (and to have a positive
return over any 12-month period), by investing in
a range of assets and derivative strategies (see
Table 1 for example of its positions). Over five
years it has produced a compound annual return
of 7%, putting it in the 99th percentile of its peers
(with volatility over the past year of only 5%).
The GARS Fund has spawned a raft of
competitors in the UK but not yet in the US,
although by all accounts GARS has started to gain
traction there.
It is the leader of a growing category of multi-
asset absolute return funds, known also as
diversified growth, diversified beta or diversified
return funds. These funds typically target Libor
plus 4% or 5% (or sometimes inflation plus, say,
3%), with volatility lower than equities and often
targeted to be similar to US treasuries (i.e. 4-6%).
They usually use leverage to achieve the targeted
return. In a sense they are similar to hedge funds,
but fees are lower (GARS charges 75bp a year,
with no performance fee) and many are offered to
retail as well as institutional investors.
1. GARS fund: selected positions July 2012
Market return strategies
High yield credit
Russian equity
Korean equity
Global index-linked bonds
FX hedging
Directional strategies
US forward-start duration
Long USD v CAD
Mexican rates v EUR
Long BRL v AUD
Long equity volatility
European swaption steepener
Relative value strategies
Relative variance income
US tech stock v small cap
European financials capital structure
Hang Seng v S&P volatility
HSCEI v FTSE variance
Broad v financial sector equity
Financial sector v broad credit
Source: Standard Life, public website
The track records of GARS, and of many of its
later-established competitors, have been
impressive. But multi-asset funds have their
detractors, too (and not only among houses late to
the game).
The growth of multi-asset
 Funds that target Libor-plus absolute returns, with bond-like
volatility and costs lower than hedge funds, look attractive to us
 The success of Standard Life’s GARS has spawned competitors
 Multi-asset funds are likely to grow further, even in the US where
they have yet to take off

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Some argue that Standard Life has been lucky to
achieve such good returns (or maybe has done so
only because its fund managers are particularly
talented) and wonder whether similar funds would
be able to replicate the returns. Won’t multi-asset
funds in aggregate underperform their
benchmarks, just as active equity managers do
and (as we describe in the section below, The
decline of the hedge fund?) hedge funds may have
begun to do too? That may happen eventually, but
for now the asset class is still so small that it does
not yet face a zero-sum game.
Other critics wonder whether multi-asset funds
are really an alpha product, or simply take beta
risk with leverage. In our view, the answer to this
is that, even if part of the return that multi-asset
funds achieve is beta, timing the beta and
managing asset allocation can be forms of alpha.
A final doubt is that leverage may work with
interest rates so low, but what happens when the
cost of the leverage goes up?
It is also somewhat of a puzzle why multi-asset
funds in the US have failed to take off yet.
Certainly, most CIOs at US funds we talked to
were aware of the GARS phenomenon, but few
have tried to market anything similar. One
problem is that required returns in the US are too
high: pension funds typically assume a return of
close to 8%. Setting up a multi-asset fund with a
target of Libor+7 or Libor+8 would, in the view
of most fund managers, involve taking too much
risk. Retail investors, in the current environment,
also tend to be wary of anything that isn’t yield
oriented. Would there be a way to set up income
multi-asset funds?
The obvious attraction of multi-asset funds
(decent yield with low volatility at a reasonable
cost) means that, in our view, they should
continue to grow rapidly and develop more
diverse structures. Eventually, their flourishing
may push down returns but, for now, they are rare
enough that there is still plenty of alpha to be
picked up.
As multi-asset funds grow, they should aid the
development and liquidity of more esoteric asset
classes (look at the sort of things that Standard
Life holds in Table 1). Most multi-asset funds
implement their strategies through index futures
and other derivative instruments; these should see
improved liquidity too.

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It’s hard to beat an index
There has been a massive shift of investment
flows from actively managed funds to passive
(indexed) funds over the past 10 years.
According to EPFR data (Chart 1), passive equity
funds worldwide have seen inflows of about
USD660bn over the past 10 years, and active funds
outflows of USD543bn (one-third of their assets
under management at the start of the period).
1. Cumulative net inflows into mutual funds worldwide (USDbn)
-600
-400
-200
0
200
400
600
800
01 02 03 04 05 06 07 08 09 10 11 12
USDbn
Passive Active
Source: EPFR
In the US, according to the Investment Company
Institute, inflows to passive mutual funds have
totalled USD427bn over the past 10 years, bringing
the total size of such funds at the end of last year in
the US to USD1.1trn. There have been particularly
big flows into bond funds over the past three years
(Chart 2); these now total USD242bn.
TowersWatson estimates that global assets managed
passively totalled USD7trn in 2010.
2. Annual flows into US indexed funds by type, 1997-2011
-10
0
10
20
30
40
50
60
1997 1999 2001 2003 2005 2007 2009 2011
USDbn
Domestic equity World equity Bond & hybrid
Source: ICI
This is unsurprising, in our view. Almost all
academic studies find that in aggregate active
funds underperform their benchmark, particularly
once fees are taken into account. This logically
must be so since, before fees and trading costs, the
average investor must by definition perform in
line with the index. But the turnover of an active
fund is almost always higher than that of an index.
So, even before fees, the average active investor
must underperform. (The only question is
underperform what? – a subject we return to
later.) Index funds also typically charge lower
annual expenses, for example usually 20-30bp for
The shift to passive
 A third of active money has shifted to passive in the past 10 years
 Passive encroachment is likely to continue, since active funds
empirically underperform on average (and have higher costs)
 But indexing strategies will need to get smarter: which index?

