Investment Industry Of The Future

By M. Isi Eromosele

The pace of change in the investment industry is more rapid than ever before, creating enormous challenges for institutional investors, investment managers and intermediaries such as consultants.

In this more complex investment world, not all organizations will be agile enough to exploit the new opportunities on offer. Those that make the attempt will need to match the strategies they follow with the skills they possess.

If there is one word that captures the expected flavor of the next few years in the financial industry, it is complexity. The ordered sequential way of anticipating change will be challenged because of the more complex world.

The future will be buffeted by unknowable extreme events, ‘black swans’ and the industry will react in jumps, not smooth transitions from one state of the landscape to the another.

With such a change, it is critical to stay with this clear big picture: that the investment industry has a core purpose, which is turning today’s workplace savings into tomorrow’s retirement income in which success is critical.

Key Industry Issues

There are a number of significant issues facing the investment industry:

• There are fault lines with the investment management value proposition, in that the vast majority of investment products carry too much cost for the value they deliver
• There is little long-term in thinking about investments
• The industry is prone to crises because of poorly structured incentives and other excesses.

The main problem resides in excessive competition, complexity and compensation. The rewards and sanctions facing industry participants are not always appropriate; resulting in participants being lured to act in ways that will ensure the system remains prone to periodic crises.

The Current Forces For Change

There are several areas where important changes have occurred (or will occur) in the thinking and the approach of global market players. Each of these is a catalyst for further change in the system:

• The preference for absolute return products - created by the end of the last bear market in 2003
• Fresh governance model thinking  - captured by the Philips Pension Fund’s move to fiduciary management in 2005
• New framing of risk - the financial crisis has precipitated major changes in the modeling and viewing of risk
• New regulation - a future phase of significant regulation which will impact the financial industry on a scale similar to the Sarbanes-Oxley Act effect on US corporations.

These events are defining moments which send development down one path rather than another.

Near-Term Trends

Six major trends have been identified as acting on the institutional investment industry in the near term:

• Pressure for talent: Talent needs to stretch more in both breadth and depth with talent shortage normal; return on talent likely to increase.
• Improvement in governance: Improved recognition of return on governance feeds through in increased attention and new models; more talent attracted to Chief Investment Officer role at funds.
• Product Proliferation: Product specialization leads to major proliferation, with risk, style and scope of mandates all getting broader; particular growth in absolute return and alternative assets.
• Extra financial factors: Environmental, social and governance considerations grow in impact both as indirect sustainable performance influences and as desirable end attributes in their own right.

Pension fund investment governance

To cope with the changes, pension fund governance may need to adapt to complex circumstances in order to secure any competitive advantage. This could include, for example, a step change in organizational design, with more use of non-executive boards, delegated executives and fiduciary management.

Pensions design

A considerable shift from the provision of DB to DC is being driven largely by demographics, the regulatory environment and a shift in social structures from paternalism towards individualism.

Extra-financial factors: sustainability

The pressure for institutional funds to apply responsible investing principles has increased in recent times. Sustainability is moving up the agenda, with climate change the strongest element.

The talent bubble

The demand for talent has grown, with particular competition for leadership talent. Compensation will be a big driver of talent mobility, but there is an increasing emphasis on non-compensation drivers such as culture and associate development.

Product proliferation

Product proliferation is being driven primarily by players seeking to secure an advantage in the marketplace. Particular growth areas are likely to be in diversity of asset classes and derivatives based strategies.

Organizational change

Within all this change, the current trends that have been identified are:

• Convergence between mainstream firms and alternatives firms as their
• competitive fields overlap
• Categorization of active products into two types - relative return mandates and absolute return mandates, with growth particularly in the latter
• Increased specialization, whether by asset class, risk level or investment style
• Consolidation of firms, whether to fill product holes, add capability, address geographical diversification or to augment manufacturing and distribution capabilities.

The Longer-term Trends

A Better Journey Design

Pension fund investment is a journey rather than a destination but interim assessments, such as annual measurement, are necessary.

While this provides scope to adjust strategies, annual scorekeeping can introduce shorter-term thinking and behaviors. The better-governed funds of the future will reconcile the tension between shorter-term scorekeeping and journey planning, but there will be no mechanical formula to follow

Improved DC

There is scope to improve investment efficiency, through strategies with greater exposure to alternative assets and better cost structures. We also expect DC schemes to become pioneers in risk protection strategies. Furthermore, developments in technology will make it easier to enhance glide-path design that turns a member’s age and other life circumstances into an optimal investment strategy.

New Value Chain

Funds will create a more effective value chain, with cost control attracting major attention. The key change will be the introduction of full-time executive investment expertise, which may be out sourced. This approach allows the governing board to concentrate its efforts on issues of strategic importance, while the investment executive translates the strategy into actions.

New investment content

Part of the shift in the value chain will be supported by the emergence of new investment content offering higher efficiency. Beta creep and exotic betas will enable investors to secure cheap market returns.

Some trends are already established, with increased use of short selling, derivatives and leverage. The subsequent phase of transition will be the growth of solutions and outcome-specified mandates, which can be divided between part-fund and whole-fund solutions.

Part-fund solutions are more sophisticated products, such as downside protection funds and multi-asset portfolios, meeting relevant absolute return targets. Success with whole-fund, whole-journey solutions involves the deployment of effective LDI (liability hedging), reliable alpha and cheap, dynamic, efficient beta.

Continuing crisis contagion

The issue of excess competition, complexity and compensation will continue to hover over the industry. There will be attempts by regulators to address some of these difficulties, particularly incentive structures.

Dealing with risk in a more hazardous and unpredictable financial environment

Successful funds will recognize that their mission is a journey in which ideal risk exposure adapts to changing circumstances. The fund of the future will be a more dynamic institution when it comes to strategy and risk taking. 

There will be more attention on the clarity of mission and greater awareness concerning the factors that support risk taking: sponsor covenant, relative wealth and investment opportunity. Furthermore, there is demand for a more sophisticated performance measurement framework which better accounts for risk.

Improving the weak value proposition of many investment products

As fund governance improves, there will be a greater awareness of costs relative to the value proposition. Funds will also be more aware of the misalignment of interests within current fee structures.

The fund of the future will assume more influence over costs through negotiation and will seek a clearer value proposition from investment managers. Funds will make greater use of cheaper beta-based strategies and pay performance fees for true skill.

This is a time of increased concern and anxiety about the effectiveness of the global financial infrastructure. The industry faces certain defining moments in framing these responses.

But this is a world of opportunity for those fit enough to change, where fitness is increasingly defined by the ability to be adaptable and apply new thinking in a highly competitive market place..

M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance

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