Process Alpha and Beta: Assessing Value-add at Each Stage of the Value Chain

The Parallel of Investment Returns

When investment managers discuss their returns, these returns are usually assessed on a relative basis. We use the terms alpha and beta here to describe that relative nature, but as an industry we don’t discuss the rest of the value-chain in the same way. Despite the terms being less meaningful to a retail investor, it makes sense to those in the industry to continue to use these terms to discuss returns to differentiate between what could be achieved with a potentially lower cost index portfolio relative to the hoped-for incremental return from an actively invested portfolio.

Investors and managers alike have started to derive alpha returns through the combination of index portfolios timed and weighted to gain the maximum upside, i.e. a combination of beta exposures can be used to deliver alpha returns, or at least a part thereof. As a result, managers who used to say they would never touch index investments are now deploying third party beta within their portfolios alongside their own active management to deliver returns in a more cost-effective manner.

The discussion around this moved slowly to start with, but the proliferation of index portfolios—which can now replicate more and more of what used to be considered alpha—has encouraged managers to focus on where they add most value. Not everyone needs to focus on the same set of securities, but they can still gain the upside from an industry utility that does.

Modularising Investment Management

In parallel, another shift has occurred. The fortress of investment management has come down and its walls have been replaced by revolving doors. Investment managers need every process to be done but they don’t necessarily need to deliver all those processes internally.

If we consider one strand of this on the investment product side: some funds of funds added external managers to offer capabilities which the manager may not have wanted to deliver in-house or which they could not deliver in-house.

Over time, this openness has expanded to other areas of investment expertise such as risk analytics, with risk systems developed by a small number of investment managers offered to others. More recently, we have seen the emergence of JV-like structures to offer distribution or white-labelled capabilities to other managers to expand each firm’s geographic reach or range of product offerings, often in other jurisdictions.

In theory, both firms can gain from such measures as they are able to leverage the scale provided by the other manager and / or create stickiness with their investors who might have gone elsewhere to access the capabilities now unlocked through the expanded offering.

If we take a step back and assess the value chain for investment managers, there are a multitude of processes involved in investment management where managers may not need to differentiate themselves, especially in middle and back-office functions.

The modularisation of investment management could enable smaller firms to continue to create value without needing to spend large amounts on building out ancillary capabilities. It may also enable larger firms to monetise their work in different areas more easily.

Further Outsourcing

Some of these processes are outsourced and, as an industry, we are comfortable that these processes remain as such. For example, many buy-side firms rely on their sell-side counterparts for custody services. An asset manager could self-custody, but most would not find the prospect appealing given the range of available sell-side partners and the significant cost of building a proprietary system.

Implicit within any judgement to build, buy or rent capabilities is whether the service would incrementally increase their value-add were it to be done in-house rather than provided by a partner. Often, this decision is based on the concerns surrounding migrating from an internal capability to an outsourced function, coupled with a reluctance to immediately amortise the historic cost of legacy internal systems.

Amortisation of Legacy Systems

However, the next phase of investment management may leverage central bank digital currencies and other digital assets which may entail an overhaul of the existing operating infrastructure in order to settle these digital transactions.

That means that legacy systems may need to be overhauled in any case, and so reduces the concern about moving to an outsourced service provider as even an internally created system may require a migration. That overhaul is likely to be costly, yet unavoidable, for the industry as a whole.

Assessing the Value-Add

Selecting which services to in-source or out-source will require investment managers to have an honest conversation about the strengths and weaknesses of various parts of their businesses. One firm’s alpha could be another firm’s beta process.

As firms assess their capabilities, they may make some of their capabilities available as utilities for other managers, i.e. generating an additional revenue stream from an existing asset. As an example, an algorithm developed by one manager to size a trade could be used by many others for a fee without disclosing the respective trades before going to market.

The benefit for the consumer is knowing that they wouldn’t have to expend time and resources to innovate in an area where they do not have a competitive advantage and they can instead focus on their own comparative advantages. For example, KYC systems are usually individually maintained by each manager, however there is no additional positive value each time the investor is asked the same questions, so an industry utility could enable managers to deprioritise their individual efforts.

Trusted Platform-Like Mindset Emerges

Due to the trust relationship required to outsource capabilities, the number of providers for these industry utilities may remain relatively limited. Individual process providers may work together to ensure seamless integration of their systems. The vertical integration of these processes into a platform-like approach may simplify the partner selection process.