How does a fire-hose company from 1870 evolve into a major aerospace company or a lumber company from 1865 end up as a mobile phone business? And what leads a 250-year-old company from the coal mining industry into auto parts? The answer is rather obvious: Survival. As Charles Darwin said, “It is not the strongest of the species that survive, nor the most intelligent, but the one that is most responsive to change.”
Investors know all too well that past success is no guarantee of future success. Markets are constantly fluctuating, and a good idea today almost certainly won’t be a good idea in a few years’ time. It’s for this reason that the wild success of certain corporations sows the seeds of their future failures. The bigger and more successful a firm is at a given point in time, the more likely it will get stuck in a certain operating mindset that prioritizes efficiency gains and asset exploitation at the expense of innovation and exploration.
Stanford professor emeritus James March argued in his 1991 seminal article “Exploration and Exploitation in Organizational Learning,” that “the basic problem confronting an organization is to engage in sufficient exploitation to ensure its current viability and at the same time, devote enough energy to exploration to ensure its future viability.” In short, the companies that thrive and survive over hundreds of years are able to adapt to changing environments. They have to keep making improvements in how they “keep the business running” while simultaneously coming up with and rolling out new ideas. Without this dynamic capability, Marriott would be known for root beer, Hasbro for carpets and Black & Decker for bottle caps.
Importantly, research shows that the ability to be both innovative and efficient is directly associated with firm performance and long-term survival. Put another way, companies that have plans to be around for decades seem to take the mixing of efficiency with innovation quite seriously. In academia, we refer to this duality as organizational ambidexterity.
Given all this, you might naturally assume that most institutional investment organizations — many of which have been around for 50 years or more — have focused intently on innovation and evolution in the face of market volatility and technology changes. But you’d be wrong.
In reality, institutional investment organizations often enjoy a monopoly over their asset base, as sponsors rarely set up multiple and competing institutional investment organizations (compare Sweden AP Funds). As such, the threat of extinction does not motivate these organizations as it does the private sector. In fact, institutional investors are often allergic to change. They prefer the company of a good herd. They tend to focus on managing political and career risk instead of investment risks. They are often dependent on external service providers, which means their ability to change their own organizations is limited. To give them some credit, many are beholden to the prudent man rule; with its antiquated notion of fiduciary duty that roots organizations in a mindset that rejects an enduring focus on innovation.
And all this occurs despite clear evidence that innovation within the business of institutional investment offers significant rewards, much as it does in other industries. Most of the world’s top institutional investors got to be top institutional investors by doing something distinctly different from their predecessors. The endowment model saw university endowments move aggressively into a diversified portfolio of risky alternatives. The Canadian model saw public pension funds aggressively move assets in-house. The Dutch model saw industry funds aggressively match assets to liabilities. And there are others. What they all have in common is innovation. They started out producing investment returns one way and evolved over the years to produce investment returns in an entirely new one.
That last sentence reminds me that I should pause and refresh readers on the unique nature of investment production functions. All institutional investors produce the same thing: money. They take an initial stock of money — what we’d call financial capital — and they try to generate more money by convincing developers, corporations, entrepreneurs or any other capital seeker to accept their money and then give them more after a given time period. How do investors achieve this feat? For the most part, they all use the same inputs. To their initial stock of money they add healthy dose of human capital, a dash of informational advantage, and a smattering of policies, processes and procedures. And, in the end, they hope that their production function can produce more money than their peers, given similar inputs.
Innovation in the business of institutional investment, then, is really about improving the quality of inputs and changing how those inputs are combined and mobilized. It may sound relatively simple. It’s not.
This is partly because there’s not a lot of research and understanding on how these investment inputs should be combined. Granted, there are many studies to guide investment professionals on investing but surprisingly, there are very few studies on the actual production of investment returns. Unlike the models and theories that underpin modern portfolio management, the production of returns depends on motivating employees, managing technological systems and even developing procedures and norms for decision-making. Success is about great people, data and decision making and then changing what is meant by “great” over time to reflect environmental conditions.
Today, most institutional investors are unable to do this, which is a shame. As is the case with other industries, the success of institutional investors demands a mountain of innovation and adaptation. In fact, I think the next big model of institutional investment will be based specifically on the ability to innovate.
In other words, the investment organization that can best adapt to changing market conditions will come to be known as the “adaptive model;” rooted in the aggressive development of new ideas rather than a streamlining and repackaging of old ones.
At its heart, this is about asking Giants to engage in experimentation and pilot projects that may only have payoffs in the distant future. This won’t be easy, as research shows clearly that building organizations that can be efficient and innovative is challenging and demands a cultural focus that embraces exploration. But, in a hundred years, it’ll be worth it.
Perhaps the first step then is to build organizations with multiple perspectives, filled with both mathematicians and artists.
