Do investment innovations work?
The current crisis will be the mother of innovation. But Amin Rajan cautions that, after a traumatic decade, it is also time for a reality check: which of the modern innovations have worked, which have not, and why?
Choosing to remain anonymous, the CIO of a large French pension plan recently observed that: "Many risk takers have taken their profit and gone. The originators of risk are not in the business of holding it. That job has fallen on investors like us who have to be prepared for the long haul. We are very cynical of the word ‘innovation' - it stands for the next con trick to fleece clients."
Strong stuff. So, what went wrong?
The funding crisis in the wake of the bear market at the start of the 2000s triggered heightened interest in the idea of uncorrelated absolute returns.
Alpha became the new mantra. Too many products were flooded on to the market without due regard to their inherent value or client needs. Some were resprayed versions of the old; some were neither tried nor tested, by time or events. Few foresaw the ‘fat-tail' risks which eventually devoured them.
Many hedge funds, for example, were seen as running a Ferrari with a Citroen's brakes. Their replicators went further and promised outsized returns of hedge funds at a fraction of the cost.
Risk was stacked up like a wedding cake. In hindsight, alpha was everywhere except in performance numbers. Innovation got a bad press.
The good, the bad and the ugly were tarred with the same brush, as clients painfully discovered that they no longer managed risk; they managed uncertainty. One relies on known probabilities of expected returns on different asset classes; the other on pure guesswork.
Arguably, many of the existing generation of products might no longer be ‘fit for purpose' in the unusually uncertain environment of this decade created by two mega forces - massive deleveraging in the West and beggar-thy-neighbour policies in the East.
Yet, without innovation, clients face a steep climb out of their current predicament.
In hindsight, asset managers have learned three lessons. First, market volatility requires more robust approaches to innovation: simulation models, copycat mentality or personal reputations can no longer ensure the viability of new products.
Second, the investment landscape is heavily nuanced. It demands frequent opportunism within a replicable process that can capture special market insights and foresight.
Third, new products need to be piggy-backed on operational and business model innovations. The latter are now crucial in delivering outperformance via the compounding effect of lower costs over time.
What do pension plans want?
The seductive charm of uncorrelated absolute returns has created a pensions black hole that is deeper, darker and scarier than anyone imagined. Sponsors' nerves have been strained to breaking point by the scale of current deficits.
The recovery in 2009-10 will ease the pension crisis but not solve it. Previous recoveries have merely concealed deep-seated problems and postponed a root-and-branch look at various areas in the pension food chain.
One such area is investment innovations, according to our latest soundings from pension plans and their asset managers. We heard three things loud and clear.
First, without credible innovation, pension plans will stumble from one crisis to another during this decade. Neither plan sponsors nor their members can now afford to write big cheques.
Second, innovation has to be about seeking new ways of meeting client needs, including ones they did not know they had: ways that isolate new ideas from clever fads and deliver value for money to end-investors.
Third, without viable products in the pre- and post-retirement phases, DC plans will follow the same death road as DB plans, causing yet another headline grabbing mis-selling scandal.
It is time for fresh thinking.
To kick-start a new way forward, IPE is helping to launch a global survey in partnership with CREATE-Research, the UK-based independent think tank.
Jointly sponsored by Citi and Principal Global Investors, the survey aims to:
• Carry out a robust stock-take on prominent innovations of the 2000s. By separating the wheat from the chaff, we aim to underline the lessons that need to be learned in the next wave of innovation;
• Highlight areas in the DB and DC segments where further innovations are necessary in the turbulent environment of this decade. We aim to focus on the art of the possible, not another list of desirables;
• Promote a lively debate on whether investment innovations can, in fact, deliver replicable outcomes when there is so much random ‘noise' in financial markets where opportunities appear and vanish as fast as spring snow.
As a start, we aim to evaluate four kinds of innovation making headlines in the last decade (see figure):
• New asset classes;
• New asset allocation techniques;
• New hedging and returns-enhancing tools;
• New product overlays.
Moving on, we will address five related issues:
• What practical improvements are required in each of the above four categories;
• How asset managers can develop external alliances to generate the requisite credible ideas;
• How lower costs via operational excellence can become a key source of out-performance;
• How innovation processes can become more robust in capturing and implementing good ideas;
• What asset managers can do to match words with deeds.
In the process, we will also address the big question, namely: how can investment innovations deliver demonstrable benefits to clients?
Professor Amin Rajan is CEO of CREATE-Research