Dispatch №8

The wealth technology sector is reaching a key point of maturity. Equity funding to wealth tech startups hit a new record of $18.9B in 2021, nearly tripling that of 2020. That funding is now being put to use in tech-driven marketplaces, artificial intelligence, and blockchain, driving innovation in areas like capital markets and asset management that are burdened with inefficient legacy systems.

Topic of the week.
The Future of Investing

How technology is reshaping wealth and asset management

Global assets under management (AUM) — the total value of retail and institutional investments held by financial institutions — reached $112T at the end of 2021, according to BCG. For context, that’s 117% of the World Bank’s estimate of 2021 global GDP.

How that $112T is invested has a significant impact on how individuals build wealth and save for retirement. It also affects how institutional investors — and, at a larger scale, the biggest financial services organizations — operate.

Meanwhile, public markets recently fell to a new low in 2022, with the S&P 500 down more than 20% at the end of September since its peak at the beginning of the year. With struggling stocks, interest rate hikes, inflation, and recession fears, both retail and institutional investors are grasping for new ways to generate returns.

The future of investing creates opportunities for the largest financial institutions in the world, including investment banks (JP Morgan, Goldman Sachs), investment management firms (Blackstone, State Street), asset managers (BlackRock, Fidelity), private equity firms (KKR), and private companies looking to raise capital.

These financial incumbents are partnering with and investing in fintechs at the forefront of investing’s evolution, including alternatives marketplaces like iCapital Network, sustainability and ESG reporting platforms like Clarity AI, and tokenization platforms like Securitize.

The traditional investment portfolio of 60% stocks and 40% bonds may become a thing of the past. Disappointing performance of public stocks, rising inflation, and interest rate hikes pressuring the economy are all giving rise to alternative investment strategies. These include a wide range of assets, from private equity to real estate to art.

Alternative investments

Alternative investments bring opportunities for enhanced returns compared to investing in stocks and bonds alone. Alternative investing is any investment opportunity in assets beyond traditional stocks, bonds, and cash. These include private equity, private credit, venture capital, hedge funds, real estate, land, commodities, art, wine, collectibles, and cryptocurrency. Alternatives are typically illiquid, meaning they’re more difficult to buy, sell, or convert into cash. They’re also deemed riskier than traditional investments. It’s harder to get out of an illiquid investment when its value is depreciating.

As such, assets under management (AUM) in alternatives are expected to rise from $13T in 2021 up to $23T by 2026, according to forecasts from Preqin.

Alternative investments have historically been reserved for institutions, as alternative asset managers targeted those who could write the biggest checks. Pension funds, endowments, and large institutions can afford the $20M+ minimum investment requirements. But that’s now starting to change as tech companies look to the retail market, opening up opportunities to wealth managers, advisors, and even consumers.

Private market alternatives including private equity, venture capital, hedge funds, and certain real estate are considered especially risky. Private companies have a high rate of failure and the real estate market has historically been difficult to predict. Due to the higher levels of risk, the SEC only permits institutional and accredited investors to invest in private markets. That said, private markets represent the largest share of alternative investment dollars by far — the higher the risk, the higher the reward.

Endowments (e.g., universities) and ultra-high-net-worth individuals allocated about half of their investments to private market alternatives at the end of 2020, according to a study by KKR. The average retail investor on the other hand, only allocated about 2% to private markets, per McKinsey. But that gap is slowly starting to close. McKinsey predicts that between 2020 and 2025, the growth in alternative investments from retail investors could be between $500B and $1.3T, representing 3% to 5% share.

Implications

Unlocking private market alternatives for financial advisors, wealth managers, and their wealthy clients will create a new retail market worth hundreds of billions in AUM.
Alternative investing will allow individual investors to diversify portfolios outside of public stocks and bonds, which cost US households $9T in losses in H1’22.
Alternatives will challenge the traditional retirement account, changing what it means to save for retirement. Startups and even some legacy providers (e.g., Fidelity with Bitcoin) are offering crypto, real estate, art, and more.

ESG powered by AI

ESG in investing brings together the worlds of financial markets and environmental sustainability. ESG-mandated assets are projected to account for half of all professionally managed assets globally by 2024, according to Deloitte.

Some of the most common applications of ESG in investing are mutual funds and exchange-traded funds (ETFs). Across the globe, there are now over 1,200 ESG ETFs, according to counts by Trackinsight.

