Has the market for investment operations outsourcing services reached a saturation point, as some critics would argue? Has it even matured? The answer to both of these questions is a resounding no.
The concept of outsourcing, still a relatively new business, today stands at a crossroads. The decision to turn over middle-, back- or front-office servicing capabilities to a third party isn’t one to be made lightly. But the future of this trend will depend on the industry’s ability to get it right. There is no
room for error, and certainly none for complacency.
The extent to which the outsourcing market has already evolved and will continue to evolve has become a perennial question. But it remains a perfectly acceptable one to ask.

The case for outsourcing
The underlying drivers for outsourcing remain strong. The aging of the world’s population is stretching overtaxed pension schemes and spurring the creation of company-sponsored defined contribution (DC) plans and individual savings accounts. As a result, asset management firms now have more investors with more demands and more sophisticated accounting needs. At the same time, the slowdown of global markets has increased industry competition, which is leading to consolidation. Lastly, more regulation is driving up the cost of doing business. These pressures are causing asset managers to reexamine the way they do business. Finding ways to cut costs and remain competitive is paramount.

A shift to multinationals
Whereas the first wave of outsourcing arrangements were mostly single-country asset owners outsourcing middle-office services such as trade administration processing and reporting, the next round will move multinational.
In this era of heightened transparency, chief executives of multinational fund management groups are demanding more detailed performance information about their operating groups. However, timely and accurate information is often hard to come by, especially when growing companies with a variety of products and jurisdictions discover that legacy systems and operational differences can obstruct good information flow. The desire for consistency will be a key driver for cross-border outsourcing.
Asset management companies typically focus first on ways to enhance their front office or client servicing capabilities. Allocating resources to the back- office functions such as fund accounting, transfer agency and administration services is usually not as much of a priority. And yet, efficiency in back-office systems is what generates the quality, accuracy and absolute certainty that clients require. Other drivers for outsourcing are the challenge to stay ahead of new trends in technology, the introduction of new products, which can be expensive when implemented in-house, and the increasing need to enhance risk controls around the operational process.
Against this background, growing globally is the key to the future, and multijurisdictional business will become more, not less, of a norm. High-growth opportunities will present themselves to the best-positioned suppliers. Today, Europe represents a US$9.3 trillion collective and pension fund market with a projected 6% annual increase of pension assets and a 10% annual increase in collective investment assets. Credible suppliers looking for continued growth need to be able to provide a broad set of products in every key market.
Beyond Europe, there are also opportunities for outsourcing growth in the Asia-Pacific region. An example of this is Japan, which has US$6.9 trillion in assets and where an economic recovery is at last underway. As is the case around the world, Japan’s aging population is putting significant pressure on government pension schemes, heightening the need to increase returns and reduce costs. In this market, outsourcing asset management mandates are poised to increase.

Outsourcing’s new landscape
Already, we have seen international institutions such as Investec and ABN Amro outsource their back and middle offices across Europe. These types of arrangements will increasingly be built upon and around cross-border transactions. The middle office, including trade support, communication with custodians and processing, is the prime area for this next wave of outsourcing.
Two years ago there were comparatively few middle-office deals. In the last 18 months alone the volume of deals has doubled as suppliers and their solutions have gained experience, attained increasing credibility and demonstrated the value of their propositions.

Markets pave the way
At the same time, the prolonged equity bear market has generated many reasons to be bullish about outsourcing, and the steady accumulation of outsourced assets has conferred tremendous insight upon asset owners.
As investors search for higher returns, the growing interest in hedge funds provides a unique opportunity. Now a US$1 trillion asset class with a significant global presence, hedge funds remain one of the fastest growing segments of the asset management industry. From a service provider standpoint, this growth offers opportunity on a number of fronts.
First, as assets managers look to introduce hedge fund products , they can do so more easily when using a third party that has scalable, consistent technology platforms. Second, as the percentage of capital committed to hedge funds also continues to grow, firms that specialize only in hedge funds may be better served if they focus more on asset gathering and client servicing, and turn to a sophisticated service provider who can handle middle- and back-office functions.
As with more traditional investment products, service providers can also
help asset managers ensure that new regulatory and reporting requirements are met.
The combination of the institutionalisation of hedge funds and increasing sophistication and complexity of them and other alternative products create enormous growth opportunities for providers of securities services across the board.

A suitable partner
Firms with extensive experience in investment servicing are the best positioned to take advantage of these growing trends. Successful providers are the ones who can demonstrate quality and consistency in their service, taking innovative approaches that
will meet the evolving needs of their customers.
Reduced to its simplest form, outsourcing is well suited to custodians. After all, the back-office value chain sits at the heart of their business model. Outsourcing is a vertical integration of existing relationships, and with every outsourcing deal suppliers increase scale, become better informed, better developed, and more experienced.
An understanding of the requirements of the growing asset manager is essential to a successful outsourcing arrangement. Every customer, irrespective of asset class, is unique. Every relationship demands constant tailoring. But whether customers manage hedge funds or are in the wealth management business, they share a core activity. Service providers who are positioned to succeed will be able to understand both unique and common traits, while adding scale, ingenuity and long-term commitment to that relationship.
If the investment service industry draws from its experience, outsourcing is well placed to take the next leap into the future. Going forward, asset managers face their own set of choices. The intellectual argument to shift to outsourcing is compelling, however the bigger questions surround the timing of such a decision and the selection of the most appropriate service provider.
Making a fundamental change in infrastructure in order to deliver high quality customer service, increased efficiency and performance is not only possible, but essential.

Jay Hooley is executive vice president and head of global investor services at State Street.

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