Although making predictions about the future is never a simple task, it can become complicated even further during periods when disruption and transformative change are the norm. This has been the case for the asset and wealth management (AWM) industry for the past decade; after the upheaval of the 2008 global financial crisis, regulatory pressures, new technology, and calls for greater transparency have led to revolutionary changes in the field.
Despite the difficulties in making these predictions, PwC recently released a report—“Asset & Wealth Management Revolution: Embracing Exponential Change”—in which they discuss how the AWM industry will evolve over the course of the next 10 years and beyond. They argue that four transformational trends will reshape the industry to make it more technology driven, results-oriented, and client-centric. Notably, many of PwC’s predictions are similar to those of the CFA Institute’s “Future of Finance” report, which I have previously discussed in great detail.
Encouragingly, PwC predicts that the total assets under management (AUM) will nearly double from $84.9 trillion in 2016 to $145.5 trillion by 2025. The engine of much of this growth will come from developing markets, such as Asia and Latin America, while developed markets will grow at a slower pace.
At the same time that AUM grows, firms and asset managers will need to contend with greater demands for transparency. Even today, investors are insisting upon full disclosure of fees that they pay and some investors, particularly millennials, are forgoing the apparent opacity of asset management altogether in favor of fully transparent ETFs. There are also increasing regulatory pressures on firms requiring them to make certain disclosures to investors. PwC anticipates that these trends will only continue, driving down costs and increasing transparency, which will bring about the first of their four revolutionary changes: the development of a buyer’s market in AWM.
Additionally, technology will play an important role in the future of the AWM industry and actually represents PwC’s second revolutionary change. Firms will automate functions and services as a method of driving down costs and increasing transparency; meanwhile, new technologies, such as artificial intelligence, big data, and blockchain, will improve and streamline due diligence, analysis, and enable customized investment strategies. The latter point plays into another of the revolutionary changes that PwC forecasts, “outcomes matter,” in which investors will prioritize a set of specific desired results over a particular style box of investment.
The final revolutionary change is “funding the future” in which asset managers will pursue new opportunities to fund real assets like infrastructure and real estate and generate alpha. They will also be able to design new products to meet the needs of new clients.
The full PwC report is available here.
Imitation has been called the sincerest form of flattery, and if so, pension funds around the world are beginning to show admiration for the private equity funds they have so often invested in. As a recent article from Bloomberg Businessweek explains, in the face of sluggish returns and increased operating costs, pension funds have started acquiring companies and investing in private debt themselves, bypassing the private equity funds and alternative asset managers to whom they typically outsource these investments.
Pension funds, particularly in Canada—such as the Ontario Municipal Employees Retirement System (OMERS) and the Ontario Teachers’ Pension Plan (OTPP)—are forgoing private equity funds to directly acquire small and mid-size businesses. OMERS recently purchased a minority stake in the pet care provider National Veterinary Associates, for example, while OTTP outright purchased PetVet Care Centers several years before that. Although both examples are drawn from the same industry, they illustrate the larger trend that pension funds are now prepared to buy businesses or private debt rather than investing in private equity funds, which would have simply invested in some of these companies and their debt anyway.
Additionally, pension funds are assembling their own teams of experts to identify investment opportunities in sectors like private, middle market loans. These new hires empower pension funds to make their own investments while furthering their transformation into quasi-private equity funds.
According to the Bloomberg article, there are several advantages to this strategy, although the primary benefit is increased returns. Pension funds get to improve their returns by avoiding paying asset management fees to private equity funds—and since private equity’s fees have remained relatively high owing to their spectacular returns of late, this could represent a significant savings.
While this trend has been good news for pension funds so far, private equity funds may need to adjust their own practices if it continues. The Bloomberg article suggests that as the private equity’s stellar returns begin to cool, more and more pension funds will exit to avoid paying fees on lower yields and instead begin to directly invest in private debt and acquire companies on their own; this may prompt private equity funds to begin to lower their fees.
Today’s private equity sector is thriving, but that doesn’t mean that firms have stopped working to develop new competitive advantages. Many such efforts focus on how firms can cut costs or enhance returns, but another avenue firms should consider involves taking advantage of the breadth of raw data available online to strengthen and streamline their due diligence processes. As a recent Forbes article points out, this data can help private equity firms “increase the speed and reliability of insights” that shape their decision making and make it easy to determine prices for various assets.
Incorporating digital data mining into due diligence is part of a broader trend of digitalization in the private equity and financial services industries. Firms have availed themselves of a wider range of digital tools and technologies to improve outcomes and entice customers while also increasing their own efficiency. For example, as the Forbes article indicates, in the case of due diligence, the labor intensive and time consuming process of identifying and analyzing a firm’s strengths and weaknesses can now be completed within a few days using data easily obtained via the internet, which saves firms time and money.
