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Risk Management Key in Financial Innovation: Report

Monday, 27 Jun 2011 | 5:20 AM ET

Investors have been disappointed by popular financial innovations, including portable alpha and structured products, and current innovations, including Exchange Traded Funds, could be storing up risks for the future, according to a new report by Principal Global Investors and Citi.

Co-author Jim McCaughan, CEO at Principal Global Investors, told CNBC that even those instruments seen as innovative today could be harboring problems for tomorrow.

He argued there was a real quagmire with ETFs in particular.

“ETFs could be an issue. They started off as very positive 10 or 12 years ago, which allowed cheap data but not much else. But the way they are now being used for shorting or leverage, you get shorting of long-only ETFs and commodity ETFs. The survey respondents were ambivalent but there were some wholly positive stories too,” he said.

McCaughan added that he hoped the financial crisis had changed investors’ attitudes to risk.

While thoughtful innovation was helpful, he said, there was the risk of some new products going badly wrong.

Financial innovation is going through a transformation in the aftermath of the global financial crisis, according to the Create Research report, which examined failed innovations and those which appear to have worked and remain in use.

It also looked at emerging innovations.

“The top of the list that disappointed was leverage, structured products and the now infamous portable alpha, where there was less alpha to port than people had thought there was, partly because there was a lot of pressure to outperform their competitors,” the report’s co-author Jervis Smith, global head of the investors client executive at Citi, told CNBC.

He added that those that with the highest leverage probably had the greatest regrets.

The survey revealed that over the last decade, emerging markets delivered the most returns for investors.

The principles of risk management and more solution-focused products were revealed as key to investors in the survey.

“Necessity should be the mother of innovation, not commercial profits, and that’s what this report says: that risk management is very important,” Smith said.

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