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Innovation is in urgent need of revival

The good folks from Occupy Wall Street/St Paul’s/the City have rightly drawn the world’s attention to many of the worst ills of contemporary capitalism, but they have not yet mentioned one which we consider to be equally pernicious: the financial system’s almost pathological abhorrence of innovation.

By “innovation”, we are not referring here to the profusion of arcane, opaque financial engineering that is trotted out as proof that Wall Street, the City, and their peers are the apotheosis of ingenuity and dynamism. No, instead we mean real, fundamental innovation that challenges the basic assumptions that underpin the financial system, and which acknowledge past failings and the fact that today’s and tomorrow’s investment environment is unprecedented.

In brief, we believe that both asset owners and their investment managers all over the world are failing to demonstrate the level of innovative thinking – and action – commensurate with the gravity of the current global economic, environmental, and social conditions.

At its most superficial level, the strongest manifestation of this systematic abhorrence of innovation can be seen in asset owners’ nearly universal insistence on a substantial historical track record from asset managers. It apparently matters little whether or not that track record is consistently egregious; what matters is that it simply exists, and the longer the better. Asset owners increasingly pay lip service to wanting innovation and creative thinking, but that innovation had better come equipped with a three-year track record, at a minimum. It’s a Catch-22.

One could readily be forgiven for thinking that the risk that investment committees and CIOs are really trying to manage is an entirely different kind of risk, and one far more feared: career and/or personal reputational risk. That is, it’s the risk involved in doing something substantially different from one’s peers.

Now, this might be acceptable if the “tried and true” approaches of the past were delivering terrific results. But they aren’t.

While governments can be justly criticised for their unsustainable debt levels, it is the investors that must accept responsibility for investing without questioning the long-term ability of a country to actually pay off its debts, or of companies to deliver financial, social and environmental sustainability.

The world confronting investors today is radically different from that which obtained even 10 years ago. The world’s centre of economic gravity is shifting inexorably from west to east, from north to south, and from rural to urban. Natural resource degradation and scarcity are increasingly constraining both economic activity and the quality of life for hundreds of millions. Growing population and consumption are putting an unprecedented strain on natural and social systems. Income inequality is not only increasing, but it is now far more likely to catalyse radical political change and even violence. In short, sustainability considerations are becoming increasingly critical to companies’ competitiveness and profitability.

An unholy concatenation of cognitive blinders, institutional inertia, and a dogged unwillingness to break ranks with one’s peers has created an entire investment ecosystem where true innovation is consistently stifled to the point of near-extinction.

As the debt crisis plays out, we have reached a point where asset owners and their money managers must innovate, or risk wiping out significant portions of their investment portfolios.
Existing asset allocations to fixed interest, which will mean continued exposure to toxic sovereign debt, need to be questioned.

Sticking with investment managers that hug benchmarks will result in sub-optimal returns for most. The good news is that it doesn’t have to be that way.

It’s all about the global megatrends, really. Unless and until fund managers change their investment assumptions, analytical models, or investment processes in response, both investment returns and the planet will be the poorer for it.

Asset owners must lead the way and somebody needs to make the first move.

This article first appeared in FTfm, the Financial Times funds management supplement, 5 December 2011.
​Copyright © The Financial Times Limited 2011.

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