Stress for some; opportunity for others

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The financial services industry appears to be on the back foot. Banks and bankers are back to being public enemy number one; private equity is under fire thanks to the focus on the riches gathered by Republican frontrunner Mitt Romney while heading Bain Capital and the low tax rate he pays on them; hedge fund managers appear to have lost their performance mojo; traditional fund managers have been accused of failing their customers by hiding the true cost of investing via actively managed funds; and last but not least, a new report on the UK’s annuity industry is damning in its condemnation of current practice.

On top of the general opprobrium, business is tough too. The economic environment makes it hard to provide good returns, so margins are under pressure as investors either sit on cash, demand lower fees, or move to low cost passive strategies. There are regulatory challenges as well that are likely to increase the cost of doing business. Customers would normally bear the brunt, but it may prove hard to pass on higher costs unless risk appetite returns and performance improves.

Technology could also prove disruptive. It has already changed the economics of trading, with investment banks losing business to more tech savvy operations such as high frequency traders. The fund industry is way behind, with orders still often paper-based and inefficiencies galore. Having to be more cost efficient may focus minds and force change.

Some see opportunity amid all this. BlackRock, for example, believes the new regulatory restrictions on banks will enable the manager to widen its offering to investors on the alternative investment front.

Investors will have to move alternatives from the periphery of their portfolios to the centre, according to Matt Botein, who heads up BlackRock’s Alternative Investors and Special Situations Investment Group. Pension funds are underfunded wherever you look, and will need to boost returns somehow. If they had invested 100 per cent in alternatives over the past decade (50 per cent hedge funds, 25 per cent private equity, 15 per cent real estate and 15 per cent energy) they would have earned annualised returns of 12 per cent a year, Mr Botein maintains, compared with 4.5 per cent for the typical 60/40 equities/bonds exposure.

There is good reason to expect alternatives to continue to outperform, he says, as bond yields are so low they have nowhere to go but up. As for the objection that big money flows into alternatives are likely to erode returns, Mr Botein says simply that managers will have to find new sources of return.

For example, he says, BlackRock is lending to real estate borrowers, plugging a gap between bank and equity finance. So-called mezzanine debt is a part of the capital structure that will pay 10 per cent. Reinsurance, particularly of catastrophe insurance, is an area that can soak up plenty of investor capital, and is attractive for its uncorrelated nature.

Stepping into banks’ shoes and acting as the conduit for investors to lend to corporate borrowers is another ambition. Banks can no longer provide the liquidity function they were to some extent paid for, creating opportunities for others, says Mr Botein. BlackRock does not need a balance sheet to support such activities because it has investors’ money to call on.

Infrastructure, particularly renewable energy, is also on the list. Western governments have said a certain proportion of energy must come from renewable sources, thus creating what Mr Botein views as a “very significant opportunity” for investors to obtain an inflation-linked return through involvement in a wind farm or similar project.

BlackRock is trying hard to avoid being labelled a systemically important financial institution. It is the world’s biggest asset manager, and if it takes on all these functions on behalf of investors, it will be an important part of the shadow banking system. In theory, it does not need much capital to support its activities, and could go bust without knock-on effects, as all investor monies would be ringfenced. But it would be understandable if regulators want to err on the side of caution and seek to ensure the transfer of erstwhile banking activities to the buyside does not create systemic risks through under-capitalisation.

To the extent that investors benefit from such transfers, by the removal of bank intermediation fees, it is a welcome development, and to some extent a return to the old way of doing things.

It remains to be seen, though, whether asset managers can operate effectively in this area and provide good returns to investors as well as a living for themselves.

The finance industry is often tempted to line its own pockets at the expense of its customers. Here’s hoping shadow banking does not turn out to be another such example.

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