Alternative Investment Management Association
Innovation — how do you define it? That was one of the questions Ernst & Young asked CEOs, CIOs and heads of innovation of asset management firms as part of its Innovation for Asset Management Survey 20121. While innovation in terms of traded markets, asset classes or frequency has been vital to generating performance for hedge funds, asset managers have seldom targeted innovation to explore it across the business holistically. With hedge funds looking to attract fresh capital, as well as address concerns where performance has been indifferent, the time is right for firms to focus on innovation to maintain margin and competitiveness.
Business journals are always telling readers that they need to innovate. But as famous computer programmer Dan Fylstra said, “Innovation is hard to schedule”. Innovation is difficult, and as seen in other industries, money and time spent on R&D do not directly lead to innovation or, ultimately, better portfolio performance. There is a lesson for the hedge fund industry here — focus, culture and passion are perhaps just as important as spend.
But as admired as innovation is in the technology sector, the public sees it as dangerous in the financial markets. For many, it evokes memories of complex products and financial engineering that have been blamed for recent market dislocations. Yet innovation has been the sine qua non of the hedge fund industry in particular. Every entrepreneur knows that innovation and growth are linked, and for mainstream businesses competing to maintain market share against cloned services, the mantra is “innovate ordie.”
Challenges facing the industry
Innovation’s importance cannot be overstated in the face of increasing challenges for hedge funds. The industry’s post-crisis performance has been patchy at best, with 2012 returns generally lagging behind US and global stock indices. Although reports indicate continued growth for hedge fund assets under management (AUM), they also show some signs of stagnation, with levels still more than 20% off their pre-crisis peak2. Large dispersion of asset growth rates between winners and losers, many in the positive or negative double digits, show investors are quick to shift their money to strong-performing managers and away from those that disappointed. Traditional asset managers are launching products that aim to deliver alpha returns without charging hedge-fund sized fees.
Economic challenges have been joined by mounting regulatory pressures. In Europe, the Alternative Investment Fund Managers Directive (AIFMD) is placing hedge funds under greater supervision and potentially increasing future compliance burdens. European fund launches slowed significantly in the first half of 2012 with 37 funds launches raising US$3.6 billion compared to 45 funds launched in the first half of 2011 raising US$5.2 billion3. Several prominent hedge funds, in their quest for a diversified revenue and investor base, have been increasingly reducing leverage and short-selling in favour of traditional long-only investment strategies.
In addition to the issues posed by the current economic and regulatory climate, levels of wealth are increasing, especially in emerging economies. Consumers are becoming more financially savvy and in turn more demanding; and technology is increasing, especially in the social media and mobile spaces. Innovation, when coupled to fiduciary responsibility, boosts reputation — the converse spells reputational risk.
The ins and outs of innovation
To better understand how these factors are affecting asset managers, Ernst & Young conducted its first innovation survey for the asset management industry. The data behind it was gathered with Institutional Investor’s European Institute faculty and with participation from 36 global bank-owned, insurance-owned and independent alternative asset managers and hedge fund managers, who collectively have more than US$10 trillion of AUM. The survey canvassed the views of CEOs, CIOs and heads of innovation across asset managers running different portfolio manager styles — spanning active, passive, hedge, ETF, quant, alternative, real-estate, UCITS and LDI strategies. Of the firms surveyed, 47% were actively involved in hedging strategies. Some of the key findings include the following.
Fixed income and equities are still the main areas of focus. Individual firms indicated a preference for developing new funds and products such as farmland funds and the use of new OTC instruments within their trading strategies. However, they told us that the majority of their innovation budgets remained focused on fixed income (26%) and equity products (29%), including equity income and absolute return. One asset manager puts this succinctly: “Our current focus is centred around outcome-oriented solutions based on multi-asset strategies.”
Innovation comes from the CIOs and the CEOs. A majority of firms (83%) said that the CIO was a key innovator. The results from the survey also indicated that investors represented the biggest source of innovation in terms of product structuring. However, although CIOs and CEOs spend on average 20% of their time with investors, they said that innovation was seldom discussed. Hedge fund managers must think of more effective ways of engaging their investors to innovate on products. Sales and investment professionals, who interact with investors more frequently, need to be better leveraged for ideas in support of innovation, such as the growing interest and product demand coming from family and wealth management offices.
Outsourcing decisions need to be fully thought-out with regard to future flexibility. Several firms described their relationship with select outsourcers, such as fund administrators, prime brokers and asset servicers, as like that of a business partner, directly providing additional input into the innovation process. However, 33% of respondents felt that outsourcing actually inhibited innovation under circumstances of significant regulatory change, stressed market conditions and complexity. Many firms expressed irritation at the loss of control. They told us that outsourcers were sometimes slow to respond to the pace or depth of change requests, that change requests were expensive and that there was a lack of engagement when modelling extreme event risk. Outsourcing and delegation to service providers need to be well-planned with regard to benefits realization and future flexibility. This is especially important with AIFMD on the horizon, as more firms will be adopting a multi-prime broker and custody model.
Characteristics of innovative firms
So what are the commonalities across innovative firms? Our research has shown that there are five dimensions to consider:
· Culture. Innovative firms have a culture that supports the development of new ideas with minimal bureaucracy, and they show a willingness to make mistakes.
· Connection. Innovative firms are full of connections — internally across business functions and externally into the market, with clients, distributors, regulators, consultants and more.
· Resources. Innovative firms have the talent and are willing to invest their resources into new ideas, often with little short-term return.
· Processes. Innovative firms have processes in place that facilitate idea capture, development and realization
· Passion. Innovative firms have belief and dedication.
Innovation is clearly on the minds of many C-suite executives and hedge fund founders, and the results of our survey have given us grounds for renewed optimism and many interesting insights.
The views reflected in this article are the views of the authors and do not necessarily reflect the views of other members of the global Ernst&Young organization.
 To be sent the detailed report or discuss any of the issues raised in this article, please email one of the authors: Julian Young, EMEIA Hedge Funds Leader; Zeynep Meric-Smith, AIFMD Leader for Asset Management; Nicholas Phan, Senior Consultant Asset Management; Anthony Kirby, UK Asset Management Regulatory Reform, Risk and Regulatory Practice.
 Hedge Fund Industry — Assets Under Management, BarclayHedge website, www.barclayhedge.com/research/indices/ghs/mum/Hedge_Fund.html, accessed 7 November 2012.
 “New fund assets slide in first half,” HedgeFund Intelligence, Autumn 2012.