25
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an S&P500 index fund, compared to 80-150bp for
a traditional actively managed US equity fund.
Data from Standard & Poors suggest that over the
past 10 years, on average only 40% of large-cap
US funds and 38% of small cap funds
outperformed their benchmarks (Chart 3).
3. % of mutual funds outperforming their benchmark
0
10
20
30
40
50
60
70
80
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Large cap funds Small cap funds
S i 3
Source: Standard & Poors (Large cap funds were compared with S&P500, small cap
funds with S&P SmallCap 600)
Will the shift to passive continue? In our view,
almost certainly. Passive funds still comprise only
16.4% of US equity mutual funds (up from 10%
ten years ago). International equity funds run
passively in the US total only USD120bn. Index
funds are still relatively small outside the US.
With interest rates and expected returns from all
assets very low, investors will focus more and
more on minimising expenses. Going passive is
the best way to do this. Sophisticated investors,
such as institutions or high net worth individuals,
will also increasingly separate beta and alpha.
They will do this, for example, through so-called
80:20 solutions, where they have 80% of their
assets in passive market-linked beta assets, and a
20% alpha tranche aggressively managed in
alternative assets (with the market risk hedged
out). They will want to buy the beta portion as
cheaply as possible.
Fans of active investment have a number of
arguments against this. Many claim that, while the
average investment manager may underperform
the benchmark, their firm has superior investment
processes that allow it to outperform consistently.
Unfortunately, academic research shows little
evidence of sticky outperformance.
Others argue that, if an increasing portion of the
investor universe turns passive, there should be
more merit in picking stocks, since they would be
increasingly mispriced. That is an appealing
argument, but not well grounded in logic. Think
of it like this: if there were 98 passive investors in
an asset class and only two active managers then,
after fees and trading costs, the two active
investors would still in aggregate underperform
the index.
Bond houses argue indexing might not make
sense for bonds. Bond indexes are unlike equity
indexes in that they include many more securities,
which change frequently (for example when their
credit ratings downgraded) and most of which
have a finite life. They are usually weighted by
the total outstanding debt of the issuers, which
means highly indebted and risky borrowers
represent a large part of the index. Many active
bond managers claim it is not hard to outperform
bond indexes for these reasons. Standard & Poor’s
data does not bear this out, though: almost no
category of US-based bond funds has
outperformed its benchmark in aggregate over the
past decade (Chart 4).

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4. % of bond funds outperforming their benchmarks
0
10
20
30
40
50
60
General
intermediate
Government
longfunds
EMdebt
Global
income
MBS
HY
2002-2006 2007-11
Source: Standard & Poors
It may be possible to outperform an index when a
large group of investors hold the securities for
non-investment reasons. An example is Japan in
the 1990s, when many foreign investors
outperformed the Topix index simply by
underweighting (or owning no) banks. Bank
stocks were mainly owned by Japanese corporates
for relationship reasons.
But which index?
This all begs the question of which index. Some
perform better than others. A traditional large-cap
market cap-weighted stock index, such as the
S&P500, may not be the best choice. That is
because, empirically, smaller cap stocks
outperform large caps in the long run. Moreover,
when using market capitalisation, expensive
stocks are overweighted. It is well accepted that
value stocks also outperform in the long run.
(There is a possibility, though, that both these
phenomena may just be capturing the greater
illiquidity and higher transaction costs of small-
cap and value stocks.)
So in the US, for example, the S&P500 index has
risen by 50% over the past 10 years, while an
equal weighted index of the same stocks has risen
by 105% (Chart 5).
A further problem is that, when stocks are added
to a popular index, they tend to rise on the
announcement (but before they actually join the
index); similarly, deleted stocks fall before their
removal. A less well-followed index with similar
characteristics might outperform.
5. Performance of S&P500 market cap and equally weighted
0
500
1000
1500
2000
2500
90 92 94 96 98 00 02 04 06 08 10 12
SPX Index SPW Index
Source: Bloomberg
Many passive investment managers understand
these reservations, and have moved to index-plus
or passive-plus strategies. Fundamental indexes,
where stocks are weighted by sales or book value
(or even the number of employees), rather than by
price or market cap, have also grown.
If we are correct to believe that passive
encroachment has years to go, there are many
important implications for asset prices.
6. Average correlation of MSCI country indexes with ACWI
0.0
0.2
0.4
0.6
0.8
1.0
90 92 94 96 98 00 02 04 06 08 10 12
Average
Correlations between markets, and between stocks
in a market, have risen consistently over the past
decade. The average correlation between MSCI

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country indexes and the overall MSCI All
Country World Index (Chart 6), for example, has
risen from 30-40% in the early 2000s to 60-70%
by 2010 – although they are some signs of it
declining recently, perhaps as flows into equity
funds, whether active or passive, have stagnated.
At the stock level, the implied correlation between
individual stocks in the S&P500 index (Chart 7)
rose to a peak of 80% late last year, from 40-50%
in 2007 (when the correlation contract was first
launched on the Chicago Board Options
Exchange).
7. Implied correlation of S&P500 stocks (%)
0
10
20
30
40
50
60
70
80
90
07 08 09 10 11 12
Implied correlation
Source: Bloomberg, CBOE
Further growth of passive funds is likely to push
correlations up further, or at least keep them at the
current elevated level.
If bond funds grow in popularity, a similar rise in
correlations may happen between different bond
classes or issuers.
The growth of index-plus strategies or
fundamental indexes might also offer some
arbitrage opportunities in securities lying just
outside the major indexes, or which are large but
underrepresented.

