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Innovation?

 Salomons Judgement

Is the financial world innovating or is only the surface being refreshed? Fintech and smart indexes show that innovation is also possible without creating a completely new model.

Recently, I was a member of a jury judging a pitch for start-ups that were looking for new capital. I heard a lot of fintech, including adding a starting asset manager and a new insurer. No completely new models, but smart use of technology to lower the threshold of a not very accessible market. In my opinion, this is not really innovation, but more of a pleasant disruption. Nice profit margins and interesting business models. In both cases without much extra supervision, but we’ll come to that some other time. What I would like to discuss now is innovation in the financial world.

Does it exist? I talked to a colleague about this and soon we entered into a discussion on factor investing. Let’s check up on it in the academic literature on this topic. In the beginning, the beta of the share determined the risk and the expected return in a CAPM Model. In the time that I went to university, the investment theory was quite clear. Two extra factors were widely accepted. Smaller companies and low-cost companies were also found to explain the return as a factor within shares. In the nineties, the momentum effect was added to this: the trend is your friend.

Since then, the academic and financial worlds have not been sitting idle. In a recent article, Campbell Harvey discusses over 300 different factors that have now been tested and all lead to better investment results. I won’t go into much detail here, but let’s say that some scepticism towards the positive results is justified, and that a theoretical basis might be lacking. One of my first lessons at university was that everything can be proven. Data are willing in the hands of a quant with a fast computer.

For academics probably less important, but for practitioners it’s crucial to know whether a strategy is implementable. Because that is where the innovation is. Years ago, I argued that the rise of the index funds was fantastic. It reduced the costs for private investors, while institutional investors got the opportunity to obtain some low-cost exposure towards a market index. The emergence of the smart index enables a better management of the factors that drive long-term profits. Breaking up returns by underlying factors also enables a serious evaluation of the asset managers. Does the portfolio manager practice what he preaches? Does he really beat the market index? Does he have a positive alpha? Or does he simply have more exposure towards the small or undervalued companies? Does any alpha remain after adjustment?

Can this be called innovation? I don’t know. Many of the factors mentioned are now available at low cost as aproduct in their most pure form or in a combination, as a smart index. I have my reservations towards a number of products, as there is no consensus on all 300 factors. The low-cost provision of factors on which consensus does exist, however, can certainly be considered as innovative. Not a completely new model, but a smart use of technology that makes a market accessible. A pleasant disruption.

The author

Roelof Salomons

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