What does an investment management firm look like, if you redesign it based on first principles and based on the true “jobs to be done” of an investment manager? That’s what we’re working on building at Versatile VC.
We outline below the five characteristics that will differentiate the winning investment management firm of the future:
1) Use technology to rebalance value to investors. Internally, money managers are investing in artificial intelligence and big data capabilities and 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. D.E. Shaw, Two Sigma, Renaissance Technologies, etc. 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.
Eric Kohlmann, Venture Partner, Arc Ventures, observes, “The vast majority of short term trading in liquid markets is already driven by quantitative investing [which requires significant investment to run effectively]. Similar to the large tech companies today, we will be left with an oligopoly of investment firms that benefit from aggregating the most data and being able to spend the most resources on computing infrastructure. Assuming quantum computing enters the realm of certain highly specialized financial mathematics (e.g. risk modeling and portfolio optimization), this trend will be amplified further.”
2) 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 similar to public companies, to give money holders and intermediaries comfort that decisions are being made thoughtfully and to create checks and balances on the historically all-powerful or cult CIO. We expect the current largely manual and sporadic due diligence process to be revamped to include more systematic, ongoing oversight and governance.
3) 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 often 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 (talent retention, investment in infrastructure, succession planning).
4) 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, e.g., special situation or frontier markets, are shrinking over time. We envision that the ability to allocate in an agile way 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 those investors with a portfolio acceleration toolkit, typically including experienced operating executives and a set of preferred operational service providers.
5) Professionalize human capital management. The investment industry is today very immature in its human capital management, with high turnover, minimal succession planning, and a strikingly homogeneous workforce. As founders age and investor demographics change, the established investment firms will face a talent crisis and will have to rethink how to attract, develop, and retain talent. “Purpose-driven companies,” says Jeff Hunter, CEO of Talentism, “are more likely to have employees who exhibit cohesive behavior and act in the best interest of the company and the investors.” Thus, we foresee a professional CEO role emerging in asset management: She 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.
In our research, four significant opportunities for disruption stand out. In each, we see substantial room for value creation:
- Despite emerging innovation, retail investors remain the most ill-served group in asset management. Few quality investment opportunities exist for individuals with less than $1 million in net worth, and yet these investors represent a $147 trillion market globally. We see many models focused on this niche, including robo-advisors 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 companies and 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 so that more value accrues to the ultimate beneficiaries, e.g., the retired employees, public servants, and taxpayers. 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. Under pressure from regulators, Blackstone Group LP recently disclosed that it could collect as much as $20 million annually from investors and companies in one of its buyout funds for services such as healthcare consulting and bulk purchasing. In response, leading public investors including CALPERS and New York State are aiming to uncover the hidden fees in their portfolio by augmenting their due diligence and governance processes. 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 industry-wide set of standards and benchmarks (such as the ILPA standards) will further help.
An even more radical, but common sense, idea is to create business models that better align the incentives of the money manager with the incentives 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, i.e., 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 the significantly underfunded US pension funds, who are unlikely to close their asset and liability gap, may require wrenching political reform. Liability matching is a forefront concern for both the $12 trillion defined benefit (DB) pension system and the US government. The IMF has warned that the drastic underfunding of US pension funds poses a systemic risk to the global economy. 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, and have simultaneously led to some uncomfortable questions being asked about the quality of investment options available in corporate 401k plans, for example. An emerging pain point is balancing the needs of employees in one firm benefiting from a DB plan vs. 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 one 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 mass transition to a new generation of managers needs to happen without disruption to the system. 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 in talent retention (because junior people see their path blocked); succession planning (when their path eventually gets unblocked); and eventually in 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.
Suzanne Ley, formerly Head of Financial Institutions, Westpac, observes that, “Even millennial-friendly platforms like Betterment, Robinhood and Wealthfront are only approaching their businesses one-dimensionally. We need to focus on how China is leading the way with its complete reinvention of how we think about money and investing, e.g., in just four years Alibaba’s Yu’e Bao fund, grew to be the largest fund in the world. The walls between shopping, banking, investing, and social networking are quickly evaporating. The only name I can think of in the US that comes close is SoFi with a concept of a full-service lending, money management, and social networking platform is where we are headed.”
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 whether these changes most successfully will be the ones that do not just sit back and wait for these disruptions passively, but instead those that identify the trends to which their strengths play best, and actively pursue strategies to turn those imminent disruptions from threats to opportunities.
Continue reading…
This is part of a series on disruption of investment management that I co-wrote with Katina Stefanova, CIO and CEO of Marto Capital, a multi-strategy asset manager, which creates customizable investment solutions for institutional clients. We based this on interviews with over 50 family offices, sovereign wealth funds, endowments, pensions, and other institutional investors.
- The Peculiar Investment Management Industry
- The Macro Trends Forcing Change on the Investment Management Industry
- What are the “Jobs To Be Done” of an Investment Manager?
- The Investment Manager of the Future
We wrote the first version of this research with Brent Beardsley, formerly a Partner with Boston Consulting Group.
Contributors
This study would not have been possible without the collaboration and support of Brent Beardsley and 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, where David Teten is an Advisor.
Disclosures
David Teten is an investor in Republic via HOF Capital, where he was formerly a Managing Partner.
Previously posted at Techcrunch.
