Ron O’Hanley: Building for the future

Ron O’Hanley: Building for the future

Ron O’Hanley has been at the forefront of asset management for almost 30 years, leading three of the top-five asset managers in the world.

He experienced the dominant days of active management at Fidelity Investments and BNY Mellon Investment Management before in 2015 becoming the CEO and president of the world’s third-largest asset manager, State Street Global Advisors (SSGA), which now boasts $2.56trn AuM.

It has been a career spanning industry mega-trends and spent purposefully capturing the resulting tailwinds, which he fully intends to do in the current era at the helm of a behemoth that spans active equities and alternatives to a leading position in beta and smart beta funds.

“I see very significant sea changes in the industry,” he says. “There’s so much change underway that it’s driving how we think about our clients, how our clients think about us and even how we think about products.”

Asset management was blessed by circumstance as it got started in its modern form – from rising equity markets and falling interest rates to market liberalisation and technological developments – as it became a global, institutionally- organised system.

“Since 1974 there’s been extraordinarily positive tailwinds but that led to the productionisation of what we do,” he says. “It really helped the economics of the industry, but it wasn’t great for clients.”

While it was easy to create funds, and multiple vehicles to lower the minimum efficient scale, it led investors to focus on products. “But that’s not what they needed, what they needed were outcomes and the achievement of objectives.”

One crucial objective for many is securing retirement income, whether by pension fund trustees or individual defined contribution (DC) scheme members.

“Actuaries now play a major part, as we think about how to help clients get where they need to be,” he says.

This approach has also reprioritised the facets of the investment process. He sees value in both passive and active funds, but considers them as components in the more important stage of asset allocation.

“The technology helped us to do really important things such as separating out pure beta and smart beta exposure into highly precise building blocks – but now they need to be put together,” he says.

“We’ve got a long history in what I call assembly, or asset allocation. I would argue that the new active management is actually the assembly of building blocks.”

BESPOKE ASSEMBLY

The asset allocation role can be applied on many levels. At one extreme SSGA creates target-date funds, where it puts everything together in a way that’s usable for retail investors, and at the other it produces highly-customised bespoke work for large institutional investors, often working alongside a consultant.

“What the consultants need are incredibly high-quality building blocks – it’s not about going after the role of consultants.”

Pension schemes, most notably in the UK but increasingly around the world, have strived to de-risk their liabilities through insurance-based buyouts but this has often proved too expensive due to low bond yields, on which buyouts are based.

The inability to achieve the required funding level has left funds looking for alternative ways of reducing their involvement, if not discharging their liabilities.

Many are turning to the outsourced chief investment officer (OCIO) market (or fiduciary management in the UK), where institutional investors hand over asset allocation decisions to a third party.

It was one of the strategic rationales for purchasing GE Asset Management, a deal it completed on July 1 2016 and brought in fresh expertise and more than $100bn of additional AuM.

“It took our own capability, which was substantial, and brought what we saw as distinctive capabilities in the high-end corporate OCIO market.”

The longstanding global move away from DB to DC pension schemes – a trend O’Hanley says that he personally doesn’t like – takes longevity risk away from the sponsor and places it on the individual.

While traditional investment funds build DC assets efficiently the result is divorced from retirement income so a new generation of products is needed.

Target-date funds, which de-risk as the investor’s retirement date approaches, have emerged as a powerful low-cost technology but suffer from the assumption that one-size-fits-all within each cohort.

A group of people of a similar age could have radically different incomes and liabilities – some may have a working partner while another may be caring for elderly parents for an unknown length of time.

“Why shouldn’t all of that be incorporated into a savings plan?” he says. “I think you will see the rise of multiple target-date funds, maybe even evolving to the point where you have a structure where you’ve got a target-date fund that is almost liability- driven for the individual.”

It represents a new area where the best-equipped firms have an opportunity to add real value.

“It’s always been difficult for large firms because the small firms could be laser-focused on a particular asset class. I would argue that for the first time, maybe ever, that’s not relevant any longer.