But the current state of ESG is flawed. ESG data and ratings will have to evolve with advances in technology in order to have a tangible impact in the years to come. While ESG is often an instrumental part of socially responsible and impact investing, they’re not the same things. ESG is more of a framework to identify opportunities and mitigate financial risk of companies and investments. It doesn’t necessarily have to be a vehicle for enacting good in the world. ESG ratings are used by investors and fund managers to select companies that are better positioned against climate and social risks, with the ultimate goal of generating higher returns.

For ESG ratings to have a real impact on the future of investing, they must overcome 2 key flaws. ESG data and ratings are:

inconsistent (i.e., not standardized), and
incomplete (i.e., lacking comprehensive data).

Both of those factors have cascading effects on the legitimacy of the space. Corporate greenwashing — exaggerating claims of environmental sustainability through marketing and advertising — is very much present today. And studies measuring ESG’s impacts on the financial performance of investments and companies have seen mixed results.

The first flaw of having inconsistent ratings and reporting will eventually be solved with regulation. There have been multiple proposals on ESG disclosures from the SEC in the US, along with concrete laws already in place in Europe (e.g., the EU’s Sustainable Finance Disclosure Regulation). It may take time, but more regulation will lead to standardized ESG disclosures and ratings, ultimately providing more transparent and trusted information for investors.

The second problem of incomplete data, ratings, and information will be addressed with advances in artificial intelligence. Established financial data and intelligence firms, as well as dedicated ESG ratings and analytics fintechs, are leveraging machine learning and natural language processing (NLP) to collect, structure, and analyze ESG data at scale. AI solutions will be critical to the accuracy of ESG ratings moving forward and to the funds that use them.

AI improves the volume, speed, and accuracy of ESG ratings at 2 key steps in the ratings process: 1) data collection; and 2) data analysis and scoring.

During data collection, machine learning algorithms train computers to identify and extract ESG-related data and information from thousands of sources, including company disclosures, news and media, questionnaires, academic studies, government sources, NGOs, and more. Natural language processing is used to pull company information from the text of unstructured sources, like transcripts and social media.

Machine learning and natural language processing are also used to power ESG analysis and scoring models. The models are trained using years’ worth of historical data.

MSCI, S&P, and Bloomberg are all using AI to tackle the problem of incomplete ESG data and ratings. Each provider covers thousands of companies and hundreds of thousands of securities:

MSCI uses machine learning and NLP for data collection and validation, allowing its ratings, indexes, and research to leverage alternative data outside of voluntary company disclosures.
Similarly, S&P uses Databricks Lakehouse to process billions of ESG data points and run machine learning models to derive insights for customers.
In October 2022, Bloomberg announced it’s using machine learning smart models and estimates to increase its carbon emissions dataset to cover 100,000 companies.

Fintechs specializing in ESG and sustainability assessments are challenging legacy data providers with their focus on AI and scalability. For instance, Clarity AI uses machine learning to analyze over 2M data points for ESG ratings, risk assessments, carbon footprints, net-zero analysis, and regulatory compliance. The platform covers over 30,000 companies and 300,000 funds, which it claims is more than triple those of most competitors.

EcoVadis, a provider of business sustainability ratings, raised a $500M Series D in June 2022 at a $1B valuation, with plans to use the funding to deepen its AI and machine learning capabilities. EcoVadis serves businesses that want their own sustainability assessments, as well supply chain enterprises, private equity firms, banks, and other financial institutions that need ESG assessments of companies and portfolios. The platform covers over 100,000 companies across 200 different industries.

To get ahead of disruption, some incumbents have been quick to acquire ESG-focused fintechs powered by AI. The London Stock Exchange acquired Refinitiv in 2019 for $27B, and Morningstar acquired Sustainalytics in 2020. Both Refinitiv and Sustainalytics use NLP engines to extract ESG information from 1M+ news articles each day for sentiment analysis.

Implications

ESG ratings providers leveraging artificial intelligence will solve ESG’s incomplete data problem. Machine learning and NLP can extract and structure ESG information from thousands of siloed data sources at scale.
While regulation will make ESG reporting more transparent and standardized, machine learning and NLP will make ESG ratings more accurate. AI’s impact on both the volume and variety of data will lead to more trusted and thus accepted indicators for valuing companies and assessing risk.
Once ESG data and ratings become consistent and complete, it will be easier to more accurately test ESG’s impact on investment returns and company performance.

