The investment manager of the future

What does an investment management firm look like when it’s redesigned based on first principles and based on the true “jobs to be done” of an investment manager?

“Even millennial-friendly platforms like Betterment, RobinHood and Wealthfront are only approaching their businesses one-dimensionally,” said Suzanne Ley, formerly head of financial institutions at Westpac.

“We need to focus on how China is leading the way with its complete reinvention of how we think about money and investing.

For example, in just four years Alibaba’s Yu’e Bao fund grew to be the largest in the world. The walls between shopping, banking, investing and social networking are quickly evaporating.

The only name I can think of in the U.S. that comes close is SoFi — a full-service lending, money management and social networking platform is where we are headed.”

We outline below the five characteristics that will differentiate the winning investment management firm of the future:

Investment firms today
Investment firms of the future
Technology
  • Correlation models/predictive analytics based on observable historical data.
  • Data/data management as a competitive advantage.
  • Big data, AI and social media powering investment decisions.
Transparency
  • A post-crisis regulatory environment focused on past crisis issues.
  • CIO communicating to clients/regulators.
  • Regulatory oversight with external boards.
  • Due diligence as a systematic, ongoing oversight and governance process.
Risk management
  • Asset class silo risk systems with static firmwide risk systems (e.g., counterparty risk).
  • Operational risk silos.
  • Risk-based on leading indicators not lagging.
  • Integrated, dynamic risk management across public and private/illiquid asset classes.
Alpha creation
  • Individual security selection, active fund selection and asset allocation with passive funds.
  • Investment theses expressed across asset classes including public and private/illiquid.
  • Influencing outcomes/activist investing.
Culture/talent
  • Focus on cohesive culture.
  • Little real talent management.
  • Professionalize human capital management — workforce planning and leadership development.
  • Firm leadership as a professional CEO — not part-time CIO/sales.

Using technology to re-balance value to investors

Internally, money managers are investing in artificial intelligence and big data capabilities as well as a more seamless integration of front and back-office processes. Externally, leaders are building mobile and tablet apps and expanding their use of social media.

In the future, innovative models, especially in the retail space, will integrate investing with elements of social media, interactive gaming and education. For institutional investors, technology will enable more proactive, fully customizable risk management and governance. Firms like D.E. Shaw, Two Sigma and Renaissance Technologies have validated this quant model in the public markets. We now see firms like Versatile VC, Signalfire and GV using technology to produce better returns in the private markets.

Create and sustain trust through transparency

As opacity recedes, money holders will see who has been working with their best interest at heart. We foresee reduced interest in the black box hedge fund model.

According to Amanda Tepper, CEO of Chestnut Advisory Group, investors are increasingly demanding clear, concise and consistent communication from their asset managers. In a recent Chestnut investor survey, 92% of respondents said they view investor communication as integral to an asset manager’s mission. In addition to investor demands, money managers must comply with an increasing array of regulatory requirements.

That said, regulators have a history of protecting us from the problems of the last crisis, not the next one. As self-protection, we see increasing use of self-regulation. For example, some private investment firms will establish active executive boards to give money holders and intermediaries comfort that decisions are being made thoughtfully and to create checks and balances on the CIO. We expect the current, largely manual and sporadic due diligence process to be revamped to include more systematic, ongoing oversight and governance.

Manage integrated risk, not risk in separate silos

The traditional view segregates risk into the market, credit and operational buckets. For example, in the classic organizational chart, the investment officer is responsible for market risk, the treasury officer or CFO for counterparty risk and the COO for operational risk.

However, the risk is not additive or linear, and hot spots in one area may cause undetected issues. The money manager of the future will learn to look at risk holistically and pay attention not just to lagging indicators (losses) but proactively to leading indicators such as talent retention, investment in infrastructure and succession planning.

Generate new sources of alpha

The preference for alpha generation based on security selection, i.e., “stock picking,” has transitioned to alpha generation based on fund manager selection. This, in turn, has transitioned to alpha generation based on asset allocation — both strategic as well as tactical. The best opportunities for alpha generation at the security and fund level — special situation or frontier markets, for example — are shrinking over time.

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We envision that the ability to allocate in an agile manner across multiple asset classes will be a differentiator across both public as well as private/illiquid assets, such as private equity or real estate. We also envision a more aggressive use of activist investing, broadly defined. In the world of private equity and venture capital, the equivalent of an activist strategy are investors with a portfolio acceleration toolkit, which typically includes experienced operating executives and a set of preferred operational service providers.

Professionalize human capital management

The investment industry is today immature in its human capital management, and consequently sees high turnover, minimal succession planning and a strikingly homogeneous workforce. As founders age and investor demographics change, established investment firms will face a talent crisis and will have to rethink how to attract, develop and retain valuable staff.

