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Impact Investing

IPE special report May 2018

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Top 400: Are we doing this right? Are we doing this well?

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As investment firms grow they find that the core business model of investment management is not easy to manage. Revenues are related to market levels while costs are often locked in place in a way that is difficult to fine-tune. Products require a full team of investors, client sales cycles are lengthy and expensive, and complex systems platforms need constant attention to stay up-to-date.

What is also becoming clear to both the operators and owners of investment business is that behind the core business model is an asymmetric risk/reward equation. The assets that investment firms manage are usually several hundred times the size of their own balance sheets – and when things go wrong, the fines and restitution required can be shockingly large. The ‘million-pound error’ has been an unwelcome, but accepted, fact of life for many years, and now as regulators sharpen their pencils, fines are climbing into the tens of millions, in addition to the forensic work required to sort out the correction and compensation which can take months or years.

The likelihood of something going wrong also grows as firms design increasingly complex products, often with barely-adequate support tools. Fixed-income strategies using leverage and derivatives present significant investment and operational risk challenges when running on legacy platforms originally designed to support buy-and-hold equity strategies. 

Despite this, investment management firms still have excellent margins, with our benchmarks showing an average cost-income ratio of around 67% across a wide range of different business models. However, these studies also show that there is no one business model that guarantees success – managers with high or low charge rates, scientific or artistic investment approaches, global or single-site operating models, can all be found with cost-income ratios better than 50%, but also with ratios worse than 80%. The difference comes from the way that the businesses, rather than the investments, are managed. 

The top-performing firms have built strong mechanical support for their products and are able to manage the cultural changes required to make deeper and more subtle changes to keep themselves ahead of developments.

With this in mind, we will examine the top three challenges faced by our clients, which are regulatory change, data management and front-office systems.

It will not come as a surprise that projects involving regulatory change are the biggest challenge, since regulation has been the subject of non-stop debate since the global financial crisis. 

On the mechanical side, we have formal regulation such as AIFMD and EMIR, where the regulation can be read, interpreted and enacted. The problem now is a worrying ‘last-minute’ attitude, with the details of regulation changing up to and even after the required implementation date. These changes can have a huge impact on the work needed for compliance, and the subliminal message to investment firms is that there is no point in trying to be prepared in advance. This means using manual processes and therefore introducing more operational risk, which is certainly not what was intended.

On the cultural side, regulators are definitely becoming more assertive, especially around the area of fees and charges. There is a growing emphasis on the quality of conduct, the management of conflicts and the care that investment managers should take with the money that has been put in their care. Changes here require cross-business co-operation to reset the underlying assumptions about whose money is being spent and how clients should be respected. 

The second challenge is data management. Firms are increasingly aware of the problems caused by poor data management. Errors in client reports will undermine confidence in the manager, errors in pricing and risk models can result in costly breaches, and the sheer price of data increasingly means that firms need to have a rigorous process to turn off data sources as well as turning them on. Business managers are finding that their mechanical solution of an expensive data warehouse has not fixed the problem. 

What is needed is a cultural change to build better data governance rather than faster data manipulation – to sort out, or move the source of the problem rather than trying to clean bad data faster. The result has been a visible shift over the past decade in the position that data holds within the firm – the original IT problem moved into a data team, then a ‘data czar’ was appointed and now many firms are appointing a chief data officer. 

Firms that have succeed in this have seen their data turn from a liability into an asset. Clean, reliable data gives a hidden but genuine competitive advantage, allowing firms to be faster to market as well as avoiding the sheer cost of time spent repairing the data month after month. In addition, the latest regulatory developments also give access to new income streams as firms can extend the range of services they provide to support clients.

The challenge is front-office systems. The reason that business managers are concerned with these is their link to product development and, in particular, the ability to access the attractive market for multi-asset products. Firms have tended to end up with a split front-office platform, usually with equity teams on one system and fixed-income teams running another. The reason given is functionality – that the fixed-income teams need a specialist system for their requirements; this ‘best of breed’ approach is a mechanical solution that theoretically delivers the best support for each team.

Interestingly, our benchmarking clearly shows that a split platform delivers a more costly, less efficient environment than a single system across all assets. 

The reason is that the specialist platforms may each have better functionality but the overall environment with multiple platforms is far harder to accurately maintain. Game theorists will recognise this as a classic prisoner’s dilemma, where individual selfishness triumphs over group success. Instead, by being culturally able to compromise on the headline level of functionality, the investment teams find that they benefit in many ways. In their new environment cash is accurate, compliance checking is easier, derivatives support can be centralised, and those important multi-asset products can be given strong support. 

In conclusion, investment managers have enjoyed excellent margins but it will require hard work to sustain these. 

There are still excellent opportunities as more pension savers are enrolled and clients invest for longer. However, all industries have an unspoken agreement with the societies they serve on the correct levels of corporate versus client gain. Investment firms that understand this will be able to build a culture that does the right things in meeting regulation, managing client costs, and producing really useful products and services. Within this cultural context, the mechanics of delivery will become quicker to design and easier to implement. 

Catherine Doherty is chief executive officer at Investit

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