In the third of a series of articles based on a new study*, Amin Rajan and Jervis Smith highlight the ascendancy of third-party administrators
In hindsight, the 2000-3 equity crash was a defining moment in global asset management. It set off a chain reaction whose impacts were hard to foresee at the time.
As millions lost billions, the old ways of investing fell into dispute. People discovered that relative returns couldn't buy groceries in a bear market. Nor could the hype of equity risk premium and benchmark hugging stop a severe shortfall in defined benefit pension plans worldwide.
So, they switched from relative to absolute returns. This decisive shift coincided with the most benign conditions in credit markets in living memory, until the sub prime debacle in summer 2007.
Although its impact on global markets are unpredictable, one thing is clear. Every region in the world has experienced an explosive growth in absolute return strategies, led by hedge funds and private equity. The growth in structured products - like collateralised debt obligations (CDOs), collateralised loan obligations (CLOs), asset backed securities (ABS) and structured investment vehicles (SIVs) - has been even more striking.
These vehicles are not only traded in their own right. They are also providing the building blocks required by the newly minted ‘go anywhere' type strategies in the long only space.
In the meantime, the worldwide search for alpha has intensified the use of leverage, shorting and derivatives. Chasing alpha with the conventional tools is now akin to looking for a needle in a haystack.
As a result, the product mix of those asset managers with global footprints has changed radically, according to a new study sponsored jointly by Citi*. It shows that, from an insignificant base in 2003, alternatives and structured products now jointly account for 17% of their AUM of $28trn (figure 1).
This phenomenal growth, in turn, has transformed the nature of the relationship between asset managers and administrators, whose old image as commodity merchants doing nickel & dime business is now confined to the dustbin of history.
Nearly one in every two asset managers regard a state-of-the-art infrastructure as one of the top five drivers of value creation in the brave new world of absolute returns. They increasingly see their administrators as strategic partners adding value in three areas of the asset business.
The first of these concerns operational excellence. Under the new outsourcing deals, back office functions - like clearing, settlements, custody, asset servicing - are being increasingly delivered through a single hub at close proximity to clients. Each hub is designed to be a centre of expertise that is capable of generating scale economies in functions as varied as income collection, asset reporting, corporate actions, proxy voting and securities pricing.
The last function is especially important. Institutional clients now insist on independent valuation of new instruments that cannot be marked-to-market if they are either too illiquid or over reliant on derivatives. Where independent pricing is difficult, administrators are enjoined to validate what is done by prime brokers or external specialists.
Either way, administrators now play a distinct role in ensuring the back office is seamlessly aligned to the front in hot pursuit of alpha.
The second area of value creation concerns operating leverage. The most significant globalisation of fund business has come in two overlapping waves since the early 1990s.
The first one was sparked off by large cross border acquisitions that opened up the fast growing markets in the Americas, Europe and Asia-Pacific. In contrast, the second wave, starting this decade, has witnessed the widespread creation of new manufacturing and distribution capabilities, especially in Europe and Asia-Pacific.
In both waves, creating a scalable business model has proved illusive for two in every three global houses: their cost-income ratio has risen despite a headlong growth in clients and assets in a rising market (figure 2).
The underlying causes are varied. The relative newness of the businesses is one of them. Lack of integration capability is another. But the chief one is the standalone nature of the overseas businesses. Currently, most are deliberately run as independent entrepreneurial boutiques with the mission to outperform their competitors.
The downside, as an unintended consequence, is potential synergies in the front, middle and back offices across the newly created boutiques have proved hard to harness. Back office outsourcing, using local hubs, is now being used as one of the principal avenues of integrating a variety of processes via scalable platforms. It is treated as a means to correct the fault lines created by globalisation and its associated complexity.
The final area where administrators are adding value relates to product innovation.
Having started in the back office, administrators are increasingly carving up a niche in the middle office as well by venturing into vendor management, trade reconciliations, performance reporting, performance attribution analysis, data management, complex analytics and simulation models.
These are generating numerous functionalities that support product innovation in the front office, while assuring product integrity in the middle office. They aim to accelerate innovation as well as time-to-market, especially at a time when asset managers need to be especially mindful of the ‘fat tail risk'.
On their part, administrators know full well that their credibility as strategic partners in the fast changing investment food chain critically depends on the quality of what they deliver, not what they promise.
Accordingly, some have started to implement company-wide quality improvements programs, using internationally recognised accreditation tools like Six Sigma and ISO 9000. Lessons are also being learned from quality icons such as GE and Proctor & Gamble.
Thus, as investors are stepping up their demand for alpha, backed by appropriate checks and balances, administrators are gearing up for front-to-back service offerings in ways that are changing the face of their industry beyond recognition.
*Globalisation of Funds: Challenges and Opportunities. Available free from www.create-research.co.uk
Prof. Rajan is CEO of CREATE-Research and Jervis Smith is managing director, financial institutions group, head of international managed funds and Middle East at Citi.