For asset managers, the future of innovation lies in mastering existing strategies before moving on to new ideas, writes MIRANDA WARD.
Pension funds are not optimistic about the future of innovation in the investment industry.
According to the influential CREATE-Research Report, Investment Innovations: raising the bar, most pension plans surveyed do not think financial product innovation will deliver genuine value for money to their members in the next three years.
“Pension plans anticipate no ground-breaking innovations that will markedly help them,” the report, authored by Amin Rajan of CREATE-Research, states.
Of the 108 pension plans surveyed, 39 per cent said financial innovation would deliver value (see Figure 1).
Before the financial crisis, sales and product development teams within asset managers swamped pension funds with new products. Investment professionals took a back seat. But pension funds have exerted more power in the years since the financial crisis: they have “investment-pull,” the report states.
Despite this, sales engines within funds management companies are revving up: 88 per cent of managers surveyed foresee more product launches in the next three years. Just more than half expect “incremental” innovations. These will aim to fix the problems in existing strategies before developing anything new.
“The implications are clear: improve what you have rather than search for the new,” Rajan says.
Contrary to their pension fund clients, asset managers believe financial innovation will deliver genuine value in the next three years. They think the glass is more than half full: 64 per cent are believers in innovation (see Figure 1). One manager tells Rajan: “The result is not the writing on the wall for investment innovations, but only the opening lines of a new chapter.”
Rajan says asset managers should learn to play to their strengths as they strive to be innovative.
“They should really build on their core expertise,” he says. “In the past they have strayed too far.” He provides the example of long-only equities managers who adopt long/short strategies and underestimate the required skills for this. “They have lost a bundle of money for their clients.”
Asset managers place the blame for insufficient innovation elsewhere: on the organisational structure and processes they work within. Nearly 40 per cent of the 396 asset managers in the survey identify this as a fundamental inhibitor of innovation. The report finds the innovation processes within funds management companies are not as successful as those in other knowledge-intensive sectors, like IT and engineering.
There is consensus between pension plans and asset managers on this finding.
“I suspect there will be more care taken in introducing the new generation of innovation because asset managers have learnt [at their] cost that innovation is not about leap-frogging your competitors or producing copycat products,” Rajan says. “Innovation is genuinely about producing products which are fit for purpose. I think the next wave of innovation will have a lot more wheat and a lot less chaff.”
This isn’t the only justification for poor innovation from asset managers. The report identified several internal factors that can limit the scope of their innovation (see Figure 2). Slightly less than half of managers say scarcity of investment talent is the major contributor.
This does not mean the industry has suffered a talent drain since 2008. The report states: “With the time-honoured practices in asset allocation, manager selection, portfolio construction, stock selection and, above all, risk management coming under attack, personal insights and gut instincts have become major differentiators.”
The reason why this rare talent is critical is because the investment landscape has changed dramatically in the last decade. Rajan says a “phenomenal” change in global investment markets has been rising volatility across all asset classes. This has made returns much less predictable and has increased demand for managers’ insights.
There is another reason why this rare talent is in demand. Diversification. Rajan says it doesn’t always work because correlations between historically un-correlated asset classes sometimes go “through the roof”. Investors also continue to invest heavily in equities – even though the equity risk premium is not guaranteed. “As a result of these factors, investment plans have become very nuanced and become very unpredictable and what you need are people with rare insight or foresight to understand the dynamics of the investment landscape and capitalise on it,” Rajan says.
“There aren’t many people who can do it. It’s not that these people are ill-equipped – all I’m saying is that the bar has been raised significantly on them.”
On top of these internal defects, managers name seven external factors limiting their ability to innovate (see Figure 2). Slightly less than half of the managers surveyed name the eagerness of banks and insurance companies to sell commoditised products as the primary constraint. These owners are faced with the need for fresh capital due to changes in regulation and as a result are now pushing their products harder.
Uncertainty in the global economy, due to rising inflation in emerging markets and mounting unemployment in developed markets, is the second-highest ranking factor.
Funds managers say their poor innovation processes will be short-lived.
In the aftermath of the financial crisis, these processes were put under the magnifying glass. According to the report, about 40 per cent of managers are using all or some of the following four stages to become more innovative:
1. Ideas generation: inviting investment staff to debate their ideas;
2. Evaluation: completing a feasibility study of promising ideas and crafting business cases for them;
3. Design: constructing prototype products for testing, including paper-trading to establish ‘proof of concept’; and
4. Delivery: launching the product with seed capital before pitching it to investors.
“The robustness of the process is measured by the number of kill-offs at each stage compared with the successful launches,” the report says. “The aim is to weed out the ‘dogs’ from the ‘stars’.”
The report shows that many managers are searching for ways to improve their strategies. However their tendency to develop long lists of products has not been killed off.
It finds: about 35 per cent of asset managers are promoting innovation as an integral part of corporate culture and business strategy; about 33 per cent are changing their operating model to create autonomous product teams; about 20 per cent are seeking ideas from their third party administrators that provide additional insights into stress tests, risk analytics, attribution analysis and fund structuring; 20 per cent are setting credible targets for new products as part of their corporate strategy; and 8 per cent are setting up dedicated research and development units to generate break-through ideas.
Ultimately, the innovation process is a balancing act, Rajan says. “Asset managers really need to walk a fine line between creating new revenue streams for themselves and creating new opportunity sets for their clients when it comes to innovation,” he says. “Innovation has to be a two way street.”
Rajan’s report has some tips for managers wondering how to become more innovative. To begin with, they need to examine their working environments.
“The best ideas often come from serendipity. They emerge via frequent and intensive discussions in small informal groups, with minimal bureaucracy,” reads the report. It provides the example of successful hedge fund managers attributing their success more to their free-thinking workplaces than to their inherent talent.
Corporate culture is also important.
It needs to provide financial incentives and personal recognition for successful ideas. The final factor is the fast-tracking of ideas so they are not caught in bureaucratic processes. The report named which innovations pension funds and asset managers believe have delivered the most value.More than one in four funds say that, out of all the new strategies devised in the past decade, the following five delivered the most value:
1. Emerging markets equities;
2. Emerging markets bonds;
3. High-yield bonds;
4. Liability-driven investment;
5. Exchange-traded funds.
These results are echoed by asset managers. But they add two more: hedge fund strategies and unconstrained mandate structures are both named by 24 per cent of managers as valuable innovations.