Canadian Trends
There are six important trends shaping change in the asset management industry, according to Milton Berlinski, global head of the asset management advisory group at Goldman Sachs.

1. The institutional business is becoming increasingly competitive. There is significant pressure coming from plan sponsors--they are consolidating managers and pushing for lower fees. Sales and client service are more important than ever before.

2. Growth in the mutual fund industry. Mutual funds have enjoyed 32% compounded average growth per year since 1981. This is coming primarily from domestic equity funds. The forecast for 1998 to 2000 is weaker however: 12%.

3. The importance of the RRSP. RRSPs represent the fastest growing, most stable segment of the business. The period 1991 to 1996 produced compounded average year-over-year growth of 12%.

4. Global diversification is crucial. This is a must in order to optimize risk-return trade-off, and to take advantage of the world's most attractive investment opportunities.

5. Increased focus on retail distribution. Canada's network of bank branches has been harnessed as a venue for brand name mutual fund sales. Investment performance is paramount of course, but branding is increasingly important.

6. The search for scale. The industry is focused on increasing assets under management, product breadth, a diversity of distribution channels and client-base and strength of brand. There is also a noticeable shift to e-commerce channels of delivery.

Pension Funds on the World Stage
It is no secret that Canadian pension funds are investing more assets internationally than in years past. According to Sandra Boss, a senior manager at McKinsey & Company, Inc. in New York though, this is not a trend unique to Canada. The findings below are based on total pension fund assets in each country.

The Manager Panel
Tom Gunn, senior vice-president, investments at the Ontario Municipal Employee Retirement System, Lloyd Atkinson, principal of Perigee Investment Counsel and Doug Mahaffy, president and chief executive officer of McLean Budden Limited discussed the Canadian asset management industry--present and future. Harry S. Marmer, director investment funds at Frank Russell Company made his comments later in the day.

Tom Gunn: Six issues
1. Size. It is important to recognize the inherent complexities in large pension funds. Large Canadian funds must deal with market impact effects far exceeding those faced by U.S. pension funds. The future will see more large funds though, so increasingly sophisticated asset mix strategies will be adopted in domestic capital markets. This will lead to increased efficiency and volatility.

2. Efficient markets. Markets remain years from achieving true efficiency. As a result, superior securities selection and active management still deliver significant value.

3. Information. Technology continues to improve access to information. This means, for example, a first quartile Canadian equities market could work out of Hong Kong. That said, while an information edge can create "alpha," the key is to understand the data once it is collected.

4. Organization. Asset growth raises the need for better corporate management practices. That means actively managing the investment management firm or the pension funds.

5. Risk management. More and more, risk-managed goals are taking the place of simple return targets. We're seeing the development of risk management systems.

6. Focus. Defining core competencies is a significant key for the future. Institutional funds need to determine which skills are essential to keep in-house, and they need to have access to world-scale skills. But that is not to say funds need to own the skills exclusively. Strategic alliances and satellite organizations are becoming more prevelant.

Lloyd Atkinson: Three issues
1. Risk management. The sponsor community is increasingly focused on risk management. They want to know how much risk the fund is exposed to in the process of adding value and generating alpha. Information ratios, Sharpe ratios and the like are becoming important items in routine reporting/performance review packages.

2. Consolidation. More consolidation is inevitable. The Canadian asset management industry still has more than its share of fragmentation and excess manufacturing capacity. Eventually the business will be dominated by a few large players that offer multiple products and multiple management styles. A few niche players will also play a role.

3. Defined contribution. Growth in the defined benefit pension business is slowing. The defined contribution business will enjoy considerable growth moving forward. Brand recognition is important here. Among the challenges are increased distribution and marketing costs.

Doug Mahaffy: Eight issues
1. Balanced mandates. Balanced mandates have not completely lost out to specialty mandates. There remains many small- to mid-sized accounts requiring balanced asset management. The list includes defined contribution plans and group RRSPs distributed through insurance companies.

2. Capacity. Too many top managers are closed for Canadian equities mandates. However, there are no capacity constraints in bonds and global equities. Managers shouldn't price a scarce resource cheaply, and they ought to learn how to say no.

3. Size. Large firms are well suited for the defined contribution/RSP market. Large multiproduct international players and a few small niche players will enjoy the strongest growth. Firms should plan ahead, and build research and servicing capacity.

4. Foreign content. The foreign property ceiling will be raised from its current level of 20%. This will prompt the entrance of foreign firms in a more significant way. It is essential to broaden stock research and build international affiliations.

5. Private clients. This is a high growth segment. Accounts are smaller, and a higher level of service is demanded. But fees are higher and the loyalty issue is considerable.

6. Research. Do as much on your own as possible. Mentors should be designated to train analysts. Keep written reports short.

7. Pricing. Fees need to be more closely matched to the value added. Capacity constraint should be kept in mind. There is often no need to discount.

8. Organizational culture. There is no one right way. Firms should develop a culture and stick to it. Organizational culture should be kept as flat as possible, communication should be open and there should be a blending of young and old talent.

Implementation Shortfall
Harry S. Marmer, director, investment funds at Frank Russell Company, breaks down the asset management system into three parts: governance; advice (objective setting, asset allocation and investment strategy); and implementation (manager structure, manager research, manager selection, performance evaluation and rebalancing and transition management).

Implementation shortfall can be caused by several factors, including a poor manager selection process, an unsatisfactory manager structure, too much manager turnover or inadequate rebalancing.

Marmer makes five recommendations to reduce implementation shortfall.
1. Outsource the investment management monitoring and replacement process.

2. Evaluate managers on qualitative factors, and outsource the manager selection/monitoring process. The process must be more rigorous and disciplined.

