I had a conversation recently about the investing business with Katina Stefanova, who recently left Bridgewater, the largest hedge fund in the world. I’ve always had great respect for Bridgewater, which unlike most investing organizations realizes just how critical processes and culture are to investing success.
Katina served as a Senior Executive and Management Committee Advisor at Bridgewater Associates. Reporting directly to the CEO, Katina managed various departments including Back and Middle Office, IT, Recruiting and Talent, Client Service Reporting, Fund Legal and Compliance.
(Interestingly, the New York Times just ran an interview with James Gorman, CEO, Morgan Stanley, which showed that he shares the Bridgewater focus on management as a discipline. That is one of the reasons why he’s CEO, despite not coming from a traditional investment banking or trading Wall Street background.)
My conversation with Katina below is part 3 of my series on disrupting asset management. Part 1: Asset Management Is A Peculiar Industry Ripe For Disruption; Part 2: Why Some Investors Are Happy with Lousy Returns.
David Teten: Katina, what should asset managers be worried about?
Katina Stefanova: The investment management industry is a unique space where a disproportionate portion of the profits are captured by the asset managers with little to none of the risk exposure. However, this is about to change. Technology innovation, globalization of markets, and recent market volatility such as the 2008 market collapse are driving painful changes (for some) in the asset management industry.
As described in the recent McKinsey financial industry outlook report, investors are becoming increasingly skeptical of experts and are looking for alternative ways to manage their money. For example, for long-only mutual funds, the heydays of the 1980s and 1990s are over. The asset management industry is confronted by the reality of increasingly lower fees and more intense competition. However, as always in a period of change, innovative business models emerge and financial technology is more and more at play as critical enablement of innovation.
David Teten: Clearly, the asset management industry will have to change to adapt to the forces you mention above. What are some of the disruptive trends that you see already taking hold?
Katina Stefanova: There are a number of business models that have already taken place or are at the tipping point. The most pervasive has been the expansion of passively managed portfolios, such as index funds and ETFs, which allow both retail and institutional investors access to a broad spectrum of investment opportunities at a much lower cost.
David Teten: No question in my mind that passively managed index funds are the best example of the Clay Christensen paradigm in asset management. What drove the expansion of the ETF market and who are the players that are taking advantage of it?
Katina Stefanova: The rise of the ETF market has been long coming. The market collapse in 2008 ushered in a four-year period of unprecedented volatility when traditional risk management models failed because of increased correlation among all asset classes. Many actively managed funds lost a lot of money for their investors and failed to beat their benchmark. At the same time, a small but dominant contingent of asset management firms has captured meaningful market share with index-based mutual funds and passive ETFs that carry very low management fees. ETFs have expanded not only as a percentage of the total asset management portfolio, but also in the breadth of their variety, providing both institutional and retail investors easy access to asset classes that were before only available through expensive actively managed funds. For example, one of the most prominent players in this space is Blackrock with its iShares brand totaling nearly a trillion of assets under management.
David Teten: Why are ETFs growing vs. traditional index funds, and what do you think is the prognosis for the former vs. the latter?
Katina Stefanova: In my view, there is room for both in the marketplace and it is unlikely that traditional index funds are going away. ETFs have become increasingly popular because of the lower cost, generally tax beneficial structure and a wide variety of products now available. The Wall Street Journal recently had a good article comparing the two.
David Teten: You talked about market volatility as a driver for innovation in the asset management space. How are investors thinking and protecting against volatility in their portfolios?
Katina Stefanova: Investors lost a lot of money in the 2008 crisis and became far more concerned about the risk profile of their portfolio. Simply delivering returns is no longer adequate as a measure of success; investors want to know the level of risk embedded in the portfolio.
Historically both institutional and retail investors selected fund managers based on their past returns and managed risk through traditional allocation models. Now, these same investors have realized that most asset classes become more highly correlated in times of volatility than previously envisioned. What that means is that a traditional 80% / 20% equity bond portfolio is set to lose a lot more money in a crisis than most investors are comfortable with.
Additionally, the population in the US is aging: Over 75 million Americans, or approximately 25% of the U.S. population, will turn 62 or older by 2020 (www.census.gov). An aging population entering retirement in the US and Europe desires predictable income from their nest egg. Growth is still a must for underfunded pension funds and retirees who have not saved enough.
This environment provides opportunity for financial technology solutions in the risk management space, as well as for innovative asset managers who provide downside protection while tapping into unexplored growth opportunity spaces.
For example, Blackrock’s technology platform, Aladdin, provides risk management solutions for over a trillion dollars of assets under management at its clients as well as at Blackrock itself.
David Teten: Of course, this creates its own systemic risk; if a $1tr is being invested based on Blackrock’s models, the inevitable blind spots and biases in their models will have a dramatic impact when they are exposed.
