The Future of Investment Management

Research Foundation Books 12 November 2018

The Future of Investment Management

Ronald N. Kahn

Overview

Investment management is in flux, arguably more than it has been in a long time. Active management is under pressure, with investors switching from active to index funds. New “smart beta” products offer low-cost exposures to many active ideas. Exchange-traded funds are proliferating. Markets and regulations have changed significantly over the past 10–20 years, and data and technology—which are increasingly important for investment management—are evolving even more rapidly.

In the midst of this change, what can we say about the future of investment management? What ideas will influence its evolution? What types of products will flourish over the next 5–10 years?

I use a long perspective to address these questions and analyze the modern intellectual history of investment management—the set of ideas that have influenced investment management up to now.

One central theme that emerges is that investment management is becoming increasingly systematic. Our understanding of risk has evolved from a general aversion to losing money to a precisely defined statistic we can measure and forecast. Our understanding of expected returns has evolved as the necessary data have become more available, as our understanding of fundamental value has developed, and as we have come to understand the connection between return and risk and the relevance of human behavior to both. Data and technology have advanced in parallel to facilitate implementing better approaches.

With an understanding of the ideas underlying investment management today, including several insights into active management, I discuss the many trends currently roiling the field. These trends, applied to the current state of investment management, suggest that investment management will evolve into three distinct branches—indexing, smart beta/factor investing, and pure alpha investing. Each branch will offer two styles of products: those that focus exclusively on returns and those that include goals beyond returns.

Contents

Foreword ix
   Richard C. Grinold
Preface xi
Acknowledgements xiii

1. Introduction 1
2. The Early Roots of Investment Management 4
   Pre-Modern History: The Early Roots of Investment Management 4
   The Dutch Origins of Investment Management 7
   The Evolution of Investment Management in Britain and the United States 9
   The Evolution of Investment Data 10
   Bibliography 11
3. The Modern History of Investment Management 12
   The Origins of Systematic Investing 12
   The Birth of Modern Portfolio Theory 15
   Active Management Strikes Back 25
   The Evolution of Investing 33
   Appendix 33
   Bibliography 34
4. Seven Insights into Active Management 38
   Insight 1. Active Management Is a Zero-Sum Game 39
   Insight 2. Information Ratios Determine Added Value 41
   Insight 3. Allocate Risk Budget in Proportion to Information Ratios 45
   Insight 4. Alphas Must Control for Skill, Volatility, and Expectations 46
   Insight 5. The Fundamental Law of Active Management: Information Ratios Depend on Skill, Diversification, and Efficiency 50
   Insight 6. Data Mining Is Easy 59
   Insight 7. Constraints and Costs Have a Surprisingly Large Impact 65
   Summary 70
   Technical Appendix 70
   Bibliography 72
5. Seven Trends in Investment Management 74
   Trend 1. Active to Passive 74
   Trend 2. Increased Competition 78
   Trend 3. Changing Market Environments 81
   Trend 4. Big Data 83
   Trend 5. Smart Beta 86
   Trend 6. Investing Beyond Returns 95
   Trend 7. Fee Compression 100
   Bibliography 104
6. The Future of Investment Management 107
   Index Funds 107
   Smart Beta/Factor Funds 109
   Pure Alpha Funds 111
   Investing Beyond Returns 112
   Fees 114
   Conclusion 114
    Bibliography 115

About the Author

Ronald N. Kahn

Ronald N. Kahn is a managing director and global head of systematic equity research at BlackRock, where he has overall responsibility for the research underpinning the Systematic Active Equity products. His service with the firm dates back to 1998, including his years with Barclays Global Investors, which merged with BlackRock in 2009. Prior to that, he worked as director of research at Barra. An expert on portfolio management, risk modeling, and quantitative investing, Dr. Kahn has published numerous articles on investment management, and he coauthored, with Richard Grinold, Active Portfolio Management: Quantitative Theory and Applications. The two of them won the 2013 James R. Vertin award, presented periodically by CFA Institute to recognize individuals who have produced a body of research notable for its relevance and enduring value to investment professionals. He has won the Bernstein Fabozzi/Jacobs Levy award for best article in the Journal of Portfolio Management. Dr. Kahn is on the editorial advisory boards of the Financial Analysts Journal, the Journal of Portfolio Management, and the Journal of Investment Consulting. He teaches “International Equity and Currency Markets” in the Master of Financial Engineering Program at the University of California, Berkeley. Dr. Kahn received an AB in Physics, summa cum laude, from Princeton University and a PhD in Physics from Harvard University. He was a postdoctoral fellow in physics at the University of California, Berkeley.