Punctuated Equilibrium and the New Asset Management Reality

The asset management industry needs to get onboard with technological disruption — or risk going the way of the dinosaur.


What do Darwin’s finches and active managers have in common? Evolutionary biology. Although birds from the Galápagos aren’t quite what you’d find on modern-day Wall Street, the parallels between their species and our industry are real. Unprecedented advances in data and technology are unlocking new sources of alpha that are reshaping the investment kingdom and helping spur a new generation of management.

The concept of punctuated equilibrium caused quite a stir in 1972, when the late, great American paleontologist and evolutionary biologist Stephen Jay Gould of Harvard University, along with his colleague Niles Eldredge at the American Museum of Natural History, challenged Darwin’s traditional view of gradual evolutionary development, arguing that the fossil record showed virtually no evidence of evolutionary gradualism. Instead, it seemed that long periods of stasis or evolutionary equilibrium dominated the history of most fossil species until there were quite dramatic inflection points — or punctuations — when step changes occurred that transformed our world.

Investment management, too, has experienced important punctuations. For many years, investing was a stable, if rather unscientific, affair of choosing companies that told a good story, seemed to have favorable balance sheets and were run by leaders who seemed trustworthy by virtue of the families they came from, the schools they attended or the clubs they belonged to. Markets experienced periods of irrational exuberance and corrections, but the investment process remained fairly static.

Then came the creation of market-cap-weighted indexes in the 1970s and with it the era of traditional active management, in which managers tried to beat the index primarily by fundamental processes of company-focused security selection.

Over time, however, quantitative-based managers joined the industry, forging the path toward more systematic ways of understanding the drivers of risk and return with the first generation of computer-aided analysis and behavioral finance insights.

More than 40 years on from the creation of market-cap-weighted indexes, we at State Street Global Advisors think we are now on the cusp of another period of punctuation that could have far more dramatic implications for investing. The beginnings of this shift have been encouraged by the insights factor investing has brought to light, even though the initial research into factors goes back nearly as far as the first market-cap-weighted indexes.

Factor investing provides a powerful lens to investors for understanding the drivers of risk and return in their portfolios beyond traditional asset class labels. That, in turn, raises the bar for traditional active managers, who must now show how much of their return is true market-beating investing based on skill, rather than premiums that can be replicated in a more cost-efficient smart beta strategy.

Beyond smart beta, there is an entire spectrum of more sophisticated methodologies that active quantitative managers are using. They are specifying factors in more nuanced ways and managing them on both the long and short side. New data sets and tools, as well as temporary anomalies arising from regulation-driven or other dislocations in the market, provide a fertile ground for these managers to capture differentiated sources of return. This new golden age of active management will also require a new kind of talent. Graduates in data science are likely to be more attractive to the industry than are graduates in economics or traditional finance, and financial services mainstays will soon be competing with the Googles, Facebooks and Amazons of the future for talent. Or else they risk extinction.

As a number of cyclical and secular forces complicate the investment backdrop — everything from regulation to technology to changing demographics and geopolitical and policy risks — we think investors need to take a more systematic and risk-aware approach to building diversified portfolios tailored to their long-term objectives. Moreover, a new generation of alternative risk premium strategies is evolving. We believe we will be able to deliver excess returns rivaling those of hedge funds — and for lower fees.

There can be no question that these new approaches to investment management should reorder and reorganize our industry. They point to the next evolutionary step. The only question, however, is, Who among us will evolve, and who will be left behind in a period of permanent stasis and irrelevance? One can only guess. What is an absolute certainty is that the asset management sector is set to become even more of a technology industry than it is already is. Those firms that have made the necessary investments in data and technology will have the edge.

Rick Lacaille is global chief investment officer of State Street Global Advisors in London.

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