27th November 2006

Industry developments: Exacting investors spark wave of innovation

By Amin Rajan

Deficits in pension plans and the losses notched up by mutual funds in the recent past have produced a new generation of unforgiving fund management clients.
In an effort to regain investor confidence, fund managers worldwide are pursuing product innovation in three ways.

The first promotes high conviction investment strategies by forming in-house product-based boutiques in which investment professionals have autonomy, space and accountability for generating new ideas and executing them.

The second involves creating dedicated incubators where ideas breed new ideas, some of which are then fast- tracked into new products and services.

The third relies on the adoption of multi-manager platforms that engage independent boutiques as innovation partners.

Thus, the manufacturing end of the asset management industry is becoming more fragmented since few investment strategies are scalable in today's world of absolute returns. Activities that thrive on internal expertise are being decoupled from those that thrive on external alliances, freeing fund managers to concentrate on delivering good and consistent performance.

In the earlier phase, the decoupling occurred mainly as a result of outsourcing routine back-office operations. The next wave will increasingly focus on high value-added activities such as derivatives processing and independent valuation of complex strategies.

"Service providers are using state-of-the-art technology as a disruptive force that helps fund managers to create new products or services across their value chain. Our platforms are a major source of value and growth. We are going from outsourcing to smart alliances," says Chandresh Iyer, head of North American Securities and Fund Services at Citigroup.

Such alliances are not restricted to back-office operations. In distribution, too, they are emerging in various guises: open architecture, which is spreading from the US to Europe and Asia; funds supermarkets, catering for a variety of funds; and fee-based fiduciary advisers who are increasingly replacing commission-based distributors.

The 18-year-old bull market concealed mediocrity among mutual fund managers. In the US, as investors realised they lost 150 basis points each year for poor decisions, open architecture became inevitable. Now we are witnessing the emergence of a new generation of independent fiduciary advisers, especially in the US and Australia. Thanks to regulators, there is traction developing in Europe as well, where distribution is riddled with conflicts of interest.

Such advisers are a new breed of professional buyers of funds. Using institutional-quality tools to build packaged solutions at wholesale prices, they ensure that funds are "bought", not "sold". This is driving down fund managers' pricing power, while exposing emperors with no clothes.

"Clients demand simplicity. They don't necessarily want to know how the sausage is made," says Bob Boyda, senior vice-president, investment management services, at John Hancock Investment Management. "They want to know their funds are invested within a package that is targeted at achieving specific retirement-based outcomes. Clients are reverting to old ways of investing because these packaged products have outperformed the DIY decisions,"

Some 60 per cent of fund managers in a survey sponsored by Citigroup andT. Rowe Price* anticipated a progressive decoupling of manufacturing and distribution over the rest of this decade. However, retail distribution is not the only area where newcomers are evident. On the institutional side, too, investment banks and pension buy-out specialists are making waves.

All these developments are amplifying the craft focus in manufacturing; mass customisation in distribution; and process concentration in operations.

As a result, the much publicised forecasts of industry polarisation between large players and private boutiques are far too simplistic. Thanks to the knock-on effects of innovation, the industry food chain is not what it used to be.

Amin Rajan is chief executive of Create, a research consultancy
*Tomorrow's Products for Tomorrow's Clients", available at amin.rajan@create-research.co.uk
Copyright The Financial Times Limited 2006