Rethinking growth: where long/short directional strategies fit in

Given the likelihood of rising rates in 2022, investors and asset allocators are taking a fresh look at how and where they’re accessing growth in their investment portfolios. We believe that performance dispersion in the financials sector, driven by technology innovation and adoption, provides opportunities for long/short directional strategies to exploit such divergences.

Tech-enabled innovation has been the primary driver of growth across many sectors. However, a promising start to innovation within the financials sector largely stalled after the 2008 global financial crisis as companies’ responses to increased regulation and scrutiny took precedence over tech adoption. Now, many financial services companies are catching up to other sectors, embracing and actively pursuing technological innovation. We believe this will result in a decades-long cycle of disruption, accelerated by the COVID-19 pandemic.

The pandemic as an accelerant to innovation

As early as October 2020, following broad COVID-19-induced lockdowns that began in March 2020, a McKinsey global survey reported that companies had accelerated the digitization of their customer services and supply chain interactions by three to four years. Many companies were surprised that the rapid rate of tech adoption was possible, but temporary solutions for dealing with lockdown demands have evolved to become the foundation for permanent and sustainable tech transformation.

From here, we believe tech adoption will continue to accelerate, driven by a new base level of consumer expectations and company-led ambitions to achieve lasting digital efficiencies. Dominant trends with particular relevance for financial services include:

• Early-stage growth in the use of big data and cloud computing
  

Financial services have lagged other sectors in the use of big data and cloud computing. From our research, we’ve identified that only 5% of banks can open a customer account online from end to end.1 Online mortgages are inexplicably still a manual process, while insurers are only beginning to apply big data to areas such as underwriting. This sets the stage for not only significant innovation but also disruption from new market entrants.

• Democratization of financial services
  

In the latest biennial research from the Federal Deposit Insurance Corporation, which partners with the U.S. Census Bureau to collect information on bank ownership, the most cited reason for not having a savings or checking account was not having enough money to meet minimum balance requirements.

Neobanks—financial technology (fintech) firms that offer apps and technology to streamline online banking—may be ideal challengers that are well placed to scoop up customers overlooked by traditional banks. Based on our research, Neobanks can acquire a customer at about a third of the cost of a traditional bank and still potentially derive the same lifetime revenue per customer.

• Payment systems, going cashless, and AI

Payment systems aren’t necessarily top of mind when consumers and investors think of digital disruption, but the institutions, instruments, processes, standards, and technologies used in payment systems are undergoing major structural shifts, some of which are being driven by new market entrants; one example of peer-to-peer payment services is Venmo. Importantly, payment systems aren’t just one thing but a myriad of disparate components, any one of which can be disrupted—and digitization plays a large role. In December, Amazon announced a ban on accepting Visa card payments from U.K. customers. Visa and Mastercard have long held a unique position in being able to set merchant rates for swipe fees, but with the emergence of Venmo—which is being added to payment options for U.S. Amazon customers in 2022—and other payment channels such as PayPal and ApplePay, disruption within this former duopoly is under way. In tandem, the very existence of physical currency is being argued with advocates and detractors on both sides. Meanwhile, artificial intelligence (AI) continues its key role in transforming and disrupting multiple segments.

There will be winners and losers in tech adoption and innovation

The widening gap between fintech companies and traditional banks able and willing to rapidly adopt technology is creating an uneven playing field where—increasingly—clear leaders and laggards will emerge.

This is readily seen in the performance dispersion within the financials sector—one of the highest among all sectors. Naturally, where dispersion exists, long/short directional strategies may thrive, investing in companies believed to be leading while shorting, or selling, perceived laggards that are expected to underperform on a relative basis. 

Dispersion in performance for financials is pronounced 

Top- vs. bottom-decile average performance, December 2002–December 2021 (%)

Source: FactSet, as of December 2021. Average performance is represented by the MSCI World Financials Index, which tracks large- and mid-cap financial stocks across developed markets. It is not possible to invest directly in an index. Past performance does not guarantee future results.

Where all roads meet: financials sector sits at the intersection of innovation and disruption

Sooner or later, almost all digital innovations intersect the financials sector. This presents unique investment opportunities; however, performance dispersion within the sector will likely persist as new technologies are introduced. This may serve as an advantage to active managers and long/short strategies in particular. With digital adoption on the fast track, we believe the next decade will consist of a near-total rewiring of the sector through changes in global payment systems, facial and voice recognition for online security of everything from bank accounts to mobile phones, digital banking, trading, and, of course, cryptocurrencies, among others. In our opinion, this presents a unique moment in time for the financials sector.