In 2007, as part of its ongoing policy of monitoring asset management practices and comparing them with the results of academic research, the EDHEC Risk and Asset Management Research Centre undertook an in-depth survey of the risk management, portfolio construction, strategic allocation, and performance measurement practices of European asset managers and investors.
The EDHEC European Investment Practices Survey is built on a sample of 229 institutional investors and asset managers who, with respect both to the nationality of survey respondents and to the amount of assets under management, are largely representative of the European asset management industry. In all, respondents to the survey have more than 10 trillion of assets under management and include the major European firms in the industry.
The major conclusion of the survey is that investment professionals are often familiar with research findings and new techniques but that these are rarely used.
This failure to take advantage of research advances does not come without an effect on performance and on risk management in Europe, as made clear by the substantial investment and risk management inefficiencies pointed out by the EDHEC study. In short, for each of four key components in the investment process, the EDHEC European Investment Practices Survey highlights wide gaps between state-of-the-art research and industry practices.
Although a majority of managers take the “core-satellite” approach to asset management, many neglect the fundamentals of this approach and thus fail to take full advantage of the opportunities it provides for improved management of absolute and relative risk. For example, 23% of survey respondents believe that actively managed funds in traditional asset classes belong to the “core”, a belief that translates into inefficiency in terms of tracking error management, searches for managers, and overall management costs. In addition, new risk management techniques such as “portable alpha” and completeness portfolios, the use of which is made easy by the “core-satellite” approach, have been taken up by very few European asset managers.
When it comes to portfolio construction and risk management, asset managers have made significant progress since an earlier EDHEC survey in 2002. Today, the majority of respondents no longer consider volatility alone to be representative of investment risk; instead, they use Value-at-Risk (VaR) and Conditional Value-at-Risk (CVaR) as indicators for portfolio risk management. The lessons from the post-2000 crises and the growth of absolute performance offerings have clearly allowed the asset management industry to appropriate concepts that were hitherto used exclusively by investment banks. But this progress has its limits. When they calculate VaR or CVaR, more than 42% of survey respondents assume the normality of returns, an assumption that, in the end, makes their calculations neither relevant nor realistic.
Since 2000, the major index providers have offered new forms of indices in response to criticism of the lack of efficiency and stability, of the stylistic and sector-based biases, and above all of the momentum of capitalisation-weighted indices, which are considered problematic by close to a majority of European asset managers and investors.
This criticism, however, has not yet had an effect on the choice of benchmark. Assets indexed to the major capitalisation-weighted indices account for more than 75% of all assets managed by survey respondents.
This predominance has not prevented the emergence of alternative forms such as equally-weighted indices or characteristics-based indices, which are used by nearly 20% of respondents. But this success does not mean that, in the short term, these alternatives will become the new benchmarks for index-based management. Indeed, a majority of respondents believe that fundamental indices are representative of Value-type active strategies and are thus not “neutral” benchmarks or vehicles for long-term allocation. In the end, only 35% of respondents believe that these new indices are preferable to the traditional capitalisation-weighted indices.
It is here that the EDHEC European Investment Practices Survey reveals its greatest surprise: more than 42% of the institutional investors surveyed do not explicitly take their liabilities into account when they are drawing up their asset allocation strategies.
The EDHEC study shows likewise that when investors do manage assets and liabilities they favour simple solutions such as cash-flow matching or liability-driven investment, which now account for nearly half of the ALM approaches used.
A very small number (19%) of those institutional investors using ALM examine extreme shortfall risk measures, with the majority limiting themselves to average risk indicators.
The Sharpe ratio and the information ratio are still the most frequently used gauges of performance. This popularity rests on a conceptual framework that has been tried and tested but that has several drawbacks, in particular when it comes to measuring the real added value of active management. So, although managers now fairly often use measures of extreme risk to construct their portfolios, these measures are used much less frequently when reporting on performance and on the risks borne by funds or mandates. Indeed, fewer than 30% of survey respondents use VaR-based measures to evaluate risk-adjusted performance.
The relative performance of a portfolio is still often measured by comparing returns to a market index, even though research has long since established that this comparison is not the best way to make allowances for the risks taken by the investor and to measure the value added by investment management. Likewise, 70% of respondents may use the information ratio, but only 7% take into account the risks of downside tracking error that underlie the calculation of this ratio.
Finally, the industry as a whole speaks of alpha, but very few professionals measure it correctly. Despite the criticism in the Myners report, more than 62% of those responding look at performance in peer groups, easily the most popular method of measuring alpha, far ahead of methods involving multi-factor models, methods that are widely backed by financial research but used by only 23% of respondents.
In conclusion, EDHEC intends to draw the attention of regulators and professionals to the findings of this study, and we believe that, as things currently stand, practices in the European asset management industry have failed to keep up with the research advances of the last twenty years. This failure concerns professionals no less than it does researchers, who clearly do not put the transfer of knowledge to the industryviewed more often as a source of corporate patronage than as a testing groundat the heart of their work and of their objectives