There are a number of specific areas where digital data can offer private equity firms important insights. By studying online customer reviews, a private equity firm could learn more about a target company’s products or services, its relationships and standings relative to competitors, and more. Additionally, the authors of the article–all of whom are leaders of Bain & Company’s private equity practice–discuss an example where they “combined online data with store visit observations for the potential buyer” during their due diligence of a sporting goods retailer to evaluate the efficacy of the company’s organizational structure; they found that, in comparison with other firms in the industry, the retailer in question had a larger proportion of managers and support staff than store employees.
Data mining can also improve outcomes for due diligence by analyzing relevant social media posts from customers, e-commerce data, geographic presence, and more.
This approach is not without its limits, however. Analyzing such large data sets could require firms to acquire new software that can process the sheer volume of information. Furthermore, this practice would not replace traditional methods of due diligence like customer surveys. But for firms that are looking to make digitalization a competitive advantage, the Forbes article offers a promising path forward by proposing data mining as part of enhanced due diligence efforts in the world of private equity.
A flood of new investors and new firms as well as record amounts of uninvested capital, or dry powder, are just a few reasons why today’s private equity sector is thriving. Both the number of firms in the industry and total assets under management are at historic highs, and according to Preqin’s 2016 Global Private Equity & Venture Capital Report, 94% of investors in private equity plan on committing at least the same amount of capital to private equity again next year.
Even amid these prosperous times, however, there are signs of disruption and challenges to the industry on the horizon, so private equity firms should take advantage of the favorable position they enjoy today to prepare themselves for future shakeups. In fact, the Boston Consulting Group (BCG) makes this argument in its recent report entitled Capitalizing on the New Golden Age in Private Equity, which asserts that private equity firms should turn operational playbooks inward, develop a true talent strategy, and upgrade their approach to value creation.
If firms want to remain on top of the private equity pyramid, then it is critical that they refine their market positions and competitive advantages. Private equity today is thriving but also crowded, so firms require stronger positions and unique advantages in order to attract new investors moving forward. In its report, BCG suggests that many firms can find these advantages through technology and new digital innovations. By digitizing certain operations, BCG posits that firms can increase efficiency and reduce costs, allowing them to invest and manage larger pools of assets–a clear competitive advantage.
Furthermore, with private equity enjoying a period of unprecedented growth and success, firms are in a position to develop new talent strategies. The hiring approach firms used prior to today’s golden age may not serve them as well in the new private equity environment where assets and investments are larger and where LPs are looking for greater flexibility, according to the BCG report. Today, teams with a wide range of experience–former executives, investment bankers, industry leaders, consultants, and individuals with digital skills experience–are particularly valuable.
Lastly, the report calls on firms to be more active in their approach to value creation. Simply trying to reduce costs and bolster revenues isn’t enough, and with disruption upending industries from retail to healthcare, funds can no longer be passively left to themselves. BCG instead recommends more interactions with teams of portfolio managers, digital-oriented strategies, focusing on freeing up working capital and other resources to facilitate turnarounds within underperforming portfolio companies, and more.
BCG’s full report is available here.
No longer just a fad or passion project for certain members of the investment community, impact investing has become much more widespread and accepted by a wide range of investors, from wealthy individuals to corporations to institutional funds. In fact, the Global Impact Investing Network (GIIN) reported that impact investments accounted for $77.4 billion of assets under management in 2015; it also noted that private debt, private equity, and real estate held the largest percentage of these assets.
Despite the rapid growth and embrace of impact investments across the world of finance, however, they still have not gained traction among hedge funds, which held $3.2 trillion in assets under management in 2015.
Deloitte recently published a report entitled Impact Investing: A Sustainable Strategy for Hedge Funds. As the title suggests, the report outlines several factors influencing the impact investing landscape with respect to the participation of hedge funds, and it suggests that despite certain challenges, there are significant opportunities and considerable potential rewards for hedge funds that pursue impact investing.
The report points out that despite a high degree of public enthusiasm for impact investing, it remains a niche market among hedge funds; in fact, there is no existing hedge fund that is exclusively focused on impact investing. Deloitte sees this as an opportunity and mentions that the “lack of a clear hedge fund leader in impact investing suggests there may be open space for early movers to gain a competitive advantage.”
For hedge funds interested in obtaining such a competitive advantage, the report also presents a list of key considerations, including the need to standardize performance measures of impact investments, achieving comparable performance with other types of investment, maintaining fiduciary and oversight compliance, and more. While the report did take an objective look at impact investing, it did express enthusiasm as to how the trend will unfold in coming years.
“The global movement toward social finance and impact investing is becoming influential enough for hedge fund managers to thoughtfully consider their part in this next phase of evolution,” it said.
To access the full report, click here.
Today, some funds are beginning to integrate psychological and neuroscientific knowledge with economics, creating a system known as behavioral finance.
While few would dispute the assertion that investors don’t always make rational decisions, most of us like to think that we’re better than that. Michael Ervolini, the co-founder of Boston-based Cabot Research—a firm that’s using the latest behavioral finance research to advise portfolio managers—says that’s exactly the type of problem behavioral finance can help solve.
“People may have a suspicion that they aren’t perfect, but they view behavioral tendencies as happening to someone else.”
