Redefining Alpha

In asset management, alpha is typically defined as the uncorrelated return of an investment, or portfolio relative to a market benchmark. For active managers, in particular, the metric serves as  a gauge of performance, if not outright investment talent.

Independent of perceived skill, portfolio construction or style, however, few investors, professional or otherwise, manage to consistently beat the market, especially when measured as risk-adjusted returns on liquid assets, net of fees. Sure, investors may sometimes get lucky, or may take on greater risks in an effort to enhance returns, but positive outcomes are certainly not guaranteed and riskier bets could, conversely, also result in significant losses.

This is not to diminish the value of diligent research, analysis and execution in the investment selection process, of course, but the ability to derive positive alpha on a consistent basis is incredibly difficult. In fact, fewer than 10% of all active funds manage to beat their passive benchmarks over a 10 year, or greater period. And, the number falls even further after accounting for taxes and fees. As a result, flows into cheaper passive products have dominated in recent years. The growth in ETFs, too, has offered increased diversification, enhanced liquidity and typically lower cost than their mutual fund peers, even amongst active strategies. Add to this a global regulatory climate that seeks to improve investor transparency, along with a virtual price war amongst many index providers, and it’s clear that a vast amount of asset management product has become commoditized.

How, then, can managers differentiate themselves?

Institutional investors, in an effort to reduce concentration risk, will often seek to diversify not just their underlying investments and strategies, but also their managers. This, however, is hardly due to the differentiation of a given manager, and rarely applicable to retail investors. And, while long-term client relationships matter, especially amongst institutional investors, they won’t necessarily lead to perpetual mandates or premium fee arrangements; in fact, the opposite is sometimes true. Of course, a strong track-record is clearly helpful, but the answer to differentiation is not rooted in investment performance, alone.

In a recent conversation with the Chief Investment Officer (CIO, not to be confused with Chief Information Officer) of a large, traditional asset manager, I suggested that product, by itself, was increasingly commodity. I further noted that it would be difficult to grow, or command premium fees for such product, even with superior contemporaneous performance. While the CIO was intrigued by this seemingly provocative statement, he countered with his belief that performance was still the determining factor contributing to net client inflows, or outflows.

Where there is a glaring disparity in performance amongst managers, of course, this is true, but with alpha so difficult to sustain, and subject to normal market oscillations, how can performance, alone, be such an outsized catalyst? While performance is certainly not unimportant, the new differentiator, I propose, is actually client experience.

I proceeded to ask this CIO if he was an Amazon Prime member. He acknowledged that he was. I then asked if his purchasing activity on Amazon had increased over the years, perhaps in part due to his Prime affiliation. He, again, acknowledged that it had. When asked for the reasons, he highlighted convenience, 2-day delivery, ease of use, trust, and a liberal return policy. Interestingly, not once did he mention the price of goods.

I then reminded this CIO that prices on Amazon, the most comparable proxy in retail consumer goods for investment performance, are not always the cheapest, yet that hasn’t prevented it from becoming a shopping destination of choice. Amazon’s client experience, I posited, is effectively their alpha!

What can asset managers learn from this, and how can they also embrace, and enhance the client experience to redefine their own alpha?

First, it’s important to recognize that client mandates are not always cookie-cutter, nor are they always performance-driven. While this has often been the case for institutional mandates, objective driven investing is likely to become more important amongst retail investors, too. High net worth (HNW) wealth management clients, for example, often require more bespoke investment solutions that cater to their specific needs. Beyond simply growth, portfolios may therefore be structured to achieve income, capital preservation, beneficiary objectives, tax shelters or other goals. Ultimately, these kinds of solutions are far higher up the value chain than pure products, thereby justifying greater fees, but managers must increasingly be able to deliver multi-asset class solutions, inclusive of both traditional and alternative investments, at scale.

As for alternative investments, themselves, originated alternative assets are inherently differentiated from more traditional assets and strategies, including liquid hedge funds. In large part, this is due to the limited scale of investment opportunities and the reduced liquidity of the underlying assets. While potentially  subject to greater liquidity, concentration and credit risk, originated alternatives – like real estate, private equity, royalties, loans and art, amongst others – can deliver enhanced performance, but may require a longer duration to do so. The research, execution and ongoing management of these assets is often more bespoke and, like solutions, may also justify higher fees for alpha. Still, even within alternatives, the client experience can be markedly enhanced by the seamless delivery of more interactive, and timely investor reporting, insights and commentary.

Additionally, an increased interest in socially conscious investments has led to greater investor focus on environmental, social and governance (ESG) practices. While some investors believe that ESG investments will also derive higher returns over time, it’s too early to say whether that will be true, and current empirical data does not yet support this conviction. Nonetheless, it’s clear that managers unable to cater to this requirement, incorporating it into both their client servicing and investment selection processes, are at a distinct disadvantage, today.

Finally, there is the client interface, itself. Whereas many industries, including retail banking within the financial services sector, have adopted digital channels as mainstream, asset management has been a laggard. Many asset manager websites, for example, remain static and cumbersome, with little useful content beyond the occasional fund factsheet, which may itself be stale. Even beyond the marketing facade of a website, the client servicing experience underneath is often siloed, and exhibits poor client onboarding, maintenance and connectivity with product and portfolio management.

Millenial, and later generations are digital natives who value a seamless, interactive, informative and tailored experience that also facilitates self-service. But older generations, too, have adapted digital lives, as they increasingly research, consume, socialize and transact online. Further, such digital channels allow for a bilateral flow of information and intelligence: not only can compelling content be delivered to clients and prospects in an interactive medium, but data gathered about their interests, for example, can better inform product management and manufacturing functions, enabling a virtuous feedback loop.

Collectively, I submit that these capabilities – objective-driven investment solutions, at scale; access to originated alternatives; the ability to incorporate non-performance goals, like ESG principles; and the ability to deliver a rich, and seamless digital client experience, front-to-back – will ultimately enhance client experience and serve to differentiate asset managers. Moreover, success in any, or all requires that managers embrace digital and data enablement as existential parts of their overall business strategies.

If true, the likes of Amazon, Google, Uber and other successful digital properties may become the new benchmarks against which asset managers seek to redefine alpha.