Retail and institutional clients are driving their fund managers back to the their time-honoured mission to deliver absolute and consistent returns, backed by a value-for -money fee structure that clearly separates alpha and beta. They want these requirements customised on the back of business stability that can improve their replicability. Finally, they expect relative returns, closet tracking and low service quality to fade into history as this decade progresses. Sounds like mission impossible? Maybe, but that is what clients want, according to our latest study.

No wonder, despite all the hype about hedge funds and liability matching investments, pension funds’ incursion into them has been a matter of more haste, less speed. They are unconvinced that these and other new startegies implemented by their fund managers have been either stress-tested or road-tested. Many see them as old wine in new bottles. Markets have recovered. But the trust has not returned.

To their credit, most fund managers recognise that many of the new generation of products placed on the market in the past three years require further innovation before clients take them seriously. Thus, much of their innovation effort over the next five years will be towards improving product features like risk, liquidity, volatility and transparency, as shown in our last article (IPE, December, 2006).

As a logical extension, a number of process and organisational innovations are also likely to follow (see chart below).

Fund managers are planning actions that will enhance their research, investment and assembly capabilities as part of a major drive towards product innovation.

The most visible changes will be evident in the retail space. Manufacturing and distribution will increasingly decouple, as focus on performance will become the name of the game. It will be accelerated by new regulations requiring more transparency in various aspects like total expense ratio and how it is apportioned among manufacturers and distributors.

The trend towards ‘institutional’ distribution, so well established in the US and Australia, will spread elsewhere in Asia Pacific and Europe. Under it, a new breed of professional buyers of funds will increasingly deploy institutional quality tools to select and package funds at wholesale prices and sell them to retail clients. Funds will be ‘bought’, not ‘sold’ in the first instance; and then delivered as customised solutions.

Their primary oath of allegiance will be to their end clients who will pay advice-based fees in preference to front-end commissions. Under this Darwinian process, the pressure to deliver good consistent returns will intensify.

As a part of virtuous cycle, a range of organisational innovations will also kick in. Large fund houses will promote high conviction investment strategies by creating in-house product-based virtual boutiques in which investment professionals will have autonomy, space and accountability for generating new ideas and executing them.

Some of these boutiques might have their own fiduciary structures. Either way, they will be used as one of the avenues of attracting, retaining and getting the best out of top talent, especially post-mergers. This trend will spread to medium sized asset managers as well, as they grow organically.

Alliances with best of breed fund managers will become more common, either as ad hoc arrangements or part of multi-manager platforms which are expected to proliferate in all regions in search of alpha capabilities.

An increasing proportion of fund managers are expected to start
their own multi-manager arrangements, promoting the emergence
of independent as well as in-house boutiques.

Last but not least, outsourcing of back office functions will continue, as investment startegies become more complex in pursuit of alpha returns and packaged solutions.

The last wave of outsourcing
covered routine back office fund operations. The next wave will
expand to take in high value-added activities such as derivatives processing and independent valuations of complex strategies. A new infrastructure of processing platforms will emerge, offering extensive portability via modularisation of distinct services.

Over time, these developments will increasingly transform the industry value chain: vertical integration within individual firms will be replaced by horizontal integration between firms. It will amplify the craft focus in investment, mass customisation in distribution, and process concentration in operations.

As result, the much publicised forecasts of polarisation between large players and private boutiques in the global fund management industry will be wide off the mark.

Around 60% of fund managers and pension funds in our survey expect a progressive decoupling of manufacturing and distribution, and growth of multi-manager platforms.

This mutually reinforcing nature of product, process and organisational innovations will ensure that the industry evolves like fractals: portraying ‘worlds within worlds’ and acquire greater complexity as it fragments and evolves.

Thanks to the knock-on effect of product innovation, the industry food chain will look like that of the car industry, relying on specialist components from specialist firms.

Amin Rajan is CEO of CREATE, a research consultancy. Jervis Smith is managing director, global transaction sercvices, Citigroup