Asset Managers: Time to Account for Technology in Your Allocation Strategy

Six years ago, investor David Teten wrote an article that I liked a lot: Asset Management Is a Peculiar Industry Ripe for Disruption. Since then, however, I have gotten to know this “peculiar industry” a bit better, and I can’t really say that the disruption has happened. Sure, professionals use new tools and methods. And, as suggested by BlackRock’s Larry Fink’s tough stance on climate change, the industry is able to spot macro-trends and act on them. But we’re still waiting for clear signals that asset managers are able to account for the current shift from the 20th-century Fordist Age to today’s Entrepreneurial Age—and to draw conclusions where it matters most, in their allocation strategy.

Those who know their economic history realize that the current “global savings glut” can be explained by this very paradigm shift. Asset managers are still relying on allocation strategies designed for the old paradigm, but there are fewer and fewer assets in which they can deploy capital effectively. Meanwhile, the new paradigm is giving birth to a new breed of companies and assets that clearly generate returns, but that are also often misunderstood and inaccessible for the majority of asset managers.

The result is many mismatches between the needs of economic agents and the resources made available to them. You can spot these at both extremities of the value chain:

• At the bottom, both households and businesses have new needs that are not met by traditional players. To take just one example, that of tech companies, bank loans are inadequate because tech businesses are driven by increasing returns to scale and thus more prone to failure; public equity is inadequate because the barriers to entry for an IPO have become so high; and traditional private equity is inadequate because you simply can’t cost-cut your way to thriving in the Entrepreneurial Age. Only venture capital works for financing tech companies, but as an asset class it doesn’t carry much weight in allocation strategies.
• At the top, you can feel the impatience and irritation of capital owners as they look at the high fees and poor performance of most asset managers. In particular, those with a lot of capital to deploy wonder why they aren’t participating in the returns feast that tech companies seem to enable. This is why Goldman Sachs is making inroads in venture capital, mutual funds are participating in venture rounds, and family offices are investing directly in tech startups. It’s the asset managers’ job to take large chunks of capital into their custody and allocate it downstream where they generate the most returns. They should be able to catch up, but they aren’t.

Simply allocating a bit more to venture capital won’t quite do the trick—and it’s not that easy anyway. There are different problems at play here:

• First, there are prerequisites for venture capital to work. Contrary to what its name suggests, this segment of financial services is not about taking too many risks. Rather, it’s about taking just a few with the backing of powerful allies: the state, which contributes to fostering research in cutting-edge technology up the stream, and financial markets, which provide liquidity down the stream. Without state-sponsored research as an input and many IPOs as an output, it’s difficult for venture capital firms to position themselves and generate returns. And, despite a transient influx of tech IPOs this year, the situation has not been improving on either front recently. 
• Second, returns in venture capital are extremely concentrated. As first documented by Bill Janeway, top performances are concentrated in a few firms only, a phenomenon that reflects the importance of increasing returns to scale. As winners take most in the Entrepreneurial Age, only a few venture capital firms, mostly US-based, are able to reap the rewards. More recently, Ahmad M. Butt, of Jetstone Asset Management, has assessed that the value of a managing partner is a better predictor of performance than that of the firm as an organization. For asset managers, it’s not enough to track VC firms—you need to track individual partners, too!
• Third, the tech space is becoming more fragmented. The pace of technological change is different from one industry to the other, depending on the presence of tangible assets and the weight of regulations. Also, as recently as four years ago, it was still common to think that the digital economy would be dominated by just a few global players. But with Western tech companies having deserted the Chinese market, the difficulties that those same companies are currently facing in India, and a growing rift between the US and Europe when it comes to trade and regulations, there is no such thing as a global digital economy anymore. And just wait for the rise of tech giants in Southeast Asia, the Middle East—and, one day, Africa!

Above all, the current paradigm shift has critical consequences across asset classes. Again, it’s not only about allocating more capital to tech companies via funds and funds of funds. Revisiting your allocation strategy is also about reflecting on how software eating the world has an impact on every asset class:

• Public Equities—As IPOs are getting scarcer, public equity markets might not be enough to gain exposure to tech companies. Adding to the difficulty is the divide between US and Chinese tech equities (with more IPOs happening in China). Non-tech stocks are impacted by the paradigm shift, too: there are those, like Disney or Goldman Sachs, who have managed to reposition in a shifting landscape, and many others that are being badly hit by the rise of new entrants. And don’t forget the looming crisis in value investing: these days it’s all about growth stocks over income stocks and value stocks. The entire market is getting an education in venture capital.
• Fixed Income—Tech companies now dominating the economy doesn’t mean that there’s no room for corporate debt anymore. On the contrary, there are many large tech companies that rely on the bond market to access capital—including Apple, Netflix, Amazon (back in the day), and WeWork. Some tech companies even have so much cash on their hands that they themselves hold many bonds on their balance sheet. Finally, don’t forget that marketplaces for peer-to-peer lending have been relying more and more on securitization and that, in turn, venture capital firms are getting more interested in lending money (see an example here). 
• Currencies—There are two trends at work here. The first is the migrating of payments toward new infrastructures such as Alipay, WeChat, and, maybe sometime soon, Libra. In the future, the relative strength of currencies will have to be assessed based on the strength of the network effects driving those infrastructures. If network effects are stronger on Chinese payment infrastructures than on Libra, it will tell you something as to the balance of power between the dollar and the renminbi—and that should be accounted for by asset managers. The other trend, obviously, is the rise of crypto protocols and crypto assets. For that, you can read more here.
• Private Equity—For decades, buyout firms got used to investing in targets securely positioned in their value chain. They could count on steady dividends because their targets had a moat: their control of strategic assets. But now that software is eating the world, PE firms have to upgrade their decision-making and learn to invest in an unusual manner: either in tech companies that have already taken today’s best positions, or in traditional companies that will have to radically reposition, thus endangering their profitability in the process. This changes the nature of the game for asset managers as they consider investing in private equity funds.
• Hedge Funds—Matt Levine recently discussed the idea that hedge funds are an asset class. Let’s just assume that’s the case and reflect on the impact on allocation in the context of the paradigm shift. There are two things happening here. One is that venture capital firms are becoming more like hedge funds as they diversify their approach to deploying capital. The other thing is that hedge funds have a major problem: they’re stuck on public markets, and more and more that is tech-related is happening elsewhere—or it unfolds over periods of time that are too long to make a long/short strategy sustainable. And you can’t really short a private company.
• Real Estate—On this front, one thing is certain: urban real estate is bound to yield ever higher returns as the current paradigm shift concentrates the population in dense cities—unless, of course, the suffering that it inflicts on the population leads politicians to enact stupid, ineffective short-term measures such as California’s statewide rent control. But allocators should also pay attention to the financialization of real estate through innovative financial engineering like that being performed by Point, Divvy, or Virgil in France. It provides investors with an opportunity for exposure to more diverse locations, thus reducing correlation in their portfolio.
• Commodities—Not much to say here, except for three things. First, as in every period of radical uncertainty, gold is obviously worth considering. Second, what historian Niall Ferguson calls the “Second Cold War”, between the US and China, will have a profound impact on certain critical commodities such as rare-earth metals—especially now that China wants to secure its independence in the semiconductor industry. Third, technology brings visibility and transparency to every value chain, reducing the room for arbitrage—and this will certainly happen, albeit with a certain delay, in the commodities industry as well.

So, what's the future of capital allocation in the Entrepreneurial Age? If you work in asset management and are asking yourself the same questions, we’d like to hear from you!