Looking beyond the 3Ps
Investment managers will have their work cut out over the next year. If they want to keep abreast of market and regulatory developments they need to make significant changes to the systems and processes that support their businesses. Institutional clients have more expertise than ever before – and they are looking beyond ‘performance, process and people’ when making manager selection decisions.
They are demanding significant improvements to the whole client service experience and more complex investment products. They want to know if their portfolios are being managed efficiently.
And the regulators are supporting this new environment, driving towards a greater degree of transparency in financial markets and in the information clients receive about the trading costs within their portfolios. All this requires investment managers to have the right systems and operational processes. It could be a real headache for a chief operating officer. But it is something of which they are aware and they are rising to meet these new challenges. We know; we asked them.
Institutional clients want to see more, know more and understand more about their funds. We live in an information-rich age. Technological advancements mean clients can now access a wealth of information about financial markets directly and at a low cost.
This is raising clients’ expectations of the added value that should be delivered by investment managers.
Over the past 10 years, the institutional investment industry has shifted from a single-manager, multi-asset model to multiple ‘best-of-breed’ managers. Because of this, clients are now experiencing a wider range of client servicing. And there is a great disparity between best and worst practice.
Performance, while still an important reason for hiring a manager, isn’t everything – some managers retain clients during periods of poor performance through superior client service and communication.
Client management is the end product of several areas of investment managers’ businesses – sales and marketing, client relationship, client reporting, performance and attribution, and so on. All these areas work to different priorities and with different systems. It is a fragmented process and clients can often see the joins.
Nothing illustrates this better than the approach taken by investment firms when they action requests from their clients such as changing the benchmark for a fund. When the benchmark for a fund is changed, many different areas of a firm are affected. Most firms do not take a co-ordinated approach to managing the change by assessing the impact of the change, drawing up an implementation plan and assigning responsibilities to ensure all aspects of the change are delivered successfully.
Investment managers are working to improve the way they manage their clients, but they need to adopt a holistic approach. Managers should appoint one person to oversee the whole process. Those managers who have outsourced any part of their back office should review their service level agreements to ensure there is no detrimental impact on the client-management process.
Many institutional clients want a closer match between their assets and liabilities than traditional asset allocations can deliver. Liability-driven investment (LDI) using derivative instruments is one of the industry’s current hot topics, although there is some debate whether LDI is a trend that might disappear as quickly as it appeared. Whether LDI is a fad or not, (or a profitable product for investment managers to offer) it is a product in demand.
Investment managers have not yet got to grips with the downstream system and operational implications of using derivatives in client portfolios. Integration is rare. Derivatives are often treated as an individual portfolio rather than as part of the overall investment.
Accurate reporting of derivatives requires extensive change across a whole range of systems, from front to back office. Derivatives also require strong administration support. Because there may be no exchange of money at the start of a derivative contract, there is often no physical settlement event to test everything has been set up properly. Investment managers need to put additional procedures in place to track those derivative contracts in place.
There is a rapid rate of growth in usage of derivatives, yet implementing a large-scale derivatives project can take up to two years to complete. Asset managers need to plan for the changes they need to make to both systems and administration processes.
Regulators in the UK, continental Europe and the US want greater transparency in financial markets, as demonstrated by the Markets in Financial Instruments Directive (MiFID) in the EU and in the UK and Reg NMS in the US.
MiFID is a piece of EU legislation designed to improve cross-border trading and provision of financial services and although it has been a popular topic in the financial press for the past six months it is still not widely understood and there is low awareness among buy-side firms. All firms who undertake investment business – including investment management companies – have to comply with MiFID by November 2007.
But if they don’t have to be compliant until November 2007 and the FSA is not publishing the UK regulations until January 2007, why is MiFID a major priority for investment management firms?
Becoming compliant is a process that will touch many areas of a firm – and become more expensive if left to the last minute. MiFID covers so many areas of the business: risk management, outsourcing arrangements, record-keeping, client management, client reporting, client order handling, best execution, data warehousing, trade reporting and publication. It is a long list. Most of our investment management clients ranked MiFID as a top priority for 2006. Investment managers need to plan the necessary projects and budget now in order to become compliant by November 2007.
The regulatory push to make financial markets more transparent has also changed the way investment managers buy research. Prior to unbundling of commission legislation in January this year (managers now have to separate the cost of trade execution from the cost of research paid for by trade commissions) investment managers paid commission to brokers to make trades within client portfolios – remember, this is something the clients paid for, not the managers.
However, this did not just cover execution, it also paid for research from the same broker. And ‘research’ does not just mean EPS, profit growth forecasts or other company valuation metrics. It also covers written company research (the importance of which is often downplayed by investment managers), access to analysts, bespoke research and other financial models.
The unbundling of commission legislation means that investment managers now have to separate the amount paid for trade execution from the amount paid for research So, if clients are paying for the research, managers will have to prove the value of that research to each client by establishing whether it added (at least) the same amount of value to that client’s portfolio. And this is something that clients will be asking their investment managers.
The UK’s National Association of Pension Funds has given its members 14 points to raise with their managers, one being ‘please list the services paid for by commissions… and explain how you evaluate the benefit these generate for us relative to the costs incurred’.
Investment managers need to be able to prove the value of the research they receive paid for by client portfolios. To do this they need new processes to decide how much they want to pay for research. Currently, it is a simple analyst vote, with little evidence for added value.
Managers need to renegotiate with brokers; it is likely that they will want to pay less, or pay for less research. They may also want to put in place commission sharing agreements, where one broker executes the trade while another provides research and shares the commission. This will help ensure managers receive the best execution and research that adds the best value.
There is increased focus by both investment managers’ clients and the regulators on what happens behind portfolio performance. Clients expect serious improvements to the service they receive and want more complex products that many investment managers are working hard to develop and support. The regulators are demanding greater transparency in markets and client portfolios. All of these need different administrative processes, IT and other project work. Investment managers have a busy year ahead.
Catherine Doherty is a principal at Investit, based in London