Product innovation's dirty secret

Our industry has a predictable pattern. Someone launches a product. It gains traction. Marketing departments worldwide declare it revolutionary. Money pours in.

Then, slowly, the fundamental questions emerge. Does this actually serve clients? Does it do what it claims? Does it solve a real problem or create new ones?

We are watching this cycle play out across several areas right now. Private markets are being pumped as the next frontier. Active ETFs are proliferating despite practical limitations few discuss openly. 

Another dirty secret is that industry consolidation and cost pressure are fundamentally shaping what gets built and why.

The debate that will not die

Active management has been declared dead more times than we can count. Passive investing has been hailed as the rational choice, the low-cost solution, the future of asset management. This narrative has driven enormous flows and fundamentally reshaped the industry.

Passive momentum of the past decade was not primarily about passive being superior. In many ways, it has been about active management being overhyped and overpriced. 

Genuinely skilled active managers were being bundled together with quasi-trackers dressed up as active funds, all charging active fees while delivering index-hugging returns.

The rise of indexing was a necessary correction, or rather counterweight, but, somewhere along the way, the industry forgot that returns come down to two fundamental components: beta - your level of market exposure and risk - and alpha - that additional layer from getting your asset allocation right and from skilled active management.

We should couch the issue in binary terms. Instead, we should ask ourselves where active management can genuinely add value over time and where index exposure is more appropriate.

Private markets

Private markets have been around forever. Pension funds and institutions have allocated to them for decades. But recently, there has been a concerted push to make them more accessible to retail investors. 

The government has even weighed in, seemingly more focused on democratising access than addressing the inherent risks – a move we have seen before with property funds in the early 2000s. 

Property had existed as an institutional allocation for years, then it was packaged for retail, heavily marketed and money flooded in. A massive liquidity mismatch ensued.

Private markets face the same structural issue but with added complications. When everyone wants access into the same asset class, standards slip. The deals getting done today may look very different in hindsight than they do in current marketing materials.

I am not implying that private markets should not be in portfolios. For sophisticated investors who understand the illiquidity, can afford to lock up capital for extended periods and can access truly skilled managers, there is clearly a role. 

But the retail democratisation push feels like a problem waiting to explode rather than an innovation serving client interests.

Active ETFs

The industry says active ETFs represent the best of both worlds - active management skill with ETF structure efficiency. Dig into the details, though, and the proposition becomes less compelling.

The fundamental purpose of an ETF is to provide tight bid-offer spreads and exposure when markets gap. This works because market makers can hedge their positions by accessing the underlying holdings on a daily basis. For this to function properly, you need transparency and liquidity in the underlying portfolio.

Active management, particularly the kind that genuinely adds value, often involves fewer liquid positions, concentrated holdings or strategies that benefit from not broadcasting every move to the market. The moment you force daily portfolio transparency and liquidity requirements, you constrain what an active manager can do.

Active ETFs made sense for quantitative strategies where the underlying is liquid and the strategy can be replicated with transparency. But we are now seeing attempts to shoehorn genuinely active, fundamental strategies into ETF wrappers. 

The question nobody seems to ask is: does the ETF structure serve the client here, or is it just marketing dressed up as innovation?

Cost and consolidation

For the industry claims around client-centricity, much of this product innovation is not driven by client needs at all. Instead, it is driven by asset managers trying to survive margin compression and industry consolidation.

The growth of passive has put enormous fee pressure on the industry. Asset managers with bloated cost bases, particularly those carrying expensive front-office talent, are facing existential questions. 

The old model of running quasi-index trackers at active fees does not work anymore. Genuine active management at appropriate fees requires skill, patience and the courage to look different from the benchmark.

Instead, many firms are trying to find the middle ground. Can we create products that feel innovative enough to justify fees but do not require the investment in truly differentiated talent? 

Can we package things in new wrappers that create the appearance of solving problems? Active ETFs, certain private market vehicles and various ESG products feel like this to me.

Our industry is ripe for disruption. Not because of technological innovation but because the business models are unsustainable.

The unfashionable truth is that most of what matters in investment management is not new and shiny. Asset allocation, risk management, cost control, manager selection and discipline through market cycles. Fundamentals like these do not make for exciting conference presentations or generate headlines. 

But boring often beats exciting in the long run. The last thing we need is more clever product engineering. We need to get back to basics. What are we here to do? Who are we serving? And are we actually doing it well? Everything else is just noise.

Api Jeyarajah is chief commercial officer at Nedgroup Investments

This article was originally published in Investment Week: Nedgroup Investments’ Api Jeyarajah: Product innovation’s dirty secret.