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Top 400: Disruptive change - an end to the innovator’s dilemma?

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The combination of technology and innovation like exchange-traded funds looks set to change some aspects of the asset management value chain, according to Amin Rajan and Subhas Sen

Since the dawn of the internet, service industries have faced disruptive changes to their business models, primarily the result of developments in technology, demographics and globalisation. For example, low-cost airlines disrupted the business models of national airlines: they propelled the greatest growth in global air travel by targeting customers that had hitherto remained under-served and giving them a price they could afford. 

The asset industry faces a similar prospect under the current digital revolution. Starting as an information tool, the internet is now morphing into a hybrid that permits financial planning, convenience buying and relationship building via enhanced transparency around costs and benefits of investment products.  

A new generation of web-based DIY tools is enabling clients to engage directly in a variety of activities in the investment value chain. These include needs analysis, portfolio construction, periodic rebalancing and performance monitoring via user-friendly dashboards, according to a new report*.

The rise of exchange-traded funds (ETFs) also enables product simplification that appeals to a new generation of internet-savvy clients. 

Over the next five years, 75% of global retail assets – estimated at nearly $30trn (€27trn) – will be held by retirees or those nearing retirement. This is at a time when there is a dearth of decent retirement products. Many retirees are expected to invest in low-cost commoditised options that target regular income and low volatility. 

Digital tools offer transparency around the four areas that matter most to investors – the risks they are taking, the returns they can expect, the compound erosion of their portfolios due to open and hidden charges, and the scalability of their chosen strategies. 

The craft of investing is being demystified. In particular, the tools will enable clients to buy standardised products such as ETFs and money-market funds online, leaving other sales channels to provide more complex strategies. 

One start-up that has attracted extensive media publicity is Yu’e Bao (Balance of Treasure), the money-market fund of the Chinese internet company Alibaba. 

With over 80m investors and assets of over $80bn (70.4bn), Yu’e Bao’s meteoric rise as China’s number one asset manager shows the potential for new entrants to seize market share and to shape the industry. The recent launch of its stock market index based on its proprietary data is yet another example of its ambitions. 

Unsurprisingly, its success has raised the spectre of western internet companies such as Google and Facebook entering the fund market on the back of their users.

On a less grand scale, the so-called robo-advisers in the US and Europe are also spearheading the digitisation of asset management. 

As internet start-ups, these newcomers are creating tools that deliver needs analysis, portfolio recommendations, fund aggregation and client dashboards. Today their assets amount to $14bn, with most of this in the US. This is likely to mushroom to $255bn within the next five years**.

Amin Rajan

Amin Rajan

Their growth will be driven by cognitive computing, such as IBM’s legendary computer Watson. It interacts with users on their terms, and can provide solutions and recommendations across most investment activities. 

This raises the question: who will dominate the asset management industry’s dynamics as digitisation increases? There are three possible scenarios: 

• Barbarians at the gate: this envisages that the digital disrupters will take the fight to the incumbents by carving out a special niche at the commoditised end of the market. Unencumbered by either legacy systems or legacy thinking, they are likely to be especially successful in blending automation with passive investing to shape investor behaviour;
• The empire strikes back: this envisages asset managers adopting digitisation for parts of their business, in much the same way that most national airlines have emulated the low-cost airlines. In the face of rising competition and fee compression, the incumbents will recalibrate their business models to meet needs; 
• Peaceful co-existence: this envisages that, as the asset management industry continues to grow worldwide, diversity will characterise the prevailing business models. Within that diversity, competition and co-operation will prevail. If newcomers are especially successful, they will most likely seek new alliances with incumbents to scale their business, or else they risk being taken over by them. 

The first scenario is least likely. Investors will be wary of trusting their money to an organisation that lacks investment DNA and brand identity. Computerisation in banking in the 1990s led to the belief that computer and telecom companies would invade the banking business model – yet this did not happen. 

Yu’e Bao’s runaway success needs to be put into perspective. It owes more to its status as an unregulated shadow bank than its being a digital superstar. This status allows it to offer a return of around 5% – nearly twice the rate offered by regulated banks – and instant liquidity. 

Similarly, the second scenario is also unlikely while asset managers continue to suffer from the time-honoured innovator’s dilemma – why change your business model when you already have a steady revenue stream from the existing book of business?

The problem is compounded by legacy systems that also nurture legacy thinking. Business transformation is usually slow and incremental. Disruptive changes by asset managers will remain rare as long as net margins remain above 30%. 

The third scenario is the most likely one – except in one crucial respect. Incumbent asset managers will remain in the driving seat for a simple reason – they have better risk instincts than the newcomers.

Investing is a bet on an unknown future. Success requires a deep understanding of risk and its dynamic nature. On the other hand, digital tools are simple algorithms that follow a set of rules. They have their uses and limits. 

Besides, putting passive investing at the heart of the internet proposition carries its own risk: passives are not entirely passive. They are exposed to some of the same risk factors as actives, albeit to a lesser extent.

Several disruptive changes in the asset management industry are being led by startups and venture capitalists. The main losers are likely to be registered investment advisers in the US, independent financial advisers in the UK and wealth managers in Europe. 

Vanguard’s current ambitious pilot-project offering robo-like advice may well herald a new dawn. Not only could it sustain the relentless growth in the company’s assets, it could also pose serious competitive threats to asset managers and intermediaries alike. 

Smaller-scale pilot projects are now in progress in asset management firms on both sides of the Atlantic. Some of them envisage digitisation becoming an integral part of the operating model over time.

The asset management industry is well positioned to fend off threats from significant invaders, such as technology giants like Google. Time will tell whether it has the necessary will to do so. In any event, the age-old innovator’s dilemma is being eroded, as ageing demographics and globalisation reshape client needs and the drive for profit.  

Amin Rajan is CEO of CREATE-Research and Subhas Sen is COO of BMO Global Asset

Management, Canada
 

*Why the internet titans will not conquer asset management
** Robo-Advisors: Threats and Opportunities for the Global Wealth Management Industry, MyPrivateBanking Report 1st edition, 2014

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