Absorbing Complexity:
Build the Moat

Investment managers and financial services firms are confronting a rapidly changing competitive landscape and their infrastructure can be a critical gating item in their pursuit of new opportunities

Mal Cullen, Chief Executive Officer

Clayton Christensen, in his seminal book The Innovator’s Dilemma, catalogued the various patterns of innovation that can occur within a sector, establishing a spectrum that begins with the repackaging of known technologies and ends with truly disruptive innovation that can turn an industry on its head, such as Uber or Napster. While the financial services sector has not faced the latter scenario in the past quarter century, the rapid growth of the alternatives space, coupled with new advances that have commoditized what were once considered exclusive and esoteric strategies, means that investment managers today are only now being faced with the question that Christensen so poignantly addressed in his book: How do you introduce new products and capabilities without being bound to servicing the customary needs of existing clients. The difference, at least for most financial institutions, is that, it is their existing clients who are calling for disruption.

Traditional asset managers realize that product innovation has become more critical than perhaps ever before. As McKinsey identified in a December, 2014 research paper (“The $64 trillion question: convergence in asset management”), certain secular factors are driving asset managers to build out their product set to meet the heightened and more expansive demands of their clients. The McKinsey research cited that a bifurcation is occurring between large and small institutional investors, with each group approaching their strategies differently to fulfill diverging portfolio needs. Whereas smaller institutions want access to a broad range of brand-name managers with product depth and perceived stability, larger institutions are migrating to more cutting-edge portfolio construction to build new capabilities and embrace “risk-factor-based methodologies.”

Moreover, as institutional investors opt for more passive strategies, such as ETFs or smart beta funds, over actively managed products, asset managers are turning to alternatives as a way to guard against fee compression. McKinsey, in the same report, predicted that by 2020, alternatives will make up 15% of global AUM, but will generate 40% of the total revenues.

Meeting these new demands sounds easy enough but the barriers to entry in financial services are considerable. Beyond the capital requirements and licensure laws, regulatory compliance has become so intensive following the financial crisis that even established firms with the resources to pursue new strategies may require an overhaul of their back- and middle-office systems to better meet heightened transparency and reporting demands. SEC Commissioner Daniel Gallagher, in a fireside speech in March, referred to the “crazy quilt” of regulation facing financial services firms, in which literally hundreds new rules and amendments have been implemented by domestic regulators since 2010. He later estimated that these legislative efforts come at a cost to the financial services community that exceeds $1 trillion.

While these gating items and the upfront investment required to modernize back- and middle-office platforms can make innovation more difficult in the short term, solving these issues can actually create the moat that offers a competitive advantage for years to come. Salim Ismail, the entrepreneur and cofounder of Singularity University, noted at Eagle’s Engage Client Conference in March, “In [financial services], regulations can be your friend if you’re able to build the tools to navigate the complexity.”

At Eagle, anecdotally, this has translated into renewed interest for the “book of record” solutions (such as ABOR, IBOR, PBOR) that allow investment firms to replace a sprawling collection of disconnected legacy systems with an integrated platform. For instance, the enterprise data management system needs to work in concert with the accounting and performance measurement systems. Then together these platforms create an interconnected ecosystem with an open architecture, in which new capabilities and functions can be easily added and enhanced—and no CEO wants to wait on the IT department for a greenlight to move into a new region or add a new product set.

Make no mistake, though, it takes considerable time and attention to build out a truly integrated back- and middle-office infrastructure. And given the upfront investment—not to mention the rapid and far-reaching consolidation that is quickly reshaping the vendor universe—we are finding that investment firms are taking added pains to ensure they are working with the right partners. They need to know that the vendor they choose will not only be around in ten years, but also that they will bring new expertise to collaborate and help drive the innovation process, whether it is developing client-facing technology, harnessing big data, creating predictive analytics or even firming up cybersecurity.

Beyond the trend of convergence, in which asset managers adopt more of a supermarket approach to their product set, it can often be difficult to know exactly which innovation will become the catalyst that flips the industry on its head. In the past two years alone, we have seen the growing adoption of robo-advisors, such as Wealthfront and Betterment, as well as further growth in the peer-to-peer lending space, driven by the likes of Lending Club and Prosper. Even paper money is not safe, as digital currencies, like Bitcoin, could one day force us all to retire our billfolds. Innovation in financial services may also take the form of new asset classes. The last truly disruptive game changer on Wall Street was the emergence of junk bonds in the late 1980s, which effectively bootstrapped the growth of the private equity industry during that same period.

New advances that serve to reshape an industry rarely, if ever, happen overnight, even if it seems like they do to most outside observers. The issue facing asset managers and the financial services community at large, however, is that when disruptive innovation does occur, if the infrastructure and culture is not in place to respond, the moat may be too deep and too wide to ever cross.

Mal Cullen is the Chief Executive Officer of Eagle Investment Systems. A subsidiary of BNY Mellon, Eagle is a provider of financial services technology with a comprehensive suite of data management, investment accounting and performance measurement solutions, deployed over a secure private cloud, Eagle ACCESSSM. Learn more at www.eagleinvsys.com or follow Eagle on Twitter @Eagleinvsys.

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