Managers’ New Hustle Is Outsourced-R&D

The asset management industry isn’t quite being Amazoned. But its customers do want lower costs and better products, and when managers can’t make the math work, investors are taking their business to a rival. Against this backdrop, State Street’s trading facility has started peddling a new service: product recipes for other firms to license, implement, and resell at relatively low cost. 

Will Kinlaw, head of State Street’s academic affiliate, says the group is creating and licensing investable indexes that external money managers can use for their own exchange-traded funds, separate accounts, and insurance products. He believes State Street has an edge in R&D, thanks to its deep capabilities, scale, and in-house think tank. “The definition of an index has expanded. We refer to it sometimes as Indexing 3.0, which doesn’t necessarily mean superior. But it’s a new way of thinking about it,” he explains.

The first wave of indexing produced market-capitalization-weighted funds. Popularized by State Street Global Advisors and the Vanguard Group, these include industry blockbusters tracking the Standard & Poor’s 500, Russell 2000, and MSCI indexes. 

The next iteration was smart-beta and factor-based products. Since 2008 investors have increasingly bought into decades of academic research showing that factors such as value, quality, and low volatility primarily drive many active managers’ performance. Once investors believe in factors, they tend to shop for them directly. Star stock pickers exist, and continue to pull in fees and capital aplenty. But many active managers — those delivering beta at alpha prices — have found themselves caught out. 

Following market demand, asset management firms have been cultivating new factor products and marketing existing smart-beta funds, which are run by algorithms programmed to spot securities with specific characteristics (such as low price volatility or small market capitalization) at a much lower cost than employing human beings.

Researchers identified the established factors like value and size many years ago by finding and analyzing patterns in stock market data. What’s different now — and what’s at the heart of State Street’s investable-indexes business — is the explosion of data that has occurred since. The volume available to dig into dwarfs what academics Eugene Fama and Kenneth French worked with to develop their groundbreaking three-factor model. Think geographic location data beamed from smartphones, or the product and political preference information freely given out on social media platforms like Twitter. Asset managers and academics are salivating over what new factors and insights could be waiting to be discovered. 

For Kinlaw that means indexes can also be more dynamic, with the weights of securities changing through time in an attempt to achieve more consistent performance. “What does an investor really care about? Do they care about weights? Or the stream of returns and performance they get? We think it’s the latter,” he says.

Take the firm’s new inflation-hedging index, for example. Through a partnership with PriceStats, which collects online prices to provide daily inflation updates, State Street’s index dynamically shifts between nominal Treasuries and Treasury Inflation-Protected Securities, or TIPS. Investors need to hedge against inflation, but they don’t have a lot of good options, in Kinlaw’s view. Those who simply buy and hold TIPS risk losing out on returns. On average, TIPS yield less than government bonds over time, but do well when inflation spikes. 

State Street developed its index in an attempt to predict those spikes via a big-data inflation indicator, which updates more often than government reports. The index will tilt toward TIPS as inflation starts rising, and emphasize nominal bonds when it’s expected to go down. Or that’s the plan, at least. 

Another novel addition to the product buffet captures part of the return profile of private equity. Like other custody banks, State Street does performance accounting and bookkeeping for private equity investors. With client permission, State Street’s in-house lab is analyzing the enormous amounts of data it’s gathering on private markets. It has found, for instance, that sector bets such as health care and energy make up a large component of private equity funds’ performance. So the firm built indexes to replicate those sector bets, giving investors access to part of private equity returns without locking up capital or paying private-market fees.

State Street is not the only firm betting on investable indexes. MSCI is developing similar products, and money managers can also do the research themselves. Any firm with deep enough pockets can hire experts in machine learning and neural networks to analyze the potential of thousands of new data sets arriving from Silicon Valley–funded start-ups and Fortune 500 companies alike.

But it’s expensive. Kinlaw is betting that, given the choice, managers will outsource R&D to a certain specialist of scale.

With regulatory scrutiny high and alternative-data applications in their early days, corporations the size of State Street benefit from whole departments dedicated to risk management and compliance. 

“Brand matters,” Kinlaw argues. “If you’re a big institution, are you going to adopt an interesting index developed by two guys in a garage?”