In The Long Run, We Are All Dead

New York –  Brace yourself for major changes in the financial landscape, if the predictions of Suzanne Duncan of the IBM Institute for Business Value are valid.  Suzanne Duncan’s remarks at the Investorside Independent’s Day Conference have recently been posted on the Investorside website.  Her message was bullish for research – in the short run – as markets move toward transparency benefiting flow businesses such as equities.  However, longer term trends separating alpha products from beta products paint a bleaker picture for the growth prospects of the research industry.

Suzanne Duncan, the Financial Markets Industry Leader in IBM’s business services consulting division, was invited by Investorside, the trade association for independent research providers, to present the findings of surveys that IBM has been conducting of financial industry participants and their clients.

Trust

One finding, which was reinforced yesterday by a study from Forrester Research, was that clients do not believe that financial institutions are acting in clients’ best interests.  According to IBM, 70% of financial institution clients (of all varieties–pension clients of asset managers, individual clients of wealth management or banks, asset manager clients of investment banks) believe that financial institutions act in their own best interests, not clients.  Further, 60% of financial institutions agree they are acting in their own best interests, not clients’.   A study released by Forrester Research yesterday found that brokerage firms and banks had reached all-time lows in client trust.  For example, only 29% of Morgan Stanley clients surveyed by Forrester believed that the firm was looking out for clients’ best interests.

Duncan’s fragmentation analysis of client responses shows that there is no correlation between client trust and the type of client, size of client, or any other client demographics.  The decline in trust is pandemic.  Based on IBM’s analysis, the largest client segment is “conflict of interest avoiders” – clients which are seeking unbiased financial services.  The surveys indicated that clients will pay premiums for 1) unbiased high quality advice and insights (bullish for independent research); 2) client service excellence; and 3) convenience.

Industry Unbundling

Duncan predicts that there will be greater unbundling of financial products, fostering transparency, and business models.  At the firm level, the trend will be to de-construct the one-stop-shop institutions.  The bigger is better mindset has been disproven.  Specialist providers are both more profitable, and better able to manage risk.  Scale is a hindrance, not an asset.  Even prior to the financial crisis, less than 5% of financial institutions surveyed by IBM were confident in their risk management systems.

There is too much capacity in investment banking, wealth management and asset management.  There will be consolidation, along with greater specialization. In other words, firms will focus on specific specialties, and consolidate capacity in those specialties.

Governments will play an important role in the transformation of the restructuring of the financial industry.  According to Duncan, the top priorities for regulators and legislators are 1) greater transparency; 2) capital and liquidity requirements; and 3) better aligned incentives and metrics.

Before the crisis, the financial industry was profiting by exploiting opaque financial products and revenue pools such as derivatives and proprietary trading.  This game is over, according to Duncan.  Future growth will come from transparent revenue pools such as exchanges, passive investing and agency business.

Separation of Alpha and Beta

One of the key trends highlighted by Duncan is the separation of alpha products and beta products.  Much of what is promoted today as alpha generating, namely long only active asset management, will shift to more explicit passive management.  According to Duncan, 70% of assets are currently tied to long only active management, the majority of which will shift to passive over the next twenty years.  “The majority of worldwide assets under management will move away from traditional long only and will move away even from some of the alternative asset classes into beta.  We are bullish on boring beta.  85-90% of total worldwide assets under management will move toward indexing or repackaged types of beta instruments,” according to Suzanne Duncan (italics added).

Hedge funds will be impacted by this trend, and the trend toward greater transparency.  According to Duncan, only 10% of hedge funds are actually delivering alpha.  The other 90% are simply pretending, and will go away as greater transparency comes to the industry.  Those hedge funds that actually deliver alpha will grow larger.  More generally, Duncan sees a future for “alpha seekers” which will represent 10-15% of total assets, and consist of hedge funds, private equity and venture capital.

The majority of assets, and financial industry revenues, will be in beta products and flow businesses, which will have lower margins and lower volatility.  These businesses will be heavily regulated, and operate under utility type constraints.

Implications for Research

Research is only one facet of the complex financial institution industry, but the broad industry trends apply to the research microcosm.    The research industry suffers generally from an opaque business model, in which historically research fees have been bundled with execution in full-service commissions.  While the trend has been toward greater transparency and unbundling, the rate of change has been slow.  By Duncan’s logic, government influence and industry restructuring should accelerate the process.  It remains to be seen whether this will be the case.  Over a longer time period, let’s say five to ten years, unbundling is highly likely, whether through industry trends or government actions.

Duncan’s finding that the paramount client need is for unbiased high quality advice and insights would seem at first glance very bullish for independent research providers.  However, in the context of greater financial industry deconstruction, flow businesses will increasingly operate on a stand-alone basis, making the independent value proposition less compelling.

The restructuring of the hedge fund industry will have significant impacts on the research industry because hedge funds have been the most innovative users of research.  In Duncan’s world, this is likely to continue among the more circumscribed “alpha seekers”.  The paradox is that alpha seekers value opacity in research.  The more bespoke and less widely distributed, the better.  This implies smaller, nichier, more fragmented research – a trend already in evidence pre-crisis.

We are also seeing the impacts of deconstruction, as regional brokers and agency brokers prosper and more research boutiques proliferate.  Like Duncan, we have been predicting greater consolidation along with specialization, so we are inclined to accept her predictions for the larger financial industry.

The most troubling aspect for the research industry is the prospect of 85-90% of AUM tied to passive investments.  This implies a huge dislocation to research, which is largely geared to the requirements of traditional long only asset management.   If long only goes the way of the dinosaur, as Duncan predicts, most current research goes with it.  Duncan posits that research focused on industry level and sector level insights, such as investment strategy, will do well in an environment where most investors are focused on asset allocation and asset/liability matching.  However, this represents a small fraction of the overall spend on research.   The twenty-year migration of assets to passive would most likely be accompanied by a major shrinkage in the spending on research…not a happy prospect.   Good news for Ed Hyman and Ned Davis, but not so great for the rest of the industry.

Suzanne Duncan’s full speech can be found at http://www.investorside.org/imain?p=28&id=8123791301923.