The big chill has descended on innovation within financial services and it is going to get much, much worse.
A nasty combination of tightening regulatory control, institutionalised group-think and an aversion to risk by the providers of investment services is slowly killing new ideas from upstart providers within the investment space.
Financial innovation hit by the big chill
To understand the daunting challenges facing new entrants to this market, let us imagine two distinct scenarios.
In our first scenario, a bunch of fund managers with a half decent track record of managing money in a big fund house decide to set up their own boutique. They start shopping around for a new fund, which has taken months to set up via the usual chain of custodians, depositaries and so on.
Our brave entrepreneurs will also no doubt have ignored my own oft-stated concern investment management is not going to be as profitable a business as it used to be, and margins are going to get squeezed.
Undaunted, they then visit the same old bunch of candidates who control access to the big IFA platforms or the discretionary fund managers, and punt their fund. The gatekeepers frown, say they will not invest in anything without £10m/£50m/£100m in it, and they do not like anything until it has been ‘proven’, which is a tad problematic for the average new fund manager without a track record.
Ah, the enterprising fund managers say, but we have a new angle on UK equity dividends, and you can see our track record at the old shop. Eventually, someone, somewhere does the decent thing and gives them a chance.
But even if my enterprising fund managers, with their boring, slightly old fashioned fund, do succeed, I suspect they will face an uphill struggle. There are still hundreds of funds which started off as good ideas, made it past one brave gatekeeper, but then stumbled with the rest and now lurk in a kind of uneconomic purgatory.
My next scenario is even more depressing. In this example, the principals have not managed funds before in the retail space and do not have a relatively conventional (or boring) fund in mind. The first issue is custodians and UK depositaries are starting to clam up. Very few providers want to be seen to be taking risks and, if they do get involved with a new manager, they will want to be paid an arm and leg for the service. But that is the least of the manager’s problems.
The next step is to get someone interested in seeding the fund.
At the moment, a new fund manager has a snowball in hell’s chance of getting anyone to seed anything without a long track record. Quite right, you might say, as this is a serious business and you need a manager with experience. To which I would counter with two observations. Surely we do not want a situation where only people trained in the big fund houses can start a fund?
Working for donkey’s years in a big fund house is good training (most of the time) and it instils great discipline, but it cannot be the only requirement to make money for investors. Let us be honest, that professional big firm training is absolutely no guarantee they will be any good as a manager.
But there are more problems on the way for our adventurous newbies. Our fund managers admit to the gatekeepers they want to be brave and do something a little bit different within the fund, involving what some people might call ‘sophisticated’ products, at which point the gatekeepers clam up tight.
No one will quite say out loud the regulators at the FSA do not like this kind of thing, but there will be unspoken group-think going on that suggests only certain types of assets are appropriate for investors.
As an example, I know of an old friend trying to set up a fund investing in fairly mainstream equities, but from the frontier markets. He might as well be trying to sell death bonds (rightly the subject of regulatory attention), even though the underlying assets are as liquid as can be and have actually performed strongly in recent years.
He does not think anyone should invest more than a tiny fraction of a percentage point in his fund in terms of portfolio allocation, but he has been told to go away by everyone and find a family office or ultra high net worth willing to take the risk. He is not alone. I can think of examples in commodities, emerging markets, US small caps and bonds.
‘Active’ managers will need very deep marketing budgets to fight against the ETF and index providers’ low cost alternatives, while true providers of innovative alpha might find themselves squeezed out of the market.
David Stevenson is a Financial Times columnist, editor at Portfolio Review and consultant. Follow him on Twitter @advinvestor
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