“Putting together the pieces requires economies of scale that many small and medium- sized managers don’t have.”

The regulatory push for fee transparency on both sides of the Atlantic also provides a tailwind for O’Hanley’s model.

“It’s driving the providers towards these low-cost building blocks, which is great. But where is a small firm of IFAs going to get the technology from to actually put it all together?”

APPROPRIATE MIX

Given that the SSGA straddles the active and passive worlds it is unsurprising that O’Hanley sees a role for both approaches. “It’s very firmly and clearly not just about everything going to passive.

A 100% passive portfolio only guarantees that you will get a benchmark- minus return, which in most cases is not enough to meet liabilities. Portfolios should be a mix of passive and active.”

Taking on the asset allocation role means that incorporating a wide range of building blocks is essential, including third-party funds.

“If you’re taking on the role of an assembler, by definition you need to source all sorts of assets. For some of the large frozen pension plans, our OCIO business is sourcing everything. We’ve got real estate, private equity and venture capital in there. Some of that is ours, but much of it isn’t.”

For retail investors the challenge is less complex and more readily lends itself to be automated.

“For individuals, there is a role for so-called robo-advice. If somebody completes the questionnaire, you could have a risk and age-based model that would be better than nothing.

“It can take a lot of work out of it, and enables individuals that wouldn’t normally be able to get one-on-one treatment to get a pretty good model.”

Commoditising the product construction element and separating out the asset allocation leaves open the question of who is best placed to make these decisions – it could potentially be done by some form of advisor or consultant but O’Hanley is clear on which entity he thinks is best placed.

“The asset managers should dominate it because the key underlying skill is asset allocation, which is an asset management skill. New entrants clearly could have an opportunity here but asset allocation is hard to do on a repeatable, tactical basis.”

Demand for alternatives is expanding rapidly among investors, which have faced low yields for a very prolonged period.

“We see a role for alternatives in a long-term, properly-allocated pool,” he says, noting that different ones fulfil particular purposes over the investment lifecycle.

For example, he says that those approaching retirement but still need to remain invested in risk assets could benefit from counterbalancing investments: “Traditional hedge funds are very important, operating as a risk mitigant.”

Likewise, younger investors could benefit from the illiquidity premium offered by private equity and real estate, although work needs to be done to manage the liquidity mismatch:

“Right now, many vehicles don’t permit that,” he says. “The industry needs to work on new vehicles, but also with the regulators.”

O’Hanley sees an opportunity to capture the useful characteristics of these asset classes in more suitable products.

“We believe that many of these exposures are identifiable and isolatable factors that can be provided at a lower cost. We’ve got a lot of work underway that’s aimed at doing just this, to put out a multi-strategy type product.

“It won’t be completely passive, but it will be closer to what you and I might today call smart beta. An assembly of factors will replicate some, but probably not all, of those things that alternatives providers can do. In the near future you could see some kind of multi-strategy alternatives funds with lots of passive exposures.”

State Street already has an index- replicating private equity product, based on data that it has access to as a servicer of the sector and built on proxies for actual holdings. It is not designed to replace a high-skill private equity investment, but provides baseline exposure or a temporary exposure while an allocation is being built.

“We’ve been able to replicate, albeit crudely, what’s going on at any given point in time through an understanding of current holdings. You’ll see all sorts of big data applications like that.”

ESG PRINCIPLES

Another prominent industry trend is for the inclusion of environmental, social and governance (ESG) factors in investment strategies. In the past, ESG was limited to specialist firms or funds but now tier-one asset managers are taking it seriously and applying it across mainstream fund ranges.

It has become a central philosophy for SSGA and O’Hanley is notable among the leaders of the largest asset managers in exposing its benefits.

He says the debate has moved beyond the initial stages – of the negative screening of undesirable stocks and then positive screening for progressive companies – to a third stage where it is viewed as fundamental to long-term investing.

