Is It Possible to Produce an Innovative Financial Product?
What differentiates financial innovation from product proliferation?
Many hear “innovation” and think I am talking about the creation of an entirely new product for the first time. But that would be an invention. The mutual fund, for example, which came on the scene quite a while ago, was such a creation.
I am talking about innovation. Innovation happens when someone improves on or makes a significant contribution to something that has already been invented. Take the iPhone, for example: Steve Jobs and his team at Apple did not invent the mobile phone — they significantly improved on it.
What Makes a Financial Product Truly Innovative?
With this definition in mind, innovation should mean that a newly launched fund offers a significant improvement compared with the thousands of other funds already available to investors.
But proving that a new fund is innovative is a tall order. When is a new fund a significant improvement? Mutual funds, like all financial products, have one major goal: helping investors achieve their financial targets and needs. So, in order for a mutual fund to be innovative, it has to be better at achieving this goal than other existing products.
If we accept this definition, then achieving innovation in financial products is inseparably connected to meeting investor targets and investor needs. Therefore, without an understanding of investor needs, there can be no effective innovation.
Financial Innovation Is about Meeting Client Needs
Today’s investors have a lot of considerations to sift through — their life stage, family situation, wealth and income, health, the country or region they live in, and, of course, their tolerance for risk, to name just a few.
Obviously, these can change over time and have likely evolved quite a bit since the global financial crisis and the subsequent response by the central banks. More than ever, the macro environment influences the prevailing needs of investors.
Let me get a bit more concrete: We live in a world of record low interest rates, but at the same time investors still need regular income to work toward their financial targets. Seven years after the global financial crisis, public debt in most developed economies has reached record levels and is continuing to rise. This problem will be further intensified by demographic challenges. In fact, with the number of people over the age of 65 growing faster than the working population, many major economies may be pressured to cut their pension and health-care costs.
How Can Financial Innovation Help?
The identification of the clear investor need for regular income has sparked a wave of new product launches. Among these are the so-called target income funds, which seek to provide a regular and reliable income stream by not investing according to a benchmark but instead aiming to achieve their target income.
This is also known as outcome-oriented investing. These products have all the characteristics of true innovation by clearly improving existing income funds for investors. The goal is no longer to outperform a market index as a nonspecific proxy for what investors want to accomplish, but rather to fully integrate the specific needs of investors to achieve a regular income stream. I would go one step further and claim that the whole family of outcome-oriented investing products is truly innovative.
Morningstar has a concept called the Morningstar Investor Return™ (familiar to CFA charterholders as the dollar-weighted return), which measures how the average investor fared in a fund over a period of time. Every now and then, Morningstar calculates the return and each time the results are shocking.
On average, investors in mutual funds do not participate in the alpha achieved by a skilled fund manager. This is because investors, on average, tend to buy at the wrong time and sell at the wrong time. This concept is highly related to the average holding period of funds. In the United States, the average holding period is about three to four years. In Europe, it is even less — only two to three years. Mutual fund investors seem to buy high, sell low, and not hang around long enough to actually benefit from their investment.
Outcome-Oriented Products Can Help
An outcome-oriented product — whatever that outcome happens to be — detaches the investor’s expectations from the volatility of the market. If somebody invests in a fund to achieve a certain promised outcome, such as a target income distribution, rather than to piggyback on the growth of a particular index, an outcome-oriented product should help to focus on the original investment goal.
By using such products, investors should maintain longer holding periods, which would ultimately benefit both the investor and the investment provider.
Therefore, outcome orientation provides a significant improvement and is the kind of innovation that we should encourage. Exchange-traded funds (ETFs), on the other hand, do exactly the opposite of outcome-oriented products: They shorten investment time horizons and thus increase the likelihood of investors not meeting their long-term financial goals. Do you agree? What do you think of these and other developments? I look forward to hearing from you in the comments section below.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: Brian Rea, 2014
7 thoughts on “Is It Possible to Produce an Innovative Financial Product?”
The definition is correct for innovation. As a research scientist, innovation is a much more profitable endeavor than invention. The innovation of outcome oriented income products should not be a recent development. All retirees have that as a goal. I have sampled my peer group( 58-63 year old investors) and they are without exception outcome oriented, income focused, and not interested in consuming principal or capital. They desire to consume dividends and interest. While the advisor community has focused on total return, their customers/ clients want to anchor their capital and generate an income stream. This disconnect is not the fault of the investor. Annuities continue to attract customers due to their appeal for defined outcome. Obviously, you give up capital preservation. Your challenge is to define portfolios that will satisfy the desired outcome without sacrificing capital preservation.
I agreed with the definition of innovation stated in the blog.
However, I disagreed about Morningstar reports relating to how the average investor fared in a fund over a period of time. I can most likely revised their conclusion if I’m given compete different or the same data set used in their analysis. The fault lies in when (or at what time) returns where aggregated in their analysis.
Finally, I think ETF should be considered as an innovation. This blog did not mentioned a DO IT YOURSELF (DIY) INVESTOR. I love the flexibility to hold and trade a piece of the market directly from my brokerage account. Besides trading fees, management / advisor fees are a lot smaller than a target income fund. Also, we assume most investor want a diversified portfolio all the time. I prefer time diversification for my portfolio.
Regarding investor’s return, I don’t think there is a distortion depending on the data set or the time it is calculated. Money-weighted return is just that, return weighted by dollars. As more dollars flow on a fund, lower subsequent performance will weigh down their annualized return vs, a geometric average of their annual return (where higher performance during asset-lean years will be “equal-weighted” in the performance measurement).
I question MorningStar report not about the data but the results used to incorrectly interpret the preference between TWR versus MWR. If we need to know which method is better for the investors, the correct analysis should be to understand why the flows happened and not used the model return results for explanation. We unconsciously treat MWR as an investor’s return but MWR can only be compared to other portfolio returns when certain conditions are met. Are investor aware about this limitation (TWR has its own limitations as well)?
When there are no flows and both MWR and TWR have identical returns, MWR would use identical return over the entire period where as TWR incorporates each periods returns. Thus, MWR is no better than TWR unless we understand why the flows happened.
Innovations have involved cost and should continue to involve cost, in my opinion. Or more precisely, value: the cost paid for the outcome.