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Attractive – but problems too
Closely linked to the rise in passive funds (see
previous section) has been the growth of
exchange-traded funds (ETFs). There are
currently over 3,200 ETFs around the world, with
assets of USD1.5trn, up from only USD105bn in
2001 (Chart 1).
1. Assets of exchange-traded funds (USDbn)
0
200
400
600
800
1,000
1,200
1,400
1,600
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012*
US Europe Other
Source: Blackrock (*end-Jun)
ETFs have a number of advantages, which explain
their popularity (trading volumes represent around
one-quarter of US stock market turnover). They
can be traded intra-day, giving investors a way to
take (or remove) exposure quickly to a country,
sector or asset class. Their liquidity means that
they are often used by institutions to execute asset
allocation changes. Some participants estimate
that as much as 60% of ETFs are owned by
institutional, rather than retail, investors. The way
ETF units can be created and redeemed by
authorised participants such as market-makers
usually means that they generally trade close to
net asset value (NAV). For retail investors, the
ability to see live prices and trade any ETF via a
discount broker (rather than having to use the
proprietary platforms of various fund management
houses) make ETFs particularly easy to use.
But they also have their detractors. Common
criticisms include:
 They are sub-optimal for long-term
investors. Why would these investors want to
trade intra-day, when they could buy an
equivalent mutual fund that guaranteed they
could buy or sell at end-of-day NAV? This
can only encourage short-term speculation,
unsuitable for most retail investors. Moreover,
since ETFs pay exchange fees and have a
bid/offer spread, they should fundamentally
cost a little more than a similar mutual fund.
The relentless rise of
ETFs
 ETF assets have grown to USD1.5trn
 But there are issues: are ETFs suitable for bonds? Will overly
sophisticated ETFs blow up and invite regulators’ attention?
 Key to future growth is whether active ETFs take off

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 They are still very much a US phenomenon.
US ETFs have AUM of USD1.1trn but
Europe only USD273bn and the rest of the
world just USD169bn. Regulatory difficulties
still make it hard to set up an ETF in Europe.
The range of available ETFs and their
liquidity is very limited in many countries.
 ETFs are best suited to equity index
products. They work much less well for
bonds or other assets. Equity ETFs globally
total USD1.2trn, but fixed income ETFs have
reached only USD308bn, and commodity
ETFs only USD35bn. Fixed income is trickier
because of the problems inherent in bond
indexes, described in the section on passive
funds above. It is also much harder to
replicate a bond index because of the lack of
liquidity in many of its components.
Moreover, the transparency requirement of
ETFs (in the US they have to publish their
full holdings daily – essential for market-
makers to create new units) means that traders
can see their positions and trade against them.
 A number of ETFs have backfired
spectacularly. Some have failed to mirror the
returns on the underlying security or index
they claimed to match. This has been
especially true of gold ETFs. More
sophisticated ETFs that promised a multiple,
or the inverse, of the return on the underlying
have diverged dramatically. The Proshares
Ultrashort MSCI Emerging Markets ETF
(Code: EEV) is one of the most notorious. It
seeks double the inverse of the return on the
MSCI EM index. But when the index fell
49% in the second half of 2008 – and so the
ETF should have risen 98% – the ETF
actually fell by 30%. It has failed in the past
12 months too, falling by 15% when MSCI
EM fell by only 8%.
The defenders of ETFs say that the resilience of
the industry, despite these blow-ups (and others
such as the flash crash of 2010, which was
partially blamed on ETFs) demonstrates the
product’s fundamental attractiveness. The chances
are, though, that regulators may clamp down,
particularly on exchange-traded products (ETPs),
which replicate an index or assets through
derivatives rather than by owning (at least some
of) the underlying securities. There are
USD182bn of ETPs, in addition to the numbers on
ETFs quoted above.
The keys for further growth
We expect ETFs to continue to grow. But there
are two key questions that will determine their
rate of growth.
The first is whether active ETFs can take off.
These are somewhat problematical. The
transparency rules mentioned earlier make it hard
to structure, say, a 30-stock high-alpha equity
fund as an ETF, since competitors and traders
would be able to see daily changes in the fund’s
holdings. Some investment houses, notably Eaton
Vance, claim they have found a way to report
daily holdings that would get round the
transparency problem. But so far the Securities
and Exchange Commission hasn’t approved these
ETFs, and indeed has been reluctant to approve
many innovative ETF structures.
Perhaps the highest profile active ETF launch
recently was Pimco’s Total Return ETF (Code:
BOND), listed in March this year. In six months,
it has grown AUM to USD2.5bn. The ETF aims
to mimic the Pimco Total Return mutual fund;
both are managed by Bill Gross. But the two have
performed rather differently: in the past six
months the ETF has risen 6.6% and the mutual
fund 3.2%. One reason for this is apparently is
that the larger size of the long-established mutual
fund (total assets USDUSD270bn) means it
cannot move in and out of positions so quickly.