One of Cabot’s clients, Principle Global Equities, has been rolling out a system to leverage market volatility using behavioral finance insights. According to Jeff Schwarte, a portfolio manager at Principle, “Volatility can be an entry point, but if a portfolio manager is worried about the next quarter, for instance, that volatility will make them question their investment savvy.”
This is only one example of the uses of behavioral finance, but it’s easy to see the promise of it. If investors can be made aware of their own biases and potential for irrational decision-making, poor and ill-considered choices could be made far less often.
Yet if behavioral finance is to make a significant impact in the investing and financial world, it needs to go beyond portfolio managers just trying to remind themselves to be more rational.
J.P. Morgan Asset Management has funds that are based entirely around behavioral finance insights, and one of their primary concerns is formalizing and institutionalizing the decision-making process. A good example they note is always recording the rationale for an investment choice, as well as the conditions under which it should be sold.
Another example, this one going back to Principle, is to ask “portfolio managers if they would buy an existing holding today.” Naturally, if they determine that they would not, they encouraged to quickly move the money elsewhere. This might seem like an obvious technique, but we know from psychology that we are disposed to a powerful bias for the status quo.
It’s doubtless too early to make sweeping pronouncements about the impact of behavioral finance on investing and the financial industry at large, but it is an interesting topic to speculate.
A recent report by McKinsey & Company revealed the ways that “leading institutional investors have grown rapidly into significant global organizations” and how these key players are forging ahead. One of the more insightful parts of this McKindsey research is the notion that “until recently strategic asset allocation (SAA) has been rather non-strategic.”
According to the McKinsey report,which is entitled From Big to Great:
“Significant adjustments to the SAA have been rare,with the exception of a long-term trend among many institutions to shift an increasing portion of their portfolios to illiquid assets. Indeed, for most pension and SWF boards, the review of asset allocation decisions has been more or less a rubber-stamping exercise.”
When it comes to strategic asset allocation (SAA), many institutions have foregone the development of an actual strategy. Changes within investing have caused previous methods of the SAA to be ineffective.Largely this lack of efficacy, says the McKinsey report, is due to the fact that “significant adjustments to the SAA have been rare” and the review of asset allocation decisions has been more or less a rubber-stamping exercise.”
Learn how to prevent mistakes with your SAA and how to adopt a better way of investing.
In the past, allocations have been based on historical estimates of correlation, returns, and volatility. In general, you were able to look at your SAA from last year as a foundation for your next allocation. But the McKinsey report suggests that using this method has led to institutions not reaping the appropriate rewards for their risks.
How Institutions Are Adapting
Due to these complications, institutions must react and do things differently to achieve long-term returns. Bulking up your portfolio construction team with more people is a great start. The decision-making process surrounding portfolio construction should also be more nuanced and dynamic. Rather than hitting the repeat button on your SAA each year, it should be more of a strategic debate. McKinsey suggests some key goals of constructing portfolios that are taking place within institutions:
- Increasing the likelihood of fulfilling liabilities
- Adopting a clean-sheet approach
- Progressive perspectives on risk factors and assets
- Participatory and rigorous annual decision-making process
The SAA requires more thought, attention, research, and debate than before.
Over the last few months, the topic of disruption has been making the rounds in investment news headlines and literature. I was particularly struck by an Institutional Investor article this Spring that discussed the asset management industry’s vulnerability to disruption. The writers purported that “the combination of new technologies and shifting demographics and client needs is bringing a sea change to the asset management industry.”
In fact, many established companies have a blind spot for disruption. This is due to the fact that ingrained assumptions have already led to success. If your business is already thriving, why should you worry about disruption? The truth is, it is almost inevitable. With technological innovation, high profits, shifting demographics, and global social changes pave the way for disruptors.
Disrupting the Current Business
One strategic way that the article suggests for addressing disruption is to launch a new product to directly compete with the disruptor. This can be especially effective for large companies that have the ability to leverage their advantages. Market knowledge, size, capital, size, and relationships all provide a benefit to incumbents.
Reportedly, some leaders in the industry don’t believe that asset managers should worry about disrupters. In response to that argument, the writers at Institutional Investor, offer the following rebuttal:
“…the profitable big players have a hard time seeing threats, especially when these are coming from smaller and more innovative players or outside their traditional set of competitors. Even when incumbents perceive the possibility of disruption, they discount it or cannot change their existing business model fast enough because of vested economic interests or internal bureaucracies — and by then it is too late.”
Invest in Disruption
A possible strategy to thinking proactively, according to Institutional Investor, is investing in the threat itself, whether it is a disruptive digitized process, human capability, or technology. It could even involve acquiring businesses with those components. Investing means preparing for disruption head on.
Focus On a Niche
Instead of directly dealing with the disruption, some companies may want to retreat and focus attention on a particular segment of the market that disruption is less of a threat. While this involves moving to a smaller market size, companies can remain profitable. Your existing capabilities provide you with a way to serve smaller markets.