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:

1. Idea innovation; and
2. 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.

Comments

[Thomas Jones]

Have you ever received an estimate on the cost of assembling a very powerful supercomputer from off-the-shelf components? I think you would be surprised at what you could buy for $200,000. The algorithms can be programmed overseas.

[Roger]

Bond Investor - thanks for the comment, but you misinterpreted the scope of my post. I wasn't making a comment on innovation in general - I've read and written a lot about that and have a pretty good grasp of the literature. My post has to do with asset management firms finding new and innovative ways of making money, so I think the cultural issues and the ways innovation take place IMHO are quite different. As it relates to Monitor110 and early-stage businesses in general, the big reason they can succeed in the face of much larger, better funded competitors is the laser-focus and outside-the-box thinking they can bring to solving an important problem. So innovation isn't simply a feature of their culture - it's their raison d'etre.

[Bond investor]

Roger, nice new format (I usually read via RSS feed so maybe it's not that new).

I think you may be missing an important part of innovation processes: the culture and commitment to innovation. Prof. Andrew van de Ven at U of Minnesota has done great work in this area. He concludes that only big companies or organizations that commit to funding "skunkworks" will have a good innovation batting average. Innovators and engineers need the financial support and time to try ideas that might fail. Small companies have little capital to expend on failures. Big companies are under pressure to reduce risks, and R&D spending that "goes nowhere" is likely viewed as just that.

Does your downbeat view of the future of "little guy" innovation have parallels in the prospects of Monitor 110?

[Michael]

Re: " Technology innovation involves creating an edge through bandwidth, processing power, execution speed..." "...Enough said."

Well, Ok, but I disagree :)