From the Mailbag: Who Will Lead the Next Wave of Financial Innovation?
Future leadership in financial innovation; this is the question du jour:
I’d love to get your take on where the next generation of financial
innovation will come from as well as on your view of the trading world
and where it’s heading.
Will it be the big firms, the Wall Street behemoths and multi-strategy hedge fund complexes? Or perhaps the small, nimble and creative start-ups and spin-outs? Where will innovation best be nurtured and developed in tomorrow’s investment landscape? In order to answer this question, I think we need to consider some of the trends taking place across the investment business.
The re-shaping of the asset management business is a mega-trend that has permeated this blog since the beginning, and was the topic of one of my very first blog posts. My view has long been that the alternative investment business will look increasingly like a barbell, with multi-strategy mega firms running tens of billions in assets and small single-strategy firms running a few billion or less. The middle will be squeezed, as the resources necessary to expand into new strategies and compete globally are too great while the ability to generate alpha relative to smaller, nimbler firms is too difficult. The middle is not a good place to be, and will become increasingly more hostile as the institutional high-end of the market solidifies while the organic low-end of the market is a bubbling cauldron of alpha-generating success stories mixed together with value-destroying failures.
Turning to the issue of innovation, I think it needs to be bucketed into two groups:
- Idea innovation; and
- Technology innovation.
Idea innovation is not reliant on massive amounts of silicon, and is largely a function of intellectual capital. The goal here is alpha, or risk-adjusted out-performance. It could be a new capital structure arbitrage strategy. It might be an attractive investment approach in an emerging market. It could be a better researched idea and a more profitable trade than perceived by the investment community. Idea innovation could spring from either large or small firms, depending upon the nature of the innovation. If the source of value requires taking a position in Sri Lanka relative to South Africa and calls for extensive bottoms-up research, then a small firm is unlikely to have the bandwidth and resources necessary to implement such an global strategy. However, if the approach is a new way to structure PIPEs deals that puts the investor on a more profitable risk-adjusted frontier and creates cheap optionality, then a small firm could be the source of such local innovation.
Technology innovation involves creating an edge through bandwidth, processing power, execution speed and intelligent algorithms. This is generally the province of larger firms, be they hedge funds or Wall Street prop desks. Plain and simple, this stuff is expensive. Being the next Jim Simons or David Shaw requires big cash, and few outside of the mega quants or Wall Street have the knowledge and resources to engage in this arms race. Enough said.
Elements of idea innovation have and always will be open to the small dreamers. The barriers to entry are brains, hard work, vision, some luck and a few bucks. Idea innovation that requires global reach and presence, however, will be hard for the smaller funds to realize. Technology innovation is now a game of the big and the rich, and those lacking a significant bankroll need not apply. And I’m not talking about renting processing power and storage on Amazon’s EC and S3 - I’m talking about boxes near the exchanges and the latest on-ramps to the silicon highway. We now have a stratified market where innovation is heavily skewed to the biggest, best funded and most powerful hedge fund and Wall Street players. The chance still exists for the small players to innovate and make it happen, but the odds are becoming longer every year.