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One answer may be quants funds which, rather
than being managed in accordance with the
manager’s judgement, chose stocks on the basis of
a model. For example, the largest ETF provider,
Blackrock’s iShares, is focusing its marketing
efforts currently on minimum volatility equity
ETFs. These use an MSCI Barra model that
optimally chooses low volatility stocks from an
index. Its promoters claim that this allows
investors to keep most of the upside, with
significantly lower volatility. And, indeed, over
the past five years, the MSCI US Minimum
Volatility Index has outperformed the regular
MSCI US by 17%, with volatility of 18%
compared to 23%.
The second key question is how financial advisers
are remunerated. Until recently, FAs were
reluctant to recommend ETFs to their retail
investor clients, even though this might have been
the wisest course since, unlike mutual funds,
ETFs do not pay commissions. But the trend is
increasingly for FAs to charge an annual fee of 1-
2% of assets for their advice, and to take nothing
from the investment products they put their clients
into. This makes them more impartial. In the US,
the number of Registered Investment Advisers
(RIAs) has soared as investment professionals
have left wire houses to set up on their own:
estimates from Cerulli Associates suggest assets
overseen by RIAs have tripled over the past 10
years to USD1.7trn.
In the UK, the Retail Distribution Review, which
takes effect next January, will ban financial
advisers (including private banks and wealth
managers) from accepting commissions for
recommending investment products to UK retail
investors. Similar moves are afoot in Australia
and Asia. This might all make it more common
for FAs to recommend an ETF-heavy investment
strategy to retail investors and spur the growth of
the product.
Bad news for mutual fund managers
This is good news for the ETF industry, but won’t
help conventional fund managers. The ETF
business is largely sewn up by three providers –
iShares, State Street and Vanguard – which
between them manage 68% of outstanding ETFs.
Other firms have struggled with whether it makes
sense to enter the business, but the only space left
for new entrants is in increasingly esoteric
products, or in low-cost ETFs on plain-vanilla
stock indexes. Both are hard to make profits from,
and ETFs from smaller providers are often
illiquid, making them unattractive to investors.
Indeed, some smaller providers have begun to pull
out: Scottrade’s FocusShares, for example,
liquidated its 15 ETFs in August and Russell
Investments announced it would scale back its
offering, currently 26 funds. A total of 71 ETFs
have closed in the US this year.
As with the move to indexation (described in the
previous section), the rise of ETFs raises intra-
and inter-market correlations.
ETFs make it easy even for large institutional
investors to change weighting rapidly. A fund that
decided to raise its weighting in Brazil, for
example, could buy a Brazil index ETF
immediately, and then ask its fund managers to
slowly build up a portfolio of their favoured
Brazilian stocks. So far this has mainly been
limited to equities. But if bond ETFs and style
ETFs (min vol, value, high dividend yield) take
off, the same effect could be seen within and
between other asset classes.

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Is there any alpha left?
Earlier this year, the assets under management of
hedge funds finally regained their previous peak
from 2007, around USD2.2trn. But that was one
of the few pieces of good news for an industry
that has struggled in recent years. In the five years
to the end of 2007, AUM grew at an annual
compound rate of 29%. Since the end of 2008, the
CAGR has been only 12% (Chart 1).
1. Hedge fund assets under management
0
500
1,000
1,500
2,000
2,500
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012*
Assets (USDbn)
Source: TheCityUK and HSBC estimates (*end-Jul)
The reasons are not hard to find. Performance has
been unimpressive in the past couple of years.
Hedge funds tend to do best in absolute terms
during economic expansions and equity bull
markets, such as 2003-7, and in relative terms
during market collapses like the Global Financial
Crisis of 2007-9 (Chart 2).
2. Cumulative performance of hedge funds
100
150
200
250
300
350
00 01 02 03 04 05 06 07 08 09 10 11 12
HF index
L/S equity
Macro HFs
Source: Bloomberg, EurekaHedge
But they may struggle during the trendless, risk
on-risk off type of market we have seen recently.
This year, for example, as of end-July the average
hedge fund monitored by EurekaHedge was up
only 2.5% y-t-d. The performance of long/short
equity funds (+1.9%) and funds of funds (+1.7%)
was even poorer. By contrast, global equities have
The decline of the hedge
fund?
 Hedge funds have struggled in the recent trendless market
 The underlying problem is that the hedge fund community has
become so big that it has harvested most of the alpha
 Large hedge funds and “traditional” fund managers are likely
to converge

32
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risen 7.5% (MSCI ACWI) and global bonds (JP
Morgan Global Aggregate Bond Index TR) 2.4%
so far this year. It’s not exactly worth paying two-
and-20 (a 2% management fee and 20%
performance fee) for that sort of performance.
Macro funds have particularly struggled in the
past couple of years. They have been one of the
strongest growth areas since the Global Financial
Crisis (when they performed well), with 10%
growth in AUM in the four years to end-2011
(compared with a 5% decline for the hedge fund
universe as a whole) – see Chart 3. But this year
so far macro funds on average have returned only
1.1% – and macro funds of funds -0.5%. Last year
too, return was poor: -1.2%. There have been a
relatively small number of consensus macro
trades (for example, betting on a rise in Bund
yields) that many macro funds put on, but which
were unsuccessful. The biggest problem is that
these funds are essentially making calls on the
actions of politicians and central banks, something
that is hard to do.
Many macro funds take an opportunistic attitude
to investing, switching from one strategy to
another as they spot profit-making trades. But this
lack of a consistent investment approach has, in
the view of some CIOs we spoke to, turned some
institutions away from macro funds.
Why should hedge funds outperform?
The fundamental problem is that, as with active
equity fund managers, in theory hedge funds
should not be able, in aggregate, to out-perform.
When the universe of hedge funds was small
enough, there was still alpha for them to harvest.
In essence, they were getting their alpha from
traditional long-only fund managers. But, once
hedge funds became a USD1trn-plus community,
they increasingly had to get their alpha from each
other. Many investors believe that hedge funds are
charging alpha fees simply for beta.
So the expensiveness of hedge fund fees is
increasingly an issue. Two-and-20 (or even one-
and-a-half and 15) is much higher than traditional
fund managers charge. Standard Life’s GARS
Fund, for example, has a management fee of
75bps despite aiming for a hedge-fund-like return
(see the section on The growth of multi-asset,
above, for details). More vehicles are becoming
available to allow retail investors to access alpha:
hedge-fund-like UCITS in Europe, dubbed
“Newcits”, can short and use leverage, for
example. These trends will inevitably put
downward pressure on hedge fund fees.
3. Growth in hedge fund AUM by category of fund, end-2007 to end-2011
8% 12% 2% 13% 10% 5% 100% 6% 9% 2% 7% 11% 2% 13%
-15%
-10%
-5%
0%
5%
10%
15%
Macro
Fixedincome
ConvertibleArbitrage
Multi-strategy
EventDriven
EquityLongonly
Total
Sectorspecific
EquityLongBias
MergerArbitrage
DistressedSecurities
Equitylong/short
Equitymarketneutral
Emergingmarkets
% of total HF AUM
Change in AUM 2007-11
Source: Barclay Hedge