3. Diversification among different management styles is critical.

4. Analyze commission costs, market impact costs and so forth more carefully during the transition management process.

5. Establish a formal procedure for rebalancing.

Opinion

Market Efficiency and Subjectivism
Capital market theory has long been tied to the concept of "efficient" markets. That is, markets in which information is embedded in prices so rapidly that it is difficult, if not impossible, to profit from additional knowledge. A large body of evidence appears to back up this contention, including the recent underperformance of equity mutual funds relative to market indices.

Yet, practitioners have long felt that there is something missing from this concept. If information is useless, then why does the industry continue to struggle and invest such vast resources in the obtaining of additional information?

In the end, the problem appears to be tied to the simplifying assumption of "rational" investors. Without rationality, there can be no efficiency. Consider an alternative concept: the "subjective" interpretation of information by investors.

Subjectivism is based upon the heterogeneous, rather than homogeneous, interpretation of information. Once we adjust for this concept, the entire efficient market edifice collapses, except in the case of short-term inefficiencies.

While subjectivism implies that markets are not efficient in the classical sense, it does not mean that it is possible for any single strategy to consistently return profits day after day, even though it is possible to turn a substantial profit over time. Because of this distinction, it would be useful to redefine what we mean by an "efficient market" as well as what we mean by rationality.

Rationality
First, let us re-examine the efficient markets concept. In its semi-strong form, efficient market theory states that stock prices already reflect all public information. Changes in price occur when new, unexpected information becomes available. In that case, prices move almost immediately to new "fair" levels as investors process the new information. Investors are rational, in aggregate, because they objectively determine the value of the new information, and uniformly decide what the new price should be.

Rationality has proved valuable in the tradition of reductionist science. In many cases, it is a reasonable take on reality. For instance, if everyone found that IBM stock rises each Friday due to a stock buy-back program, then people would buy IBM on Thursday. This would cause the price to rise a day early. The inefficiency would be eliminated. However, the rationale that accounts for these phenomena is very limited.

Efficient market theory assumes that there is only one fair price, and this price is applicable to everyone. This price, in turn, depends upon the investment horizon (or holding period). It has to be assumed that the investment horizon is uniform for all investors since there can be only one fair price. In the case of IBM investors, it is assumed to be one day, and the mispricing is of equal importance to everyone. Finally, the inefficiency is simple. Everyone knows how to value it.

Subjectivism
Suppose we examine something more complex. On June 30, 1999 the U.S. Federal Reserve Open Market Committee raised the Fed Funds rate for the first time in over two years, but shifted their bias towards further rate hikes to "neutral." Many interpreted the bias change as a signal that no further rate hikes would be necessary.

Others noted that the Fed always shifts to a neutral bias after a rate hike. Indeed, in 1994 the Fed kept a neutral bias through the first four (of seven) rate hikes. One of those hikes was an intra-meeting decision. Clearly, in this case the market is not sure how to value the information given the increase in volatility that followed the announcement, even though everyone had equal access to the same information.

In reality, important information is usually ambiguous. The interpretation of ambiguous information is always subjective. Even given the same information, there will not be a uniform interpretation of its importance.

Subjectivism embraces the idea that the market consists of investors who have multiple investment horizons, and multiple objectives. As such, each investor subjectively interprets information according to his own needs and objectives. In the spirit of fractal geometry, the market has no characteristic or uniform scale. If it did, the market could be gamed and investors could achieve riskless profits.

The information used by investors rests upon a continuum based upon their investment horizons. At the short-end, day traders rely almost entirely upon technical- or crowd behaviour-related information. As investment horizons lengthen, reliance upon fundamental and economic data becomes more prominent (as we know it is for institutional investors).

This lack of uniform investment horizon across investors generates resilience to unexpected shocks. For instance, if a technical panic occurs at the 30-minute horizon, long-term investors will consider this a buying opportunity and, through their actions, stabilize the market.

Instability
Sometimes the market does assume a more uniform investment horizon in the manner assumed by efficient markets. An economic shock can, for instance, make long-term investors doubt the reliability of their information set.

In August, 1990 Iraq invaded Kuwait and sent the price of oil soaring--just as the U.S. economy was slowing down. The uncertainty caused by rising energy prices and slowing economic growth caused the long-term outlook to become highly uncertain. In December, the Iraqi and U.S. delegates met to try to reach a settlement. The meeting lasted longer than expected, raising hope that an agreement would be reached. The stock market soared. However, when the delegates emerged, no agreement had been met. The market plunged.

Clearly, investors were not trading on long-term information. Due to economic and political uncertainty, the investment horizon for the market had shrunk to a uniform, short-term level. However, contrary to efficient market theory, such a development resulted in wildly swinging prices and market instability as all investors began trading on the same information set interpreted in a uniform manner. The result was instability rather than stability.

Market Efficiency Redefined
In the end, we have to re-examine what we mean by an efficient market. Traditional capital market theory states that a market is efficient when security prices incorporate all public information. A large body of research has been centred on a hypothetical world where markets are efficient in this sense.

However, real markets do not exist to give a uniform, fair price to investors. Markets exist to provide a liquid venue for trading, and the opportunity to make a profit. A true efficient market theory should offer such opportunities. But a market of "rational" investors, in fact, eliminates the very conditions needed for an "efficient" market. In a market of rational investors there would be no reason to trade. There would be no profit.

Subjectivism, on the other hand, leads to markets that offer opportunity to everyone, but advantage to no-one. Subjective markets are more difficult to mathematically model. Luckily complexity theory offers the math needed. But that is the subject of another article.

Edgar E. Peters is chief investment officer, PanAgora Asset Management in Boston.