“This is the real challenge for the industry,” he says. “The vast majority of our investors are long-term oriented, because that’s the nature of their liabilities, whether an individual saving for retirement or a sovereign wealth fund for the next or two or three generations. we’ve got a measurement system that has forced the industry to think very short term – quarterly, annually, maybe three-to-five years, but seldom more than that.”

He says extending the investment timescale is a far from simple: “If you try to put together a portfolio for the long term, how do you know if you’ve actually achieved that? How do you know you’re making progress? Investors may be committed – but they will not just check back in 10 years, they will want to know they are making progress.”

He says that passive investment logically leads itself to ESG; as it is not possible to disinvest there is an interest in pushing for long-term value creation.

“The easiest example is gender,” he says. “There’s empirical evidence that diverse boards more often than not lead to better long-term outcomes. We can’t not-own a company – but we can vote against them. We do that.”

Passive managers have an intrinsic problem as they are not able to disinvest or underweight a stock. In theory they have limited coercive power over company boards – which could decide to weather criticism and risk losing the occasional vote.

Indeed, many managers have taken a defeatist point of view and smaller managers have little choice. SSGA, leveraging its trillions of AuM, is in a stronger position.

“Boards are very responsive and becoming even more so,” he says. “We acknowledge that we don’t have the resources to be able to tell every company, in every index, what it should be doing.

“Our approach is principle-based and we’re looking for evidence that the board is performing its oversight role properly. We want to make sure that boards recognise that they’ve got a duty to us as shareholders.”

FACING CHALLENGES

State Street and other investors are not having this entirely their own way, however. A countervailing trend is for companies to offer fewer voting shares.

Between 2007 and 2017 the amount of non-voting shares in the S&P 500 has risen from 5% to 12%. Snap, the owner of Snapchat, became the first firm to list with no voting shares at all attached to the $3.4bn of shares it listed in March. The social media firm could have set a damaging precedent.

“I think it’s a problem that a company can access public capital markets yet not be answerable to shareholders,” he said. “This is something that money managers, exchanges and the regulators need to look at, although I’m not sure regulation is the answer.”

He says the trend been partly been enabled by exchanges becoming private companies, rather public utilities, bringing the need to compete for listings: “It feels to me like a race to the bottom.”

To counter this, O’Hanley is contemplating the creation of new products and is preparing to gauge investor interest.

“At the very least, we’re thinking about offering an alternative to the basic cap-weighted index,” adding that a fund could be weighted for both market cap and voting rights. ESG-based ETFs can certainly work.

In March 2016 SSGA launched the Gender Diversity Index ETF based on female board representation in large US companies and it became the second most successful launch of the year, by AuM.

It was also a PR coup, celebrated by the Fearless Girl statue to face the Charging Bull on Wall Street.

NEXT STEPS

While ESG has become central to SSGAs message, he acknowledges that the evidence remains inconclusive as to whether it actually improves investment returns.

“The research is divided,” he says. “Part of it is we haven’t yet had enough time with this kind of investment approach in place.”

The measurement period distorts the picture. For example, coal hit peak market cap in 2011 so a portfolio that excluded it in the run-up would have underperformed the index but would have outperformed since 2011.

“Herein lies the problem. How do we put in place the appropriate measurement regimen that acknowledges these things when we’re talking about decades and not quarter-to-quarter?”

With signatories to the UN principles approaching 1000 there is a danger of the ESG brand being devalued.

“It’s almost become a fashion, so it’s at your peril that you say you don’t think about it. Most firms don’t have the set of skills and relatively few are able to act on it. But the reality is that clients are going to drive all of us this way.”

Examples abound; Swiss Re announced in July it was to move its entire portfolio to some form of ESG investing, which perfectly fits the long-term nature of its liabilities and potential exposure to climate change.

“I’m very optimistic about the industry. There will be pressure on margins, appropriately so. It’s a high margin business to begin with and there’s a lot of smart people in the industry, so we’re going to figure it out. I think it’s going to lead to better and better outcomes, so I’m very positive.”