33
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Hedge fund managers are responding. Some
larger ones have admitted that their size makes
alpha generation hard, and have returned funds to
their investors or closed to new money. Moore
Capital, for example, returned USD2bn in July.
Others have started to tailor their funds so that
they can sell them to retail investors. AQR Capital
Management, for instance, markets a number of
retail funds with active strategies such as
momentum, risk parity diversified arbitrage, and
managed futures. KKR, best known for its private
equity business, in July registered with the
Securities and Exchange Commission two hedge-
fund-like mutual funds, which will invest in
special situations such as distressed debt in
Europe and Asia. Under the 2012 JOBS Act, US
hedge funds may soon be able to advertise for the
first time.
Hedge funds are, in our view, unlikely to shrink,
never mind disappear. After all, the industry still
represents only about 2% of the total of USD82trn
in retail and institutional assets worldwide.
But the more conventional strategies, such as
long/short equity or multi-asset macro, will be under
increasing pressure from traditional fund houses,
which will run this money for much lower fees. We
believe that large hedge funds will increasingly
converge with “traditional” investment managers, in
terms of style, fees and remuneration. There will,
though, be room for small hedge funds concentrated
on unusual asset classes, or with a particular talent
for digging out alpha.
The growing universe of investors looking at
hedge-fund-like strategies – including pairs
trades, multi-asset arbitrage, illiquid debt – should
aid price discovery, making capital markets
increasingly efficient. As long as smaller hedge
funds continue to be able to gather funds,
alternative asset classes (distressed debt,
foreclosed mortgages, art, volatility) should
become more mainstream.

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Do you really need liquidity?
In the desperate search for yield, one way of
finding it has been largely ignored up to now:
being rewarded for illiquidity.
During the global financial crisis so many
investors rushed for the exits that investment
managers have since had an almost pathological
preference for liquidity, buying assets that they
can liquidate quickly in volume if necessary.
But does this make sense? Pension funds or
insurance companies, with liabilities that have an
average duration of 10 or 20 years, do not need
much liquidity. Individual investors, particularly
for their pension savings, should preferably have
limited ability to sell their holdings, since this
would tempt them to invest speculatively, or to
use the savings for purposes other than post-
retirement income.
Moreover, liquidity comes at a price. Investors may
be overpaying for something they don’t need (or
need for only a portion of their portfolio). A survey
of academic research on this topic (“Liquidity
Premium: Literature review of theoretical and
empirical evidence”, September 2009) by risk
consultancy Barrie & Hibbert (Table 1) suggests
investors may receive 350-550bp lower returns from
liquid equities compared to similar more illiquid
ones, and 40-200bp less from bonds, depending on
their credit rating.
1. Illiquidity premium estimate
Illiquidity premium
estimate (bp)
No. of studies
Equity 450 2
Government bonds 39 5
Covered bonds 18 2
Corporate bonds 50 9
AAA 11 2
AA 15 3
A 30 3
BBB 31 3
Investment grade 53 1
BB 110 2
B 173 1
CCC 420 1
Speculative grade 180 1
Source: Adapted from Barrie & Hibbert
(www.barrhibb.com/documents/downloads/Liquidity_Premium_Literature_REview.pdf)
Gradually, though, investors are starting to look at
harvesting this illiquidity premium. Many complain,
however, that this is an under-researched area. Few
investors have a good answer to the question: where
am I paid most for illiquidity?
Harvesting the illiquidity
premium
 Most investors have a strong preference for liquidity
 But some – notably pensions and insurers – don’t always need
liquidity and may be overpaying for it
 They may start to see the attraction of the extra yield available in
illiquid assets such as infrastructure and “private debt” funds