Katina Stefanova: In the asset management space, players like Pacific Heights Asset Management with its Permanent Portfolio, and Natixis Global Asset Management and Altegris Funds offer ways to provide sustainable alpha and mitigate systemic risk. The space for total return funds, dynamic target date funds, high alpha or downside protection products, risk-adjusted model portfolios and funds, global tactical asset allocation products, and an array of hedge fund strategies offered under a ’40 Act structure is roughly $550 billion, a small fraction of a $14 trillion fund, ETF and UIT industry.
David Teten: The trends you are describing appear to be changing the traditional role of the human portfolio manager. Do you see business models that further disrupt the dominant role of the portfolio manager?
Katina Stefanova: The near collapse of the financial system in 2008 eroded the trust investors had in expert professionals. Neither prominent asset managers not wealth management advisor nor the regulatory bodies were able to perceive and/ or prevent the massive destruction of value that happened as a result of the mortgage backed security market. Thus two main and divergent trends are taking place simultaneously. On one side, empowered by technology, the individual investor has enough information at her fingertips to make informed decision and consult the wisdom of fellow investors through crowdsourcing. Why pay high fees to experts who cannot deliver? Numerous business models are arising in this space and there is still a lot of room for innovation. For example, SeekingAlpha utilizes a quality controlled crowdsourcing model for financial research and analysis. Thinknum is offering a platform of sharing of quantitative analysis.
The other trend aims at maintaining the proprietary ownership model but limiting the discretionary investment rights of portfolio managers by creating rules based, automated investment models. Imagine if you could put Warren Buffet in a box and replicate his investment strategy in a scalable and repeatable way!
David Teten: Not only investors but also the government is thinking about how better to manage the risks and volatility of the asset management industry. How does the increase in government regulations come into play?
Katina Stefanova: The government is looking for effective ways to increase transparency in the aggregate risk of the system and hold investment managers accountable. That has to be balanced with not stagnating growth. Asset managers have to not only satisfy a more demanding, more skeptical and more educated investor base that has evolved during the tribulations of the last few years, but also meet the increasing regulatory requirements arising by the government’s desire to limit macro-economic volatility.
David Teten: At the same time, the political class has a continued interest in getting continued donations from the large financial institutions, and many argue that the government is effectively subsidizing the large financial institutions, who can borrow capital at very low rates because they are perceived as too big to fail. One of the great lies of finance is “This time it’s different.”; it’s hard for a student of history to believe with a straight face that we won’t ever have another financial crisis. Do you think “too big to fail” is “too big to exist”, as some argue?
Katina Stefanova: I would not go that far – there are both benefits and costs to large, government-backed organizations, e.g., FNMA makes mortgages far more affordable than they would otherwise be. I would like to believe that the economy is evolving and all the players are learning from their mistakes while still making new ones and looking for the elusive right balance between government intervention and a free market. Thus probabilistically the various players in the economy may miss that balance, resulting in another financial crisis which again probabilistically the economy would recover from.
The current environment is reactive and still risk averse after the last crisis. However, even a new more restrictive regulatory environment does create opportunity for innovative businesses. Asset managers are looking for partners who can help them navigate the increasingly complex space of regulatory requirements more efficiently than they can do themselves. Technology and service offerings from both the large players such as State Street and IBM as well as new companies such as Accordance Technology, are aiming to take that problem away from the asset manager so that asset managers can focus on their core business.
David Teten: Do you have any thoughts on how to address the fundamental illogic of asset management, an industry in which the players are primarily playing a zero-sum game, as opposed to creating new value? Who in the industry is actually helping investors increase returns *without* just subtracting value from other people in the industry?
Katina Stefanova: To create returns above beta returns, an investment manager has to beat the rest and by definition there would have to be some that lose. In aggregate, the investment management community performs below the market benchmark when fees are taken into consideration. However, retail and institutional investors are willing to pay a lot for managers that can create alpha, but do not have ability to assess who would be able to deliver alpha.
That being said, value beyond the zero sum game model is created in different ways:
1) Players that drive and create liquidity are adding value to the overall system. For example, market makers that allow access to asset classes that investors have not had access to expand the system. E.g, Addepar (ffVC portfolio company) is creating a platform for illiquid assets.
2) Second, technology innovators and data providers that drive transparency and decrease operational costs create value to investors. For example, Openfin.com, among others, aims to create a platform for application developers and data providers to traders and investment professionals.
David Teten: One last question: you recently left Bridgewater Associates, after spending nine years there. The company is famous for its unique and apparently highly effective culture. Can you comment on what aspects of its culture you’d want to take forward with you in your next employer?
Katina Stefanova: I definitely would like to take much of Bridgewater’s culture to my next venture. A culture focused on the relentless pursuit of excellence through an understanding of what is true and accurate leads to great results and is transferable to any organization or industry. However, such a culture only works if the people in the organization and above all the leadership are willing to live by it.
David Teten: Thank you very much for your time and insight.
The opinions expressed in this interview and in our associated research project at DisruptInvesting.com are mine alone (and/or of my interview subject’s) and do not represent the views of ff Venture Capital, any other employee thereof, or of any other institution with which I am affiliated.
(Cross-posted in Forbes)