“Purpose-driven companies are more likely to have employees who exhibit cohesive behavior and act in the best interest of the company and the investors,” said Jeff Hunter, CEO of Talentism. We foresee a professional CEO role emerging in asset management. This executive will be fully focused on leadership as distinct from the traditional CIO and VP of Sales. It’s worth noting that some asset management firms, including D.E. Shaw and Blue Mountain, are leading the way by being proactive and mindful about managing their culture and principles.

Opportunities for disruption

Retail investors remain the most ill-served group in asset management

Few quality investment opportunities exist for individuals that have net worth of less than $1 million, yet these investors represent a $147 trillion market globally. We see many models focused on this niche, including AI advisers and social trading firms such as Ayondo, Collective2, EToro, Sprinklebit, Zingals and Zulutrade.

Other emerging disruptors in this space include firms like Republic, which offers retail investors direct access to alternative funds that historically they could not access. The typical user experience of playing a video game is engaging, addictive and fun; the typical user experience of investing is not. The financial services industry can do more to learn from the engagement models of the consumer internet space.

Incentives need to be better aligned

Money holders repeatedly shared that they are willing to pay for true alpha performance. However, they are troubled when they end up paying disproportionate management fees and hidden costs regardless of performance.

New types of intermediaries and industry consortiums can support institutional investors, family offices and retail investors in uncovering the true cost structure in their funds. Ultimately, we believe this will help these allocators make better decisions on who to invest with and for how long. Creating and enforcing an industrywide set of standards and benchmarks will help.

An even more radical idea is to create business models that better align the incentives of the money manager with that of the investors’. A rare example of such a business model, in an industry where money managers get paid billions even when investors lose money, is Adage Capital. This $23 billion hedge fund pioneered the approach of being paid only for alpha generation, so Adage receives performance fees when they outperform the benchmark and return money to investors when they miss the mark. Aperture Investors, launched in 2018 by former Alliance Bernstein CEO Peter Kraus, directly pegs fund management fees and portfolio manager compensation to the alpha generated by its funds.

Helping underfunded pension funds may require political reform

Liability matching is a prime concern for both the $12 trillion defined benefit (DB) pension system, and the U.S. government. At the opposite end of the spectrum, the emergence of defined contribution (DC) plans have shifted the market risk from the corporation to the individual. An emerging pain point is balancing the needs of employees in one firm benefiting from a DB plan versus those on a DC plan, without making either side feel disadvantaged.

A unique opportunity exists to help pension funds manage defined benefit and defined contribution plans simultaneously for the employees of a given employer, with consistent transparency and governance, as the industry evolves from the former to the latter. Some of the leading administrators are aiming to develop such an integrated platform.

A new generation of managers need to take the helm

The money manager owner class is disproportionately near retirement age. According to Imprint Group, “one-third of assets currently managed are managed by men over the age of 60.” This creates a challenge for talent retention (because junior people see their path blocked); succession planning (when their path eventually gets unblocked); and eventually for business continuity.

For example, Chris Shumway’s transition out of his hedge fund led to huge simultaneous redemptions, followed by fire sales and eventually the closure of a highly successful $8 billion hedge fund. In some instances, audit and risk oversight companies and technologies that help limited partners monitor founder/partner departure risk can add value. But in many cases, they are monitoring stasis without understanding the internal leadership dynamics that will make or break these sensitive discussions.

In conclusion

Emerging money managers that can scale and innovate to provide the full spectrum of “jobs to be done” — technical, functional and emotional — will thrive in the future. These managers will not only embrace the professionalization of their own management teams, but their economics will also benefit from capital-fleeing managers who failed in their leadership challenges, particularly succession planning.

In “The New Dawn of Financial Capitalism,” Ashby Monk writes that the standards in the asset management industry have fallen so low that “doing good for investors means not doing anything bad.” The storm our industry is experiencing is blowing windows open for disruptors to exploit.

The incumbents that weather these changes most successfully will be the ones that identify the trends to which their strengths play best and actively pursue strategies to turn those imminent disruptions from threats to opportunities.

Disclosures:

Katina Stefanova is an investor in AcordIQ and Long Game and is a former Bridgewater Senior Executive.

David Teten is an investor in numerous investment tech companies, including Addepar, Asaak, Clarity (sold to Goldman Sachs), Drop Technologies (Cardify), Earnest Research, Indiegogo, Republic, Stratifi, Wonder, and Xperiti. He is an advisor to Bullet Point Network.

Contributors:

The first version of this paper was co-written with Brent Beardsley, formerly a Partner with Boston Consulting Group. This study would not have been possible without the collaboration and support from Brent and from the Boston Consulting Group. We also want to thank the research, technology, and editorial team who supported us during this study: Greg Durst, Jen McPhillips, Jenny Wong, Charles McLaughlin, Michael Rose, and James Ebert, plus more recently Ariel Cohen, Caleb Nuttle, Spencer Haik, and Cormac Ryan of Bullet Point Network.