35
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We found fund managers actively looking at the
following asset classes, with potentially attractive
returns because of their illiquidity.
 Private debt. Everyone is familiar with the
concept of private equity, where a fund raises
a significant lump-sum in a big launch and
then invests it for five to 10 years, with
investors locked into the fund during this
period. Why not apply the same concept to
debt? While private placements are not new –
insurance companies use them for their buy-
and-hold portfolios especially in the US –
they look increasingly attractive in a low-
yield world, since they allow creditors to
invest in a tailor-made instrument to suit their
needs in terms of maturity, yield and
covenants. The downside is that it is very
difficult to exit a position should
circumstances or investment criteria change
prior to maturity.
 Infrastructure investment. With
governments fiscally strapped, and banks
deleveraging and constrained by tighter
capital rules (especially in Europe), there
should be opportunities for institutional
investment managers to step in. Such deals
could be structured as public/private
partnerships (PPPs), with the investors
choosing which part of the capital structure to
participate in. Some of these deals could be
low-risk, as long as they focused on income
generating assets, with utility-like returns –
but at a premium because the money was
locked in.
 Replacement for bank lending.
Creditworthy companies may also struggle to
get long-term funding because of banks’
troubles. Could investment institutions step in?
Such deals could be structured as closed-end
funds, collateralised loan obligations (CLOs).
 Real estate finance. Commercial real estate
has an obvious requirement for long-term
funding at different levels of the capital
structure. Obviously, this is a traditional area
for insurance companies and other long-
duration investors. But many fund managers
are looking at the area afresh.
There are hurdles, too. Many investors are
restricted from buying illiquid assets. This is
particularly true of defined contribution (DC)
pensions, which might actually benefit from
owning some. Defined benefit (DB) pensions are
able to buy illiquid securities, but their
outstanding assets are likely to shrink over
coming years as many such plans are wound
down. European banks have been slow to unwind
their loan books: hedge funds, looking to expand
exposure to corporate loans, have been
disappointed by the slow speed at which such
assets have come onto the market.
Illiquid assets also entail risk, rather like selling
an option. Essentially, an investor garners a
premium each year until there is a market crash
and the investor pays out by being unable to exit a
losing position. The danger is that, after illiquid
assets gain in popularity, one day they will blow
up, causing regulators to clamp down.
If long-dated debt funds were to take off, this
could have a significant impact on the pricing of
loans, commercial real estate and on the returns
available from infrastructure projects.

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The sources of growth
The changing needs and dynamics of different
investor groups – the decline of defined benefit
(DB) pensions, for example, or the growing
wealth of Asian high net worth individuals – have
major implications for the investment
management industry and offer the best sources of
growth. In this section, we discuss these changes
and look at how the industry is responding.
Liability constrained investors
Liability driven investment (LDI) has become one of
the biggest buzz-words in the investment
management industry over the past few years. DB
pensions and insurance companies need to worry not
just about the risk and return of their investments
but, even more importantly, about matching these to
what sits on the liability side of their balance-sheets.
In the past decade, they have become even more
constrained than before, as regulators have pushed
them to derisk. Low interest rates and longer life
expectancy have made it very hard for pension
funds, in particular, to produce sufficient return to
match projected liabilities.
The struggle of DB pensions
Over the past two decades, companies have
increasingly closed their DB pensions and shifted
their employees into defined contribution (DC)
plans (where the employee takes the investment
risk, but benefits from some advantages such as
the ability to take the pension pot with them to a
new job). In the UK, for example, only 18% of
DB pensions are still open to new members (down
from 35% in 2006), 54% are closed to new
members but allow existing members to continue
to make contributions, 26% are closed even to
contributions, and 2% are being wound up.
Nonetheless, DB pensions still represent the major
proportion of the total pension industry (about
USD19trn out of a total of USD29trn in the
OECD in 2010, for example), as shown in Chart
1. That is partly because public-sector pensions
are almost all DB, and because in many major
pensions markets (Japan, the Netherlands,
Switzerland, for example) DC funds are still rare.
In the US, DB pensions have shrunk to 61% of the
total, and in the UK 67%.
Where will the money
come from?
 Defined benefit pensions are dwindling
 But personal pensions, Asian high net worth individuals and
sovereign wealth funds are areas of growth for fund managers
 But each of these will demand more sophisticated products

37
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1. Global pension assets (USDtrn)
0
5
10
15
20
25
30
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Autonomous pension funds Pension insurance
Other managed funds
Source: OECD
The biggest issue DB pensions face is their
increasing underfunding, caused mainly by recent
poor returns and the fall in interest rates. A study
by pension consultant, Towers Watson, found that
last year pension funds in 11 major economies
had on average a 25% gap between assets and
liabilities (compared to a 4% gap 10 years ago).
And the true situation would be even worse if
pension funds used realistic return assumptions. In
the US, for example, both public-sector and
company DB pension schemes use an assumed
return of about 7¾%. That sounds bizarre when the
yield on a 10-year BBB-rated bond is only 3.7%
(and even the 2002-2011 average only 6.0%). But
auditors insist on sticking to the long-run historical
return in calculating assumed returns.
Investment managers are increasingly offering
holistic “pensions solutions” to plan sponsors
faced with this sort of dilemma. The sort of risk-
minimising, return-maximising strategies
described in an earlier section of this report are
often attractive to DB pensions, although their
need to make a return of Libor plus 7 or 8ppt
means they have to take large amounts of risk.
In the UK, at least, the shift to liability matching
has meant that pension funds have moved a lot of
their assets into fixed-income instruments (which
they assume – wrongly in our view – have a better
duration match with pension liabilities). This
move was propelled by the Pensions Act of 1995
and other regulatory changes. Equities have fallen
to 42% of assets from 82% in 1993 (Chart 2).
2. UK pension funds’ asset allocation
0%
20%
40%
60%
80%
100%
1962 1968 1974 1980 1986 1992 1998 2004 2010
Cash & short term Debt Equities
Source: ONS
The US has not yet seen the same phenomenon.
Equities are a smaller share of assets than before
the 2007 crash but, at 63%, they are still higher
than at any time in the 1974-95 period.
3. US private pension funds’ asset allocation
0%
20%
40%
60%
80%
100%
50 55 60 65 70 75 80 85 90 95 00 05 10
Cash & short term Debt Equities
Source: Federal Reserve
The reason US investors still hold such a high
proportion of assets in equities is their return
assumption. After all, it is almost impossible to
make a 7% or 8% return from bonds. This is also
pushing US DB funds into a wide range of
alternative assets. The California State Teachers
Retirement System (CalSTRS), with USD152bn
in assets, for example, has been looking to invest
in a range of oddities including covered calls,
infrastructure, leases, senior secured debt, royalty