Asset tokenization

Global capital markets soared in 2021, with both fixed income markets (e.g., bonds) and global equities reaching all-time highs, according to the Securities Industry and Financial Markets Association (SIMA).

But the ways securities are issued and traded are inefficient. Legacy systems result in too many intermediaries, expensive issuances, slow settlement times, and vulnerabilities to market manipulation and money laundering.

Asset tokenization through blockchain technology can potentially create a more efficient system. It will take time to transition, but some of the biggest players in finance, like Goldman Sachs and JP Morgan, are already experimenting with the technology.

Asset tokenization is the process of converting physical or digital assets into digital tokens. These tokens are issued, tracked, and traded on a blockchain network. Anything that has value can be tokenized, including securities, real estate, commodities, art, physical goods, collectibles, and intellectual property. There are 2 types of tokens: fungible tokens that are interchangeable, most often representing divisible shares (e.g., securities); and non-fungible tokens (NFTs) that are wholly unique, often representing the ownership of physical assets (e.g., art and collectibles) or deriving value themselves as rare digital assets.

According to interviews with blockchain executives conducted by Blockdata, tokenizing securities (e.g., stocks, bonds, options, etc.) has the potential to transform capital markets infrastructure in 5 key ways:

Limiting dependence on multiple intermediaries.
Reducing costs of issuance and trading compared to traditional securitization.
Reducing settlement times for central securities depositories (CSDs) & securities settlement systems.
Combining separate processes in the securities lifecycle.
Enabling alternative forms of finance for all types of organizations at a global scale.

Asset tokenization can also unlock liquidity for previously illiquid alternative assets. These include real estate, natural resources, public infrastructure, art, private equity, private credit, and more. The total market size of tokenized illiquid assets could reach $16T by 2030, or 10% of global GDP, according to research by BCG and ADDX.

Blockchain companies are working on asset tokenization efforts within each stage of the capital markets ecosystem, from tokenization and issuance to primary and secondary trading to post-trade settlement and custody.

For example, Securitize is an all-in-one platform for issuing, managing, and trading digital asset securities. The company offers security tokenization and issuance, primary market trading for institutional investors, secondary market trading for individual investors, and a menu of tokenized funds. Securitize has already worked with over 200 issuers.

In September 2022, Securitize launched a tokenized fund providing exposure to KKR’s Health Care Strategic Growth Fund II (“HCSG II”). This fund’s launch was a breakthrough in the space for 2 reasons: it brings a colossal player in traditional private equity and real estate into the fold of asset tokenization, and it gives broader access to a private market fund typically reserved for institutional investors and the ultra-wealthy.

A number of other startups are developing asset tokenization technology:

ADDX offers asset tokenization, issuance, and investment opportunities in private markets. The platform serves companies looking to raise capital in the form of private funds, private equity, and private debt, as well as accredited and institutional investors who wish to invest.
Tokeny Solutions focuses on the infrastructure side of asset tokenization, offering a platform to issue, manage, and transfer security tokens. Since it launched in 2017, the company has tokenized $28B-worth of assets.
Digital Asset is the company behind Daml, a platform for building and running multi-party applications using smart contracts and distributed ledger technology (i.e., blockchain). Daml supports tokenizing stocks, bonds, structured products, private equity, commodities, carbon credits, and more.

Traditional financial powerhouses are also making waves in asset tokenization. Goldman Sachs used Digital Asset’s Daml to develop its own end-to-end asset tokenization infrastructure. Now, Goldman Sachs is exploring tokenizing real-world assets through NFTs.

Meanwhile, in May 2022, the Monetary Authority of Singapore announced a pilot with JP Morgan and DBS Bank to tokenize bonds and deposits for blockchain-based borrowing and lending via smart contracts. In other words, the project is exploring decentralized finance (DeFi). DeFi is an ecosystem of smart contracts (computer programs coded by developers) that allows participants to access financial services like trading, lending, and borrowing in a peer-to-peer format, without relying on traditional intermediaries like banks, credit unions, or brokerages.

In June 2022, JP Morgan’s head of Onyx Digital Assets shared plans for tokenizing trillions of dollars in US Treasury securities and money market fund shares to bring them into DeFi.

Implications

Asset tokenization will increase efficiency in capital markets by lowering security issuance costs, eliminating reliance on third-parties, and reducing settlement times, all while ensuring transparency and tracking on a blockchain network.
Tokenization unlocks liquidity for illiquid assets. Private markets will become more accessible to individual investors with tokenized funds, and anything with value (e.g., real estate, land, and physical goods) can become an investable and tradable asset through tokenization.
Tokenized securities and funds will bring exponentially more capital into permissioned, compliant DeFi markets for institutional lending, borrowing, and trading.

