The march of innovation seems unstoppable. Recent years have seen a plethora of new solutions to the problems faced by institutional investors. Only some are genuinely helpful however, and the pace of innovation could do more harm than good to those swept along on the tide.
“Consultants and asset managers tend to peddle products or strategies at the worst time for their clients, but at the best fee for themselves.”
Alan Miller
The danger for institutions is allocating time and again to products just as they are exiting the sweet spot, trapping themselves in a continuous cycle of low returns. The solution? Two popular choices exist. The first is to reduce the product development and adoption cycle. The other is to delegate. Does either really solve the problem or do they expose investors to the risk of lower returns and higher fees in unproven products or strategies?
Missing the sweetspot
Before investing, investors naturally want to see evidence managers can provide consistent returns. But they also need to know it exists, be educated on the risks and characteristics of the product, take comfort from other investors’ buy-in, and then go through their internal allocation process.
Prior to that, managers go through their own innovation cycle, testing their hypotheses to produce a credible and attractive product, and then build a track record.
The product development/adoption cycle is therefore lengthy, which can significantly undermine the potential benefits to investors of the investment proposition. According to the US National Bureau of Economic Research, the average length of a business cycle between 1945 and 2009 was roughly five years.
According to Stephen Miles, head of manager research – EMEA at Towers Watson: “It is harder to sell a product if there is not a good recent track record. People tend to look at about five years. The trouble is, funds that have done well in the last five years are often less likely to be in the sweet spot for the next five years.”
Research from RPM Risk & Portfolio Management shows a detrimental impact on performance as the size and age of an asset manager increases. Their study looked at commodity trading advisers (CTAs) with the highest Sharpe-ratios over the preceding 36 months for each of the 36 months leading to July 2012. Hypothetical investments were then made in those CTAs and the performance analysed after 36 months. While the selected funds had a median Sharpe-ratio of 1.7 at the point of investment, the actual investment had a Sharpe-ratio of just 0.3.
Alan Miller, founder of SCM Private says: “Investors are normally sold things that have already done well. They also seem to take comfort in numbers so they are most comfortable investing when their peers are also investing. This is invariably precisely the worst time to invest in the particular product or manager.”
Shortening the cycle
Traditionally, products take around three years to go from idea to attracting institutional allocations according to asset management experts. Ideally, managers would correctly identify what investors will need three years hence and establish a track record before institutions realise they need the product. This is no mean feat considering the difficulties of predicting investor appetite or what markets will be doing three years hence.
Even if those predictions were to prove correct, there is the inevitable problem of a product not yet having reached its sweet spot, which will likely suppress returns. If they are subsequently to be adopted at the right time, investors will have to look beyond track record when selecting managers or products.
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