IPE - January 2007 "The Disruptive Power of Innovation"

The disruptive power of innovation
IPE.com January 2007:

In the second of a new series, Amin Rajan and Jervis Smith argue that beneath the surface of booming markets, fund management is changing irrevocably.

Retail and institutional clients are driving their fund managers back to the their time-honoured mission to deliver absolute and consistent returns, backed by a value-for -money fee structure that clearly separates alpha and beta. They want these requirements customized on the back of business stability that can improve their replicability. Finally, they expect relative returns, closet tracking and low service quality to fade into history as this decade progresses. Sounds like mission impossible? May be, but that is what clients want, according to our latest study*.

No wonder, despite all the hype about hedge funds and liability matching investments, pension funds' incursion into them has been a matter of more haste, less speed. They are unconvinced that these and other new startegies implemented by their fund managers have been either stress-tested or road-tested yet. Many see them as old wine in new bottles. Markets have recovered. But the trust has not returned.

To their credit, most fund managers recognize that many of the new generation of products put on the market in the past three years decidedly require further innovation before clients take them seriously.

Thus, the central thrust of their innovation effort over the next five years will be directed at improving product features like risk, liquidity, volatility and transparency, as shown in our last article (IPE, November, 2006). As a logical extension, a number of process and organisational innovations are also likely to follow (see figure).

Fund managers are planning actions that will enhance their research, investment, and assembly capabilities as part of a major drive towards product innovation.

Source: Create-Research 2006.

The most visible changes will be evident in the retail space. Manufacturing and distribution will increasingly decouple, as focus on performance will become the name of the game. It will be accelerated by new regulations requiring more transparency in various aspects like total expense ratio and how it is apportioned among manufacturers and distributors.

The trend towards 'institutional' distribution, so well established in the US and Australia, will spread elsewhere in Asia Pacific and Europe. Under it, a new breed of professional buyers of funds will increasingly deploy institutional quality tools to select and package funds at wholesale prices and sell them to retail clients. Funds will be 'bought', not 'sold' in the first instance; and then delivered as customised solutions. Their primary oath of allegiance will be to their end clients who will pay advice-based fees in preference to front-end commissions. Under this Darwinian process, the pressure to deliver good consistent returns will intensify.

As a part of virtuous cycle, a range of organisational innovations will also kick in. Large fund houses will promote high conviction investment strategies by creating in-house product-based virtual boutiques in which investment professionals will have autonomy, space and accountability for generating new ideas and executing them. Some of these boutiques may have their own fiduciary structures. Either way, they will be used as one of the avenues of attracting, retaining and getting the best out of top talent, especially post-mergers. This trend will spread to medium sized asset managers as well, as they grow organically.

Alliances with best of breed fund managers will become more common, either as ad hoc arrangements or part of multi-manager platforms which are expected to proliferate in all regions in search of alpha capabilities. An increasing proportion of fund managers are expected to start their own multi-manager arrangements, promoting the emergence of independent as well as in-house boutiques.

Last but not least, outsourcing of back office functions will continue, as investment startegies become more complex in pursuit of alpha returns and packaged solutions. The last wave of outsourcing covered routine back office fund operations. The next wave will expand to take in high value-added activities such as derivatives processing and independent valuations of complex strategies. A new infrastructure of processing platforms will emerge, offering extensive portability via modularisation of distinct services.

Over time, these developments will increasingly transform the industry value chain: vertical integration within individual firms will be replaced by horizontal integration between firms. It will amplify the craft focus in investment, mass customisation in distribution, and process concentration in operations.

As result, the much publicised forecasts of polarisation between large players and private boutiques in the global fund management industry will be wide off the mark. Around 60% of fund managers and pension funds in our survey expect a progressive decoupling of manufacturing and distribution, and growth of multi manager platforms.

This mutually reinforcing nature of product, process and organisational innovations will ensure that the industry evolves like fractals: portraying 'worlds within worlds' and acquire greater complexity as it fragments and evolves. Thanks to the knock on effect of product innovation, the industry food chain will look like that of the car industry, relying on specialist components from specialist firms.

Professor Amin Rajan is the CEO of CREATE, a research consultancy in the UK.

Case study .…

"In this new age of mandated transparency and endless choice, there will be zero-tolerance towards poor returns. Both the current deficits in pension plans and the losses notched up by mutual funds investors in the recent past have produced a generation of unforgiving client.

"Activities that thrive on internal expertise will be decoupled from those that thrive on external alliances, enabling fund managers to concentrate on their raison d'être: investment excellence. New linkages will proliferate across the value chain.

"In investment, fund managers will collaborate with the external best-of-breed managers, producing hybrid products based on different asset classes with a tactical asset overlay. Multi-manager platforms, too, will proliferate, giving investors access to a large range of alpha managers via a single gatekeeper. Far from polarisation, there will be huge fragmentation at the manufacturing end. Investment banks will emerge as one of the key alliance partners.

"In distribution, new alliances will emerge even faster due to regulatory pressures. They will centre on three distinct areas: open architecture, which will spread from the USA to Europe and Asia Pacific; funds supermarkets, catering for a variety of funds; and fee-based advisers, who will increasingly replace commission-based distributors. Such advisers will play a novel role: an independent fiduciary, using institutional-quality research to ensure that funds are no longer 'sold'; but they are 'bought'.

"Finally, in administration, alliances with specialist service providers will be commonplace to achieve three distinct benefits: cost savings in operations that are scalable; independent valuation of complex instruments - like hedge funds and derivatives - as alpha strategies become even more complex; and modularisation of those sophisticated back office services demanded on an à la carte basis.

A global bank

Professor Amin Rajan is the CEO of CREATE, a research consultancy in the UK.

*‘Tomorrow’s Products for Tomorrow’s Clients’ is available free of charge from amin.rajan@create-research.co.uk