Looking ahead

The future of investing can be broken down into 2 fundamental outcomes. The first is new investment opportunities for retail and accredited investors. These include private market investments, sustainable investing, and previously illiquid assets.

The second outcome is improved markets. Alternative investments can break the handcuffs limiting retail markets to stocks and bonds. ESG ratings powered by AI can enable more informed financial risk management, and asset tokenization can lead to more efficient issuances and trading in capital markets.

Innovation won’t come without hurdles. Retail investors and their financial advisors need to be convinced that alternatives are worth the risks. The future of ESG will be tied to regulatory clarity from governments, as corporate greenwashing isn’t effectively being deterred today. And the fragmented global financial system can’t switch to blockchain overnight. Financial institutions need to be on board with tokenization, and even the ones that are today are only using it experimentally.

The barriers may point to a long road ahead, but the fact that legacy financial players are making moves now — at the very same time that fintech platforms are maturing — are promising indicators of where investing is headed.

Links to consider

Infographics

Quotes

Books that caught our attention this week

How to Build a High-Performing Single-Family Office: Guidelines for Family Members and Senior Executives

by Robert C. Daugherty and Russ Alan Prince

Family offices are garnering tremendous attention from successful families the world over. They are increasingly seen as the best way for these families to manage their wealth, deal with a wide array of non-financial issues and concerns, and help ensure their affluence transfers efficaciously to future generations. More and more, family offices are perceived as the way these families can get superior results. They are being chosen over more traditional competitors such as private banks, wealth managers, law firms, and accounting firms.

Publisher: ‎Gatekeeper Press (February 19, 2021)

Language: ‎English

Hardcover: ‎174 pages

Amazon

The Myth of the Silver Spoon: Navigating Family Wealth and Creating an Impactful Life

by Kristin Keffeler

The next generation within wealthy families are often said to be born with a silver spoon in their mouths. Perceived as free from life’s toughest challenges. “Having it all.” But being raised in affluence brings a unique set of pressures and hidden tripwires. Great wealth casts a long shadow. Inheritors commonly face intense familial expectations, public scrutiny and judgment, and confusing or debilitating self-narratives, under which many flounder. And we—as family, friends, and society—slowly lose their contribution to our lives and the common good. The Myth of the Silver Spoon helps guide the next gen of the affluent, their families, and the ecosystem of professionals who influence them—wealth advisors, estate attorneys, tax attorneys, philanthropic advisors, family office professionals, and career coaches—to identify and confront negative thinking and behaviors related to wealth.

Publisher: ‎Wiley; 1st edition (November 22, 2022)

Language: ‎English

Hardcover: ‎256 pages

Amazon

Photos

Diego Maradona’s ‘Hand of God’ ball has attracted a top bid of £2 million ($2.4 million) at auction, but failed to reach a reserve as negotiations with interested parties and the seller over its sale continue. The buyer has not been disclosed.

Argentina captain Maradona scored two unforgettable goals in the quarter-final of the 1986 World Cup to beat England at Estadio Azteca in Mexico City. Maradona controversially punched the opener beyond England goalkeeper Peter Shilton – which the referee allowed to stand – before scoring a superb individual effort, later voted ‘Goal of the Century’. The Argentina playmaker, who died aged 60 in November 2020, claimed his contentious opening goal was scored “a little with the head of Maradona and a little with the hand of God”. England were knocked out of the tournament after losing 2-1, with Argentina going on to become world champions following victory over West Germany in the final.

Tunisian referee Ali Bin Nasser, who took charge of the tie, owned the ball, which was included as one of more than 300 lots put up for sale by Graham Budd Auctions on Wednesday, with the initial estimate having been between £2.5m and £3m. The bidding started at £1.4m and eventually reached £2m when the hammer went down. However, it is understood a reserve was not met, so negotiations are continuing between the seller and interested parties, with an agreement fully expected to be reached.

Maradona’s shirt from the match, which belonged to England midfielder Steve Hodge, fetched a record-breaking £7.1m at auction in May, having only been expected to achieve around £4m.

Ahead of the auction, Bin Nasser said he felt it was the right time to share the item with the world and expressed hope the buyer would put it on public display.

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