Why asset management is set for transformation and innovation
The asset management industry is set to take part in the wave of innovation currently cascading throughout the economy, helping it to more closely meet the needs of today’s investors.
This may seem like a strange prediction. After all, innovation in the finance industry has had a bad rap recently. The 2007–08 financial crisis is closely associated with ‘innovative’, highly leveraged, complex derivative instruments that blew up and unleashed chaos in the global markets. In response, politicians, regulators and investors alike called for a safer, more conservative approach to finance.
But at Unigestion, we believe that a decade from now, the investment management industry will look quite different from how it does today. We intend to play a full role in its transformation.
In this first of two papers, we take a look at why financial innovation is important for the economy, how we view innovation at Unigestion, and likely sources of future innovation by asset management companies. In a follow-on document, we will examine how companies innovate, and the implications for boutique asset managers like Unigestion.
by Fiona Frick, CEO of Unigestion
IS FINANCIAL INNOVATION GOOD FOR THE ECONOMY?
As a result of the financial crisis there has been a view among the general public that financial innovation is dangerous. Warren Buffett popularised this view by describing complicated derivatives as weapons of mass destruction. Given the events of the financial crisis, which involved the abuse of derivatives and leverage, it is understandable why such opinions prevail.
But in reality, financial innovation plays a major role in helping the economy to function and ensuring growth.
For instance, the invention of stock markets enabled entrepreneurs to fund new ventures, benefitting the economy. Pooled investment vehicles provided individual savers with greater access to the markets and to the services of professional fund managers. And, when they are used properly, derivatives are very useful for hedging risk.
The pensions industry was yet another important financial development, enabling people to save for a comfortable retirement. This sector will play an even bigger role in the future: ageing populations are putting governments around the world under growing fiscal strains, and they are increasingly looking to the financial sector for solutions.
More recently, peer-to-peer funding platforms such as Kickstarter in the US and Funding Circle in the UK have been developed, helping small investors to become ‘venture capitalists’ with tiny sums of money. Such platforms could help spur the next wave of start-ups, helping reinvigorate the global economy with new ideas and business models.
Financial innovation, like all innovation, involves risks, and these were unmistakably demonstrated by the 2007–08 crisis. But just as we should not conclude that medical research does not promote human health because it has given rise to drugs that can be abused, we should not infer that financial innovation does not promote economic growth because of the devastating crisis that we went through.
Financial innovation plays a major role in helping the economy to function and ensuring growth.
INNOVATION IS ABOUT CO-CREATING WITH CLIENTS
If innovation in finance is often viewed with suspicion, it might be linked to the common perception that it results in the proliferation of increasingly complex products.
At Unigestion, innovation is not just about launching new products. It goes beyond that, and could be defined as “bringing something better to our clients”. Innovation can be a new approach to investment management, an improvement to an investment process, a new service proposal, or a better operational process. Good innovation is ultimately about improving our clients’ experience.
As a consequence, we see our clients as innovation partners. That means listening to their needs and understanding their constraints. We share our research agenda with our clients, asking them to challenge our new ideas. Innovation is about co-creating with our clients the investment solutions that match their needs, based on the premise that we do it “with them” rather than “for them”.
An example of this was a client who was invested in our equity strategy, which is designed to reduce the impact of market volatility. But they needed even smoother returns and a very steady dividend flow. In response, we designed a strategy involving derivatives, which further reduced the impact of market movements on their assets. This went on to become our absolute return equity strategy, which several of our clients now invest in.
Now that we have set out our definition of innovation, let’s assess some of the possible triggers of further innovation in our industry.
GREAT ECONOMIC CRISES ARE OFTEN HARBINGERS OF INNOVATION
Major crises often sow the seeds for new thinking. This was certainly the case with the 2007–08 financial crisis, as a lot of established investment beliefs were proved to be wrong. The crisis showed that it couldn’t be taken for granted that government bonds are always safe investments, or that equities automatically perform well over the long term. The concept of diversification of asset classes, which was supposed to reduce portfolio volatility, turned out to be something of an illusion when asset class correlations shot up as the financial system buckled under severe stress.
The extreme volatility that the crisis resulted in has led investors, asset managers and academics to collaborate in a concerted effort to help restore belief in investing.
Risk management has taken centre stage in all of this. Risk has been redefined as volatility and drawdowns rather than tracking error against a benchmark. New risk-based approaches to asset allocation such as risk parity have emerged, in contrast to the old return-based framework. And in equities, the crisis showed that managing risk can enable investors to outperform the broad market with less volatility. Although Unigestion has been an advocate of this approach since the mid-nineties, it is only really since the crisis that this concept has gained momentum among a wide spectrum of investors.
The concept of diversification has also drastically changed. As market participants’ understanding of the different systematic factors that affect returns has increased, diversification has moved from investing in different asset classes to investing in the different risk factors that drive those asset classes.
Even the term ‘active’ management has been redefined. Previously, alpha was about generating returns that were not related to the market index. Now, it is about generating return that cannot be explained by some systematic risk factor. As a consequence, a third way of investing – known as factor investing – that is between active and passive management has emerged.
