“Innovation” is often held up as the engine of growth for modern economies. Technological innovation, business process innovation, even social innovation, have carried the hopes and dreams of companies and economies alike.
Then there’s financial innovation.
This new four letter word has been blamed for everything from the economic crisis to the cooler than normal summer in the Northeastern US. But we contend what some have termed “pure financial innovation” is much different than innovation in the financial services industry.
A new report on the global asset management industry from the Boston Consulting Group makes this point in spades (available here with free registration). The report argues that after the fiasco of the past couple of years, institutional investors will demand “innovations” such as alternative investments.
“Institutional investors have sustained substantial losses during the crisis despite highly diversified strategies. They will likely continue to increase the diversification of their portfolios and seek innovation to help them achieve this goal.”
So what kind of “innovation” will they seek? The chart below from the report answers this question:
The blue bubbles (the “innovative products”) include a laundry list of alternative investments such as: hedge funds, private equity, infrastructure, real estate, commodities, short-extension (130/30) funds, and liability-driven investments (LDI). Like all innovations, their adoption has involved set-backs along the way. But the firm is clearly bullish on these products…
“Infrastructure Funds: These funds have offered long-term stable cash flows, providing protection against inflation…Given default risks and declines in asset values since the beginning of the crisis, however, the picture has become less clear. Still, infrastructure funds should show above average growth by 2012.”
“Absolute Return and Short-Extension Funds: Given major reverses in 2008, it is questionable whether fund providers can restore investor confidence in absolute return and short extension funds (also known as long-short funds). Still, we believe there will be continued interest in absolute return products that focus on asset allocation…there is still room for products that are not constrained by benchmarks.”
“Commodities: Commodities can offer portfolio diversification and above-average long-term growth prospects, although they are still volatile. Given the continued search for diversification, the penetration of commodities into investment portfolios is likely to grow.
“Real Estate: Real Estate will remain an important asset class for investors. Given fears of inflation and the search for diversification, this asset class is likely to offer above-average growth prospects.”
Note from the chart above that these products, like innovations in all industries, command higher margins than traditional (active or passive) products. But at the same time, BCG is forecasting that passive products will actually grow faster over the next few years as money is moved out of active products.
The firm writes that “Perhaps the foremost trend in actively managed products is the continuing shift out of long-only equity allocations.” While this observation pertains to mutual funds (where assets are flowing into money market and bond funds), it applies equally to institutional assets.
As we have argued here, those institutional active assets aren’t just moving into passive products. A portion of them are also moving to these “innovative” (i.e. alpha-centric) products. So at the end of the day, the jury is still out as to whether institutions are actually “going passive”, or whether they are simply breaking apart the bonds that hold alpha and beta together and making each of those allocations separately (such as, for example, Sweden’s National Pension Fund – case study).
In any event, this report is well worth the read and contains loads of chartware in the current and future states of the asset management industry (margins, products, AUM etc.)