We previously talked about the core skill needed in researching a seemingly vast and intimidating topic: having a robust research framework that allows the breaking down of a single large problem into a series of smaller, more manageable ones. To answer the question of how we do this at Redington, it’s necessary to reintroduce our ‘7 Steps to Full Funding’, which we have previously outlined as a roadmap of the services we provide to our clients as they move along the path towards their investment targets.
For the minute, the steps I’d like to concentrate on are those in the middle of this diagram, specifically steps 3-6 (that’s not to say that the Manager Research Team doesn’t deal with the others – it most emphatically does so, but more of that here, here and here).
The eagle-eyed among you will have noticed that there is a rough symmetry between these four chunks of the 7-Step Framework – i.e. credit vs. non-credit on the one hand, and liquid vs. illiquid on the other. This pretty much mirrors how we in Manager Research look at the asset class universe in general, which in turn allows us to map investment managers and their strategies to their correct position within it.
Credit vs non-credit. The returns generated by most asset classes can be subdivided neatly into those arising from beta (i.e. the returns you would expect from following a particular market, such as US equities) or alpha (i.e. fund manager skill). Credit deviates from this picture in two key respects. Firstly, it offers contractual cashflows (which, unlike equity dividends, cannot be easily ‘switched off’ in a crisis) that cannot be well-replicated using derivatives. Secondly, as long as an investor can bear volatility in the price movements of a bond (and providing said bond does not default), a debt instrument can be redeemed by the investor at par. By contrast, an investor seeking to hold his or her equities to maturity would have to wait around a very, very long time indeed.
Liquid vs. illiquid. Rather than classifying strategies on the basis of geography, investment style, market sector, or even fee level, we have chosen a single metric applicable across the asset class spectrum: How easily can I sell something? Investors in liquid markets will typically benefit from being able to allocate and divest their holdings quickly and with minimal transaction costs. Investors in illiquid assets, on the other hand, risk being stuck ‘holding the baby’ if they suddenly require the return of their capital. It’s not easy trying to sell a supermarket to meet a cash demand occurring next week, for example. However, in return for taking on this risk, investors in illiquid assets can be expected to earn an extra return (or ‘illiquidity premium’) as long as they are willing to hold their investments for the long term. Hello pension liabilities.
If you’ve made it this far, you might appreciate sight of the following diagram, which maps ‘traditional’ asset classes versus where we would seek to put them within steps 3 – 6.
Looking at the world in this way obviously has implications for the approach to research specialisation that we take at Redington. As someone considerably more knowledgeable and experienced than me once said: ‘it’s fine to be good at everything, but to get noticed you have to be really good at something’. Or, more specifically, given the vastness of the research universe, you have to choose what you’re going to focus on and what you’re going to leave out, and more importantly, why you are going to let certain things fall by the wayside.
We find that the Seven-Step Framework provides us with a good way of tackling this decision. It allows us to concentrate on what we believe are the best asset class opportunities within each bracket and to tailor our advice accordingly. It also puts us in control of the wider manager universe and lets us present our work according to a classification system we ourselves have devised, rather than relying on outdated catch-all terms (how many of the asset classes in the table above, for example, would normally be listed as ‘alternatives’?) Finally, avoiding having to research every single asset manager in every single category gives us the freedom to offer deep coverage of the most relevant prospects in each category, rather than stretching our resources too thinly in a bid to know ‘everything about everything’.
However, we also know that we aren’t infallible, and we are hence always eager to hear advice and input from the wider fund manager universe around what we might have missed in carrying out our analysis. With this in mind, we held our inaugural Manager Forum earlier this year, an event which gave us the opportunity to discuss our approach with the asset management community. We’ll discuss what we found out in the next blog.