Piling on the services - putting quality at risk
As fees shrink for ‘plain vanilla’ services, custodians are adding extras to keep profits up and attract clients. But trustees should ensure that quality comes first.
Driven by global trends sweeping the industry, fees for ‘plain vanilla’ custody services are being driven relentlessly downwards. Core fees may be coming down, but the cost of staying competitive continues to rise. So big custodians are promoting additional value-added services in an effort to attract clients, and plump up their profit margins.
The most ambitious aim to offer ‘one stop shopping’, tempting clients with a broad range of services from basic safekeeping to such add-ons as risk measurement and cash management. At face value, this is good news for pension funds. However, not all custodians are able to provide quality service across the board, so it is up to pension funds to monitor very carefully each of the products they are getting. Another trend to watch closely is that big custodians are getting picky about their clients, and shunting aside small funds in favour of large ones with solid revenue potential. The industry is thus gradually being split into two tiers.
At its most basic level, global custody is the safekeeping of assets and the settlement of trades for pension funds and investment managers. These ‘bread-and-butter’ services include such mundane but essential tasks as income collection and tax reclamation around the world. But trends transforming the industry - globalisation, consolidation, and the growing importance of technology - have turned these services into low-margin commodity businesses. Shorter settlement times, now just T+3 for UK equities (trade date plus three days on a rolling basis for settlement), have also helped shrink fees: custodians carry less risk, so charge less as a result. Annual fees for basic custody now range from just 3 basis points for a relatively small fund to a minuscule half a basis point for a very big one.
It’s hardly surprising, therefore, that custodians are adding new products to their ‘plain vanilla’ offerings. One ‘extra’ that benefits both client and custodian is securities lending. This has exploded in popularity since the Bank of England launched the repo market four years ago, which created a demand from qualifying banks and market makers for gilt borrowing. The growth in long-short and market neutral strategies, and managers offering event arbitrage has created a demand for equities. This growth in demand has increased the fees that borrowers are willing to pay, thus making stock lending more attractive. If you want to be indemnified against the loss of your securities, you split the fee 60/40 with the custodian. If not, the split is typically 70/30 in favour of the fund, although like much in the industry, the income splits vary considerably depending on the size of the assets to be loaned.
Corporate actions services, and especially proxy voting, are also popular extras. Many pension schemes are becoming more active in their dealings with companies, especially as they are now required by law to state what ‘social, environmental, or ethical considerations’ they take into account in their investment policies. So custodians will help with proxy voting in most major developed countries, and will accept takeover offers on your behalf, subject to guidelines.
But it is as information depositories that custodians offer the most potential to add value, and also to differentiate themselves from their competitors. The data that custodians collect as part of the settlement and clearing process has now become a valuable commodity. On the back of the basic reporting function that they offer to clients, custodians are now promoting a host of other fee-paying services that slice and dice the information they routinely collect. This ‘one-stop shopping’ service is designed to tie clients in to a long-term relationship, rather than letting them choose on a product-by-product basis.
On top of basic custody, custodians now offer investment accounting for pension schemes, giving market and book values for their investments split out in various ways, such as by manager, region and type of investment. (This service should not be confused with the stock lists with market values attached that custodians provide. These are not portfolio valuations, but the equivalent of bank statements.) From here, it is a small step to performance measurement and attribution analysis - figuring out where value has been added. Using the same data, custodians also offer compliance monitoring, sounding the alarm if managers are close to breaching in-house guidelines, or breaking regulations. For instance, custodians can identify ‘at risk’ stocks, alerting pension funds that they are close to breaking the ‘3% rule’ (they must notify a company if they hold more than 3% of its stock).
Clients are always hungry for information, and all the big custodians permit them to manipulate data as they choose from their own desktops via a direct line to the custodians database. Some custodians have developed technology platforms that allow clients access to this data via the internet. The prize that so far remains out of reach is giving clients real-time access to information on their holdings.
Pension funds are clearly benefiting from these extras that are laid out to entice them. But there is a downside. As ‘add-on’ products and services proliferate, not all custodians will be able to maintain top quality standards across the board. This lack of consistency across custodians and services means that you will have to work hard to monitor each of the services you are getting. You should lay out specific parameters for each individual service in the service agreement, and make sure custodians stick to the agreed standards. This may mean playing hard ball with custodians, even charging them for compensation if they fail to meet agreed targets within the time frame specified - say, too many failed trades, or reporting times that are not met. A word of caution: though this is a good idea in principle, it will prove tough for some types of service because of the difficulty of pinning down a benchmark.
Pension funds may also find it difficult to assess just how much value they are getting from the relationship with their custodian when they opt to buy a raft of add-on services. This is because the way that these services are priced lacks transparency. Custodians charge a fixed fee for the IT platform that the services run off. They then discuss with clients which extras they want, and put a price on the total package. This makes it very hard to price the individual services. Complicating the picture further, custodians may not charge fees on a simple sliding scale according to the size of a pension fund. The fee you pay may even depend on whether or not the custodian sees you as a ‘trophy client’, one whose name looks good on his client roster. In this case you may get a better deal than another similar company.
But it is small pension funds that seem to be ending up with the rawest deal. As custodians’ profit margins get squeezed, they are getting choosier about which clients they take on - and big funds with attractive future revenue streams look like a better business proposition than smaller schemes. This means that funds with less than £200m (e330m) in assets that want to sign up with a global custodian may find themselves paying over the odds with a minimum fee. The alternative for small funds is to be pushed into the arms of a smaller specialist provider.
Either way, small funds will probably end up accepting inferior services. Even if they pay the price of opting for a large custodian, it is unlikely that they will have the flexibility of negotiating a contract that the larger schemes will enjoy.
This practice seems to be gradually splitting the industry into two tiers. At the top are large multinationals enjoying a flexible ‘soup to nuts’ service from global custodians, while relegated to the bottom rung are smaller funds, unable to benefit from the same economies of scale. To combat this, we have already seen in Europe the formation of a ‘buying club’, where a number of funds have combined to create a large pool of assets that will command ‘big fund’ fees.
To sum up, industry consolidation and a number of other factors are combining to drive down basic custody fees. In response, custodians are promoting sophisticated ‘add-on’ services, building mainly on their vast data depositories. But custodians are unlikely to be able to provide top quality service across all product lines, and they are also keen to shed small pension clients that are not such good business prospects.
Against this background, pension funds, both large and small, would be well advised to keep up the pressure on their custodians to maintain standards.
Paul Brackett is an investment analyst with consultants Watson Wyatt in