In the final article in the current series, Jervis Smith and Amin Rajan highlight the role of third-party administrators as innovation partners
Last summer, funding ratios plunged into the red zone yet again, as the sovereign debt crisis wreaked havoc on asset values. Plan sponsors operating under mark-to-market rules also took a hit on their balance sheets directly and their share prices indirectly.
Anticipating just such collateral damage when the rules were first adopted in the mid-2000s, asset managers have been obliged to use a variety of tools that ensure that their good returns persist from one year to the next, operational excellence being one of them.
Not only does it create the right environment in which the chances of replicating the past high returns are increased. It also reduces costs that are a source of out-performance over time. Not surprisingly, operational excellence now features strongly when pension plans award fresh mandates, according to the Citi/Principal/CREATE 2011 global survey entitled ‘Investment Innovations’*.
In the beginning
In hindsight, the 2000-03 equity crash was a turning point. It set off a chain reaction whose impacts were hard to foresee at the time. As millions lost billions, they switched from relative to absolute returns, intensifying the search for alpha and the attendant use of leverage, shorting and derivatives. Without them, chasing alpha was akin to looking for a needle in a haystack.
In any event, the switch transformed the nature of the relationship between asset managers and their administrators, whose old image as commodity merchants soon changed to strategic partners, as they started adding value in three specific areas.
The first of these concerned operational excellence. Under the new outsourcing deals, back office functions - like clearing, settlements, custody, asset servicing - were increasingly delivered from a single hub. Designed as a centre of expertise, each hub also generated scale economies in functions as varied as income collection, asset reporting, corporate actions, proxy voting and securities pricing.
The second area concerned operating leverage. As the asset industry went global, it was exposed to new client segments, new distribution channels and new legal jurisdictions. With too many moving parts, its business soon became overly complex. Diseconomies of scale were rife: cost-income ratio went up despite a headlong growth in assets. Back office outsourcing, using local hubs, became one of the principal avenues of integrating a variety of processes via scalable platforms.
The final area of value creation concerned product innovation. Having started in the back office, administrators increasingly carved out a niche in the middle office as well, by venturing into vendor management, trade reconciliations, performance reporting, performance attribution analysis, data management, risk analytics and simulation models. These, in turn, created new functionalities that now support product innovation in the front office, while assuring product integrity in the middle office.
Robust management information systems now provide a dashboard on the number of new funds, new business, attrition and revenues. They also provide ‘heat maps’ on investment returns and service quality - especially for premier division clients who are becoming ever more demanding.
Since the credit crisis, asset managers have continued to outsource many of the middle and back-office activities, while encouraging their third-party administrators to improve the six core functionalities that feed into their innovation engine.
These are: data warehouses that give real-time information on trades; simulation models that stress test new products; risk analytics that give second opinions; fund structuring that extends global footprints; independent valuation of illiquid assets that gives ‘fair value’ estimates; and performance attribution analysis that ensures product integrity.
Over the next three years, asset managers expect their administrators to continue an upward advance in the investment value chain:
• 34% expect them to improve the ease of fund structuring in separate jurisdictions;
• 20% expect them to develop state-of-the-art data warehouses;
• 27% expect them to develop technology to enhance client engagement via online interactive decision support tools;
• 26% expect them to develop more robust analytics for product development.
If performance is the target, focus is its silver bullet. By taking over non-core activities, administrators are emerging as innovation partners.
Asset managers have barely scratched the surface of web 2.0. Via alliances, they will before long. A whole raft of self-service IT tools is in works that will increase client engagement and weed out the embedded inefficiencies that have long conspired against the persistency of good returns.
Although these and other tools will not banish systemic crises in future, at the very least, they will seek to deliver ‘best endeavour’ outcomes.
Jervis Smith is global head of client executive at Citi Global Transaction Services and Amin Rajan is CEO of CREATE-Research.
* Available free from firstname.lastname@example.org