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streams and distressed debt to try to get high
returns outside of equities (although it still has
50% of its assets in equities).
In the end, the dilemma for DB funds is whether
they should rerisk in order to achieve the sort of
returns they need to reduce their growing excess
liabilities. The problem is that, by doing so, they
could face a blow-up that would make
matters worse.
Insurers and Solvency II
Insurance companies face similar liability
constraints to pension funds but, in Europe
especially, have been pushed even harder by
regulators to reduce risk (meaning, lower their
equity weightings).
The proportion of equities held by insurers differs
significantly from one region to another. US
insurers have significantly raised their equity
holdings over recent years; equities now comprise
27% of assets, up from less than 10% in the early
1990s (Chart 4).
4. Life insurers: equities as % of total assets
0%
10%
20%
30%
40%
50%
60%
1980 1985 1990 1995 2000 2005 2010
US Japan UK Eurozone
Source: Federal Reserve, Bank of Japan, ONS, ECB
By contrast, UK insurers have cut their weighting
to roughly the US level, 31% last year, down from
over 50% in 2000. Data for Eurozone insurers
does not go back far, but latest data show they
have only 19% in equities.
The new European insurance capital solvency
directive, Solvency II, which comes into force in
2014, will require capital to be held against asset-
side, as well as insurance, risks; equities will carry
a higher capital requirement than other assets.
Given that Solvency II has been discussed for
years, it is tempting to think that insurers must
have already adapted their portfolios for this. But
the lack of any decline in equity holdings in the
past five years suggests this is not the case. Many
believe that the insurance companies spent the
time lobbying against the new rules, not preparing
for them. It seems likely, then, that insurers will
have to reduce equity holdings from now to boost
capital efficiency under the new rules. However,
with bond yields so low, this may be exactly the
wrong time to make this move. German insurers,
for example (which already have very low equity
allocations) are reportedly asking their regulators
for the new rules to be relaxed.
Will US regulators follow the European lead and
tighten regulation on pension funds’ and insurers’
equity holdings? It is a risk that many US
investment institutions are aware of. Probably the
ingrained equity culture in the US will see off this
risk. But another big fall in stock prices could be
the trigger for regulators to force a cut in the
assumed return and tell liability constrained
investors to derisk.
The institutionalisation of retail
As retail investors increasingly take more
responsibility for their own pension provision,
their needs – and the opportunities for investment
managers – are developing.
DC pensions are growing, as we saw above. In
OECD countries their assets have doubled over
the past 10 years to USD6trn. But governments,
knowing that many people have failed to save
enough for their retirement, are increasingly
“nudging” workers to set up DC pensions. In the
UK, for example, the National Employment
Savings Trust (NEST), which begins operations in

39
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September 2012
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October this year, will automatically enrol all
employees without an existing company pension
(unless they opt out). Employers must contribute
1% (3% in future) and can contribute more.
The attraction of DC plans to investment
managers is that, since no liabilities are attached,
there is much greater freedom in the types of
investment products that can be offered. One of
the most popular has been target-date, or
lifestyling, plans which automatically shift asset
allocation as people near retirement (financial
textbooks state that investors should have
maximum equity holdings until the age of about
50, then wind that down to 0% by the time they
retire at 65). In some countries, target-date plans
represent as much as 70% of the products sold to
individual pension holders.
Increasingly, retail investors with DC plans are
demanding the sort of sophisticated products that
previously were offered only to DB pensions
plans and other institutions. This would include
access to hedge funds (or hedge-fund-like
absolute return products) and risk-aware funds. A
challenge for investment managers in coming
years will be to provide such services to retail
investors at reasonable cost, while making sure
that their clients understand the risks.
Post-retirement
With a large cohort of retirees over the next few
years, investment managers also sniff a big
opportunity in post-retirement products: providing
annuities, or other regular income-yielding
strategies, for people whose DC pensions reach
maturity. In the US, for example, 19 million
people will turn 60 between 2011 and 2015,
compared to 13 million a decade ago (Chart 5).
Increasingly, investment managers are selling “to-
and-through” products, where holders of DC
pensions are automatically tipped into a post-
retirement roll-over product.
5. No. of Americans turning 60 each five years (mn)
0
5
10
15
20
25
1976-1980
1981-1985
1986-1990
1991-1995
1996-2000
2001-2005
2006-2010
2011-2015
2016-2020
2021-2025
2026-2030
Source: United Nations
One of the key issues here is that, with bond
yields at such low levels, annuities in bonds no
longer work. The concept that, in retirement, you
should stick to bonds for income and avoid risky
assets such as equities is a non-starter. Moreover,
life expectancy has improved: a US male aged 60
can expect to live at least another 20 years. In
1971, he would have expected to live only to 76.
Increasingly, fund managers are telling retirees
not to cash in all their growthy assets. Could there
even be a market for longevity insurance?
Wealth management
It is very hard to know exactly how much private
wealth there is out there (and it depends on how
you define it). Estimates put the total at between
USD26trn and USD120trn.
What is clear, though, is that the wealth is
growing rapidly (mainly in emerging markets)
and that the wealthy are becoming more
demanding about the sort of investment products
they want.
We will not run through here all the data for the
number of high net worth individuals around the
world. Suffice it to say that Wealth-X’s World
Ultra Wealth Report 2012-2013 estimates the
total wealth this year of ultra high net worth
individuals (UHNWI) at USD25.8trn. Of that,
USD8.9trn is in the US and USD3.4trn (13%) in

