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Lower returns and constrained innovation: the unwanted consequences of product transparency and simp

Date: Friday, June 25, 2010
Author: CHW

  • Regulatory requirements may constrain the pursuit of alpha
  • Investor demands for simple, clear, low-risk products may inhibit innovation

24 June 2010 Investor demands for more clearly-defined, transparent and lower-risk products combined with regulators’ desire to exercise more control over the industry, may result in the unwanted consequences of lower returns and constraint on innovation finds KPMG’s recent survey, “Keeping Ahead of the Curve: Investment Management in the New Regulatory Landscape”.

While regulatory constraints, including limits on short selling and leverage, higher capital requirements and restrictions on the use of certain instruments, may lead to greater investor and regulator comfort and confidence, they will also impact the ability for firms to generate alpha and, therefore, returns.

Commenting on this finding, Tom Brown, European Head of Investment Management at KPMG, said: “Investors and regulators need to be careful what they wish for. The push for transparency and simplicity, while completely laudable and necessary, does have consequences for returns and may create significant long-term costs to the end consumer.”

The desire for transparency and simplicity by investors and regulators may lead to product homogenization, less choice and, consequently, a reduced ability for firms to innovate effectively, KPMG’s survey found. In order to be able to offer products that are more transparent and bear lower risk to investors, a number of respondents expected to move towards more passive management, while others are finding ways to incorporate capital protection strategies.

“Historical ‘churn and burn’ strategies are no longer viable. The industry has realized that it cannot continue to develop products just for the sake of it with the naive hope that they will ‘stick’ in the market,” said Brown. “While creating transparent and simple products with strong return profiles may be challenging, those firms that get it right are well-placed for future success.”

Other survey findings that address the impact of regulation on the asset management industry include:

  • Ability to achieve cost efficiency: Investment managers expect to absorb the implementation, compliance and management costs of new regulatory requirements, and will therefore continue the search for greater efficiencies and cost-cutting measures.
  • Onshore vs. offshore: The survey shows that for the larger, more sophisticated institutional investors, offshore centres will continue to remain attractive. That said, 62 percent of survey respondents believe that funds will migrate from offshore to onshore centres in the future, perhaps reflecting investor calls for greater transparency and regulatory oversight as well as the current state of taxation policies that influence product jurisdiction decisions.
  • Increased regulation may spur a bout of consolidation and acquisitions as smaller firms seek scale to reduce the individual cost of complying with regulation. Asset managers in more restrictive jurisdictions, however, may choose to exit some or all of their business activities rather than deal with the growing compliance burden, thus creating opportunities for market leaders to further consolidate their position.