So will all of this new investment theory prove to be more powerful than the old? Time will tell. The difficulty with investment innovations is that, in contrast to physical innovation, they are path-dependent. This means that the effects of investment innovations are dependent on the market conditions at the time they are implemented. Nevertheless, these new ways of thinking have resulted in a redefinition of real risk, and are enabling managers to run their portfolios more closely in line with the risk that an investor is prepared to cope with.
A lot of established investment beliefs were proved to be wrong.
REGULATION AS A DRIVER OF INNOVATION
Regulation will certainly influence innovation as it will force the asset management industry to rethink the way it performs its fiduciary duty to better meet its clients’ interests.
What’s more, regulation has a considerable influence on the investment requirements of institutional clients. This has a ripple effect on asset managers, forcing them to develop new investment solutions that meet those requirements. For example, mark-to-market accounting rules for pension funds helped asset managers develop their liability-driven investing capabilities. Meanwhile, Solvency II regulation created new requirements for insurance clients in terms of risk budgeting and transparency, and this forced their asset managers to come up with new transparent risk-management reporting solutions. Finally, regulation of the banking sector enabled asset managers to enter new areas, such as private lending, that had previously been generally controlled by banks. Asset managers are approaching these areas with a fresh perspective, and finding innovative new ways to invest in them.
Regulatory changes are forcing asset managers to develop solutions that meet new requirements.
INNOVATION TRIGGERED BY CHANGING INVESTOR PRIORITIES
Our clients are faced with the dilemma of how to generate sufficient returns to meet their liabilities on the one hand and the challenges of today’s investment landscape on the other. These challenges are increasingly complex, and include a poor economic outlook, declining real yields and increased regulation. The good news is that our clients are aware of the many risks that they face. The bad news is that, regardless of these risks, because of the low-interest-rate environment they have no option but to take on substantial risk to meet their goals as returns have been bid down.
Ageing populations and pension deficits are causing a noticeable shift in investors’ attitudes and priorities. At the heart of this change in attitude is their desire to achieve sustainable returns with less risk. As an example, pension funds need to be able to meet their financial commitments to their members, who are living longer than ever before.
A second shift in investors’ attitudes is their increasing focus on outcome rather than relative return. Today, they don’t necessarily choose an asset class to invest in and a benchmark to beat. Instead, they define an investment outcome that they want to achieve, such as capital growth, targeted income, liability matching or inflation protection. The role of their asset manager then involves looking at the client’s desired outcome and their tolerance to certain type of risks, and customising a solution that meets those needs. This focus on investment outcome rather than relative returns explains the renewed success of multi-asset solutions. This is essentially the revival of the traditional balanced portfolio, but using a greater range of asset classes and a more dynamic asset allocation.
Investors increasingly want to achieve sustainable returns with less risk.
DIGITAL TECHNOLOGY DISRUPTING ASSET MANAGEMENT
Digital technology has disrupted a wide range of industries over the past decade, and it is now starting to have a major impact on asset managers. Asset management is a ‘virtual’ business, but it still operates using a relatively inefficient technological infrastructure. Some online firms, such as Google, Facebook or Amazon, could decide to enter the asset management industry as they are better equipped than traditional asset managers in terms of their ability to deal with large amounts of data, the amount of information they hold about end-investors, and providing a seamless experience to their clients. The success of Alibaba Group in launching a money market fund targeted at the Chinese domestic market and attracting around EUR 70 billion of assets in a few months shows the potential of such online companies.
But big internet names branching out into asset management could also present opportunities for traditional asset managers. Google or Facebook could make a lot of money by setting up their own platform to distribute other asset managers’ funds, rivalling the platforms of the major banks. Would an investor buy a fund managed by Google? That’s still to be proven. Would they buy a fund distributed by Google? Most probably, yes.
Asset managers have a lot to learn from the digital giants.
In a period of robotisation of entire industrial processes, asset managers need to ask themselves what they can provide their clients that a robot, social media platform or algorithm cannot. Some companies, such as Nutmeg in the UK, are already entering the area of online algorithms for asset allocation. Meanwhile, social trading platforms such as E-Toro are enabling investors to copy the trades of others and turning every online trader into a mutual fund.
Clients’ demand for 24/7 online reporting and customised investment solutions will force asset managers to redeploy their technology platforms to develop user-friendly interfaces that are enjoyable to interact with and make the user experience as simple as possible.
So it’s critical that asset managers invest in technology. They will have to become technological companies in terms of the amount of data they need to store and performing tasks efficiently. They will need to put in place the necessary infrastructure to leverage the exponential volume of information available, not just to get to know their clients in more depth, but also to better evaluate market prices. Doing so can be critical to protect against disruption and could also create a sustainable advantage.
Asset managers also need to be proactive when it comes to social media as a means of communication. Investors using social media often exchange their opinions about their asset managers with their peers, and this can have a big influence on how others perceive the managers. We can imagine at some point there will be a Tripadvisor-style website with clients and prospects rating and sharing their opinions on asset management companies.
But social media platforms will also offer asset managers valuable insights into the companies that they are considering investing in – particularly in terms of their customers’ opinions and investor sentiment, both of which have an important bearing on share price performance. This kind of social activity will probably increase behavioural biases as it will amplify investors’ mood swings and increase herding behaviour and the animal spirit. After all, market movements represent the sum of the emotions of its participants. Understanding how emotions are formed and influenced through social media will lead to innovative thinking about how to manage money.
It’s critical that asset managers invest in technology.
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