40
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emerging markets (Chart 6). But, over the next
five years, wealth in emerging market is expected
to grow faster that that in developed countries: at
an annual rate of 7.9% a year in Asia and 12.1%
in Latin America, according to the report. At these
growth rates, by 2017 emerging markets will
represent 16% of global UHNWI wealth, or
USD5.5trn out of USD33.9trn.
6. Estimated ultra high net worth individual wealth by region
0
2
4
6
8
10
12
NorthAmerica
Europe
Asia
LatinAmerica
MiddleEast
Oceania
Africa
USDtrn
2012 2017
Source: Wealth-X World Ultra Wealth Report 2012-2013
Increasingly, that wealth will be held in securities,
and managed by professional fund managers. The
usual pattern is that, as individuals in emerging
markets first achieve wealth, they typically buy
real estate and leave the rest of their money in the
bank deposit. Only when their wealth grows and
they became more sophisticated, do they gain the
confidence to start to buy stocks and to go to a
private bank. In the US, for instance, almost 70%
of household wealth is held in financial assets (as
opposed to non-financial assets such as real
estate); the corresponding percentage in China is
22%, in India 5% and Indonesia 2% (Chart 7).
Over the next few years, high net worth
individuals will also demand the sort of products
institutions have previously been offered. They
tend to be relatively risk-averse and so want risk-
minimising investments that nonetheless offer a
decent return. They, too, are looking to separate
alpha from beta, for example by placing a portion
of their portfolio with hedge funds and leaving the
rest in equity index funds.
While this market offers juicy prospects for
investment managers, it is not easy to access this
wealth. Setting up private bank offices in Hong
Kong, Singapore or Miami is all very well, but
that misses a lot of the potential wealth. The
Chinese and India domestic markets are still very
hard for foreign investment institutions to enter.
Those who have done so via joint ventures have,
on the whole, not seen great success. But, given
the potential size of assets to be gathered, they
will not stop trying.
7. Household wealth distribution by country
0
10
20
30
40
50
60
70
80
90
100
USA Taiw an UK Japan Singapore Germany China India Indonesia
Non-Financial assets as % total assets Financial assets as % total assets
Source: “The World Distribution of Household Wealth” by James B. Davies, Susanna Sandstrom, Anthony Shorrocks, and Edward N. Wolff, University o9f Ontario, New York University,
UNU-WIDER (2006), HSBC

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Sovereign wealth funds
Sovereign wealth funds (SWFs) have been one of
the big growth areas for investment managers in
recent years. The total assets of sovereign funds,
broadly defined, have grown to an estimated
USD20trn at the end of last year, up from
USD16trn only four years ago. Pure SWFs
constitute only USD4.8trn of this, but FX reserve
managers and other sovereign investment vehicles
such as pension reserve funds, are increasingly
important clients for international money
managers (Chart 8).
This is a particularly attractive area since the
money is stable, these funds often have a fairly
broad mandate (including the ability to buy into
illiquid positions) and they are not liability
constrained. Some CIOs argued to us that SWFs
have been the main buyers of developed market
equities over the past dew years.
8. Assets of sovereign wealth funds and similar (USDtrn)
Official FX
reserves,
8.1
Other
sovereign
investment
vehicles*,
7.2
Commodity
SWFs, 2.7
Non-
commd.
SWFs, 2.1
Source: TheCityUK estimates (*includes development funds, pension reserve funds,
state-owned companies, reserve investment corporations)
But SWFs face similar issues to other types of
investors. How do they continue to generate
returns with interest rates so low? Reserve
managers – which traditionally bought only high-
quality, liquid fixed income securities in major
currencies (such as US Treasury bonds) – are
more and more being forced to look at other
currencies and even at credit. Some central banks
have split their reserves into a “liquidity tranche”
and an “investment tranche” with the latter aiming
to generate higher returns over the long run.
Some of the pure SWFs have very adventurous
asset allocation. At the conservative extreme,
Chile’s Economic and Social Stabilization Fund
has 20% of its assets in cash and 80% in bonds
(Chart 9). But a number of funds have high equity
allocations (Norway’s USD525bn fund, for
example, 60%). And several (for example,
Ireland’s National Pensions Reserve Fund) have a
significant allocation to alternative assets. Of
course, we do not know the allocation of more
secretive funds, such as the Abu Dhabi
Investment Authority or Government of
Singapore Investment Corp.
9. Selected SWFs asset allocation, end-2010
0%
20%
40%
60%
80%
100%
Chile
Norway
Canada
Australia
NZ
Ireland
China
Korea
Cash Equities Fixed income Alternative assets
Source: IMF
But it is not all good news for investment
managers. The more sophisticated SWFs are
bringing more funds back in-house, figuring they
can manage the money more cost effectively by
hiring experienced fund managers on attractive
salaries. They may leave some money with
external managers only to provide a benchmark to
compare their internal managers against.
There are also questions over how quickly SWFs
can grow in future. Their rapid expansion of the
past few years was due to high oil prices and to
currency management by non-commodity
producers, notably China. These conditions may
not continue.

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