What does 'going digital' really mean for pension funds?
, James King
How can digital ecosystems solve the innovator’s dilemma for asset managers?
Why do successful companies fail? That was the question Professor Clayton Christensen asked in his pioneering book, The Innovator’s Dilemma (1997). It led him to develop the theory of ‘disruptive innovation’, which made him “the most influential management thinker of his time” (The Economist).
His insight was that companies fail because they don’t innovate and embrace change as fast as new entrants. His theory was that the structures and strategies that make companies successful at scale also make them resistant to taking risks on new technologies and in new markets. Essentially, managers become so focused on improving products and services for existing customers that they actively block any disruptive technologies that threaten their core business model.
Why does this matter to established asset managers? Quite simply because they need to find new customers and markets to survive. As a recent PWC report made clear: “The costs of asset management will continue to soar and margins in 2020 may be no higher than in the current post-financial crisis era. Profits today are still 15%–20% below their pre-crisis highs and [may not] have re-attained these levels by 2020”.
Firms are focused on maintaining their scale in existing markets at the expense of innovation, new customers, products and markets. At scale, internal culture and processes are designed to maximize the existing model, innovation or disruptive ideas don’t line up well with return on investment thinking and threaten to break mature operating models. This often leads to the culling of ideas at an early stage.
Equally disruptive technologies almost always have attributes that the majority of existing customers initially consider inferior to the status quo. However, early adopters (potential new customers) find value in those attributes because they are frequently cheaper, easier to use and more convenient.
In time the disruptive technology provider builds the scale necessary to go mainstream and so remakes the old market. Christensen identified four barriers that explain why established companies struggle to harness disruptive technology and how they erode and initial competitive advantage. In part he suggested that the practical way to overcome these barriers is by setting up subsidiaries or buying innovation through competitor acquisition, we believe there is another, less capital-intensive way.
The four barriers, as they apply to established companies are effectively:
However, when Christensen wrote his book, the rise of technology platforms had barely begun. Since then, we have seen digital ecosystems, like Google, Apple, Facebook and Microsoft, flourish and in essence buck the Innovators Dilemma.
They are super innovators that continue to innovate even though they are now the largest scale companies that have ever existed. They appear to have escaped the innovator’s dilemma because they have worked out where they add value within the ecosystem; as a service provider, consumer or facilitator . So if these companies can manage to innovate at scale can asset managers for the same?
Here is how we think platform ecosystems have overcome the four barriers that Christensen proposed and what asset management can learn from them:
There are broadly only two ways for asset managers to build and maintain differentiation. They can either create investment strategies that deliver significant returns, or they can develop strong distribution networks, only a few succeed in doing both. These are their core functions and practically everything else they do is not unique (non-core) such as administration, compliance and reporting.
Companies tend to do the non-core activities in-house because, until now, they have had little alternative. However this dilutes their core strength and distracts them from potential innovations in the areas that really matter, strategies and distribution. Yet those non-core activities are seeing the largest and fastest cost increases, to keep pace with changing legislation and customer demands for bespoke services.
How can asset managers use modern business ecosystems to solve this core / non-core dilemma?
The first way is to focus ruthlessly on core activities that confer a competitive advantage – and outsource the rest to trusted partners. Why not rent what you need from experts rather than trying to build something where there is no advantage to be gained in inventing something that is already a commodity? Regulations have forced managers to use third parties for some functions, but we think companies should accelerate this process by outsourcing all non-differentiated activities where possible.
The second way is to buy in, or collaborate with others to create, the innovation you need, whether that is data or overlay services (such as ESG screening). This can enable you to offer clients things they don’t yet know they need, while avoiding the expensive R&D trap. It will enable you to test new ideas rapidly and at relatively low cost.
Maintaining growth rates that satisfy investors and provide career opportunities for talented employees is one of the big challenges facing large asset managers. That leads them to focus on trying to capture a greater share from existing large markets rather than entering new markets near the start of their growth trajectory. Yet those may well be the markets of the future.
How can asset managers use modern business ecosystems to solve this market strategy dilemma?
i. New commercial marketplaces enable asset managers to test new distribution strategies without the cost of building in-house mechanisms. These platforms offer you a relatively low cost, agile way to innovate in a live environment with new offerings to new customers. Their short term, flexible contracts make unwinding such experiments far simpler than closing an in-house operation.
ii. ‘Plug & play’ models can potentially generate an attractive revenue stream from a long-tail of low-value customers that would cost too much to attract individually. If, for instance, you are an asset manager who wants to do business with a pension company in a new jurisdiction, you can use a platform and avoid the cost of building the specialised reporting required to service the investor. Effectively, you would rent the infrastructure that someone else has built and remain nimble.
iii. Using an ecosystem is also a good way of offering a specialised service (such as a bespoke strategy) without the cost of bundling it with non-core services. If the customer wants a bundle of products and services, using an aggregator, leaves you to focus on strengthening your core offering. That helps keep your costs low and your margins healthy.
Ambitious leaders succeed by executing winning strategies based on solid market research. However, many miss new opportunities because, even when they instinctively see the potential, the data they need to justify their decisions doesn’t yet exist. The very nature of disruptive technologies makes it hard to estimate potential market size and returns on investment.
How can modern business ecosystems help asset managers solve this planning dilemma?
Platform marketplaces gather and share intelligence from multiple sources, making it easier for investors to identify emerging value trends. By ‘renting’ access to new markets, these platforms enable companies to make low cost, low risk investments to test ideas and analyse demand. We know from personal experience that having ‘skin in the game’, even when not significant, gives us an edge in assessing potential.
The very nature of disruptive technologies makes it hard to estimate potential market size and returns on investment.
Technological progress is often slow. At other times it races ahead of the market, offering improvements that mainstream customers don’t want and can’t appreciate. Meanwhile, disruptive technologies that initially underperformed relative to mainstream customer expectations may improve rapidly.
There comes a point where the new product or service becomes attractive to more than early adopters. When customers can choose between two or more products that offer sufficient performance, they will find other criteria for their decisions. Those criteria will tend to be around convenience, choice and value, which are all attributes where the new entrant often has an advantage over the incumbent.
How can modern business ecosystems solve this competitive dilemma for asset managers?
Companies that use platforms to trial new products and services avoid becoming too attached to one over-developed ‘killer product’. Instead, they cultivate an ‘always innovating’ mindset, which recognises that what was good today may well be scrap tomorrow and encourages them to test new ideas. This makes them far more agile and responsive to changing customer demands and new market opportunities.
Companies that use platforms to outsource non-core activities also save time and money by not developing dedicated in-house capabilities that don’t deliver growth to the bottom line. At the same time, by buying in innovation, they become more able to meet the non-price criteria of customers, when performance is no longer the sole differentiator. Buying in – or renting – innovation allows them to run more low-cost product or service improvement trials, which increases the chances that at least one will be a success.
Christensen’s famous work is more relevant today than any other time in history. Successful businesses across all sectors face two critical challenges today; how to innovate consistently when at scale and how to remain competitive when faced with the existential threat posed by disruptive technologies and business models. We believe the asset manager of today can do both, by harnessing this disruptive technology and focusing on their core IP.
If you would like to know how AMX can help you innovate, please get in touch.
What does 'going digital' really mean for pension funds?
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