Investment Innovations: raising the bar

3 August 2011

CITIBANK EUROPE PLC, DUBLIN - SUCURSALA ROMANIA

 

Executive Summary

Since 1980, investment innovations have come in five distinct clusters:

• new asset classes
• new asset allocation techniques
• new risk and returns enhancing tools
• new theme funds
• new business models.

Although coming on-stream at different times, their substantive adoption occurred in the wake of the 2000-02 bear market.

Focusing on the last decade, this report assesses their impact on the basis of two global surveys. One involved 108 pension plans and the other involved 396 asset managers, pension consultants, third party administrators and distributors – from 30 countries. Together, they represent a combined AuM of around US$29 trillion.

Four headlines have emerged from our surveys.

1. INNOVATIONS WORK AS LONG AS WE KNOW THEIR LIMITS

Adoption of the identified clusters gained significant traction across the Atlantic in the last decade. But the 2008 credit crisis overwhelmed their impact. Strategies that were meant to thrive on volatility – e.g. hedge funds and currency – came unhinged. Their idiosyncratic risks were overwhelmed by the systemic ones.

Even so, five innovations delivered most value:

• emerging market equities
• emerging market bonds
• high yield bonds
• liability-driven investing
• exchange traded funds (ETFs).

Pension plans that benefited from them attribute their success to strong beliefs in their intrinsic worth, a disciplined approach to buying and selling, and in-house capabilities to chase early mover advantage.

They got the timing right.

Innovations that delivered least value include:

• leverage
• structured products
• portable alpha
• currency funds.

Pension plans that lost out attribute the outcomes to the absence of intrinsic value, herd instinct and low engagement with their asset managers.

They did not heed the ‘health warnings’.

Nor did they have the skills and governance to enter into anything complex or risky.

2. ASSET MANAGERS SHOULD IMPROVE THE OLD BEFORE CREATING THE NEW

Pension plans want asset managers to take four actions that can potentially improve the outcomes of the last crop of innovations:

• deliver better returns per unit of risk within a more symmetric fee structure
• deliver greater transparency and simplicity, so that the intrinsic worth of their assets is not concealed by devices such as derivatives, leverage and shorting; these should complement, not conceal, product integrity
• create a strong overlay of human judgement in risk models and investment processes
• develop better proximity to clients in order to minimise the ‘wrong-time’ risks.

3. THE INNOVATION BOAT IS UNLIKELY TO BE PUSHED OUT TOO FAR

A number of innovations are in the pipeline. Their impact will be modest over the next three years but will build up as the decade progresses.

Their immediate aim will be to improve the product features outlined above.

Over time, four innovations are likely to prove especially disruptive to the existing business models:

• the likely abolition of commissions in the retail space in Europe and Asia
• the adoption of high watermark fees in the absolute return space
• the morphing of defined contribution (DC) products in the retirement space
• the emergence of state-of-theart data warehouses in the administration space.

4. THERE NEEDS TO BE A CLEAR LINE OF SIGHT BETWEEN INNOVATIONS AND CLIENT NEEDS

Pension plans accept that innovations cannot deliver replicable outcomes. Nor can they do without them.

Both the size of their current deficits and the returns required to fix them remain daunting in today’s low return environment.

Thus, they want to be assured that their asset managers seek ‘best endeavour’ outcomes via product integrity, process integrity, operational excellence and interest alignment.

The likelihood of such outcomes may increase if:

• there is greater client engagement that seeks new ideas as much as manages expectations of what can and can’t be achieved in today’s markets, with random bursts of risk-on/risk-off that ignore the fundamentals
• innovations stem from managers’ core skills as distinct from pure market opportunism
• innovations walk the fine line between revenue streams for asset managers and credible opportunity sets for their clients.

Over this decade, the investment value chain will be distinguished as much by introspection as innovation.

 

Report Synopsis

In the last decade, the charm of uncorrelated absolute returns captured the imagination of investors who had hitherto relied on a raging bull market to do the heavy lifting for them.

Numerous investment innovations were duly adopted: some new, some revived versions of the old.

New asset classes emerged. Some were offshoots of long only funds. Others were genuine alternatives. New asset allocation techniques were also created as strategic asset allocation became more dynamic.

New risk hedging and return enhancing tools accompanied them in the institutional market.

Finally, new theme-based products were introduced in order to meet the diverse needs of retail investors.

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