Improved client engagement, human decision-making and the sourcing of talent with a big-picture perspective will be among the key drivers of future financial innovation, a global study has found.
Increasingly, the shape of innovation is expected to be determined by government initiatives and policies in Asia, rather than the private sector in the US and Europe, its traditional breeding ground.
Independent think-tank Create-Research surveyed over 500 pension plans, asset managers, consultants, administrators and distributors with combined AUM of $29 trillion to discover which innovations in the past decade had worked, which hadn’t and why.
It subsequently carried out interviews with executives in 90 firms worldwide to gain an understanding of what, among other things, the asset management industry needs to focus on and what improvements must be made.
The researchers report that 35 innovations have been widely adopted in the wake of heavy losses inflicted by the 2000-2002 bear market: 29 were customer-focused to deliver better returns, and six were taken up by service providers to improve business resilience.
This post-2002 innovation drive, which emanated from the US where 58% of the world’s $27 trillion in pension assets are accounted for, shifted attention from relative to absolute returns; from mainstream to alternatives; and from asset investing to liability matching.
However, the 2008 global financial crisis overwhelmed their impact, and strategies meant to thrive on volatility, such as hedge funds and currency plays, were quick to disintegrate.
Survey respondents named five innovations that had delivered value in the last 10 years: emerging market equities, emerging market debt, high-yield bonds, liability-driven investing and exchange-traded funds.
In each case they noted they had clear investment beliefs that guided their choices; a disciplined approach to buying and selling that minimised behavioural biases; and the skills and governance to chase intrinsic worth via early-mover advantage.
They also named the innovations that delivered least value – leverage, structured products, portable alpha and currency funds – and pension plans that lost out cited three contributory factors.
They had relied on financial engineering to extract value where there was none; on external advice in a way that promoted a herd instinct which prevented buying on dips; and, importantly, they had low engagement with asset managers.
In fact, when asked how often their asset manager had involved them in the innovation process, 34% of pension plans replied ‘rarely’ and 39% responded ‘occasionally’.
Andrea Muller, CEO of Principal Global Investors Asia, which commissioned the study along with Citi’s Global Transaction Services, says she found this lack of client engagement astonishing and cites it as the key lesson to be learned.
“In this new world, there needs to be client engagement, but at the same time clients need to be driving the solutions, they need to talk to their asset managers about what their needs are, rather than just listening, so it really goes both ways,” she says.
The study reports that pension plans want future innovations to improve two product features which directly impact their bottom line: the risk-return trade-off and their fees and charges.
In all, 43% want greater transparency in the investment process as well as outcomes, and many are calling for independent performance attribution analysis that singles out, for example, the roles of skill, luck, momentum, industry sector and growth.
They also said they want risk models and investment processes to have a strong overlay of human judgment, particularly while the global economy remains exposed to systemic shocks.
“In the past, too many decisions were based on quant models,” says Muller. “What Asian clients want to see is human judgment, they want gut decisions.”
It leads to a third issue identified as key to future innovation: the scarcity of talent with a sound understanding of changing global dynamics.
“It’s a problem we face and that every asset manager faces,” adds Muller. “How do you find people who have instincts to cope with shocks such as a potential default in Greece, a quake in Japan or upheaval in the Middle East. Those are things you can’t put into a black box.”
Muller fully expects future innovation to be led by government initiatives and policies in Asia, where both private and pension funds will need to find solutions for rapidly rising middle classes and aging populations.
In contrast to the US-driven adoption of innovation post-2002, large pension markets in China, Japan and South Korea, for example, chose to remain home-biased, bond-biased and peer-biased.
Now their maturing liabilities are forcing them to look at more innovative solutions, and before long the adoption of the mark-to-market rules will also emerge as another driver of adoption.
“One of the drivers will be the regulatory landscape, and there is concern that regulation in the US and Europe may slow the pace of innovation, which might not be a bad thing because it will give asset managers and clients more time to figure out their needs," says Muller.
“That may be true over the next three years. But if you look at a five-year time horizon, I think a lot of the innovations we will see will be coming out of Asia. And asset allocation in Asia is driven by government policy, and that is quite a different dynamic from the West.”
Over time, the study identifies four innovations that could prove disruptive to business models: likely abolition of commissions in the retail space in Europe and Asia; adoption of high watermark fees in the absolute return space; the morphing of defined contribution products in the retirement space; and emergence of state-of-the-art data warehouses in the administration arena.
“The crisis marked the end of a chapter in the history of investment innovations: more a moment of introspection than the mother of inventions," the study finds. “Clients have wised up. Asset managers have started a fresh narrative on what they can deliver. Time will tell whether their current efforts will fare better than previous ones.”