Top 400: Clients and distribution
Peter Ellis outlines a four-point business structure for asset managers
The global financial crisis that developed in the last quarter of 2008 has led many to challenge the strong convictions that have characterised our industry for many years and this is reshaping the landscape of investment management.
Here, we provide an overview of a recent research project undertaken by Investit as part of its intelligence service. This project was a detailed investigation of how the landscape is changing and of the implications for investment managers and their service providers.
The changing needs of investors
Two years on from the crisis, it is clear that the needs of individual and institutional investors have changed, largely driven by a loss of appetite for risk. The crisis transformed investment risk from the possibility that ‘one might get a lower return than one expected' into the possibility that ‘one might not one's money back'. Thus, investment risk was transformed from an opportunity risk into an actual risk.
The traditional value proposition offered by investment managers is the delivery of an expected return relative to a benchmark. From the investors' perspective the two main issues are:
• The outcome is not guaranteed; and
• The target is to perform better than a benchmark, which means that in falling markets investors can lose money even though the investment manager achieves its objective.
Market events in the 10 years from the end of 1999 to the end of 2009 exposed these flaws with the traditional value proposition. The investor mind-set has shifted as a result. The willingness of investors to buy products that deliver a performance return relative to a benchmark is being replaced by a demand for capabilities that deliver wealth in absolute terms.
One of the most significant changes taking place as a result of investors' loss of appetite for risk is the growing trend for defined benefit (DB) pension schemes to convert to defined contribution (DC) schemes. The trend for DB schemes to close to new members started over 10 years ago; what we are seeing now is DB schemes closing to future benefit accruals. This trend gathered pace in 2010 despite the improvement in asset/liability ratios that occurred in 2009; pension schemes simply cannot rely on equities to deliver asset growth in the way that they did 20 years ago.
Another, and not entirely unconnected, trend is the growth in fiduciary management functions. These functions may be established within the scheme or outsourced to a third party, which could be an investment consultant, a specialist fiduciary management organisation or an investment manager.
Another important trend, and again one not unconnected with the move from DB to DC, is the growth in the use of fund platforms, increasingly known just as platforms. These are likely to emerge as one of the most important distribution channels for individual and institutional investors.
How investment managers need to respond
The implications for investment managers arising from these changes in the landscape are twofold.
First, managers will become more intermediated from institutional and individual investors. In the future, many investors will be clients of platforms or fiduciary managers, with managers being appointed by the intermediary to manage funds for its clients. This will change the dynamics of engagement between managers and investors, during the sales process and throughout the lifetime of client relationships.
Second, managers will face more competition as investment consultants and platform providers move along the investment value chain and start offering investment solutions.
In short, profit margins will come under pressure as managers become more intermediated from investors. Managers will become less effective as distributors of their own products, while at the same time face more competition from a wider range of organisations.
To succeed in the face of these challenges, managers will need to take action on three main fronts:
• Better alignment of their business model and their operating platforms;
• Remodelling of their organisations away from the traditional front office, middle office and back office delineations; and
• Re-engineering of the distribution function.
Alignment of business model and operating platform
Some investment managers are very successful in terms of the cost-income ratios they achieve, others much less so. Success is not a feature of size or the nature of the business: some profitable managers are large global players, others small boutiques; some are specialist stock pickers, others are index trackers, some run a wide range of funds including some with complex investment strategies.
What sets profitable managers apart is the alignment of their business model and their operating platform. By operating platform we mean organisational structure, data management processes, business processes, technology infrastructure and business systems. Some managers have operating platforms that are simply inappropriate for the book of business they are running. This may manifest itself in a failure to create sufficient value through investment processes or in excessive operating costs for the type of business, or perhaps both.
Only by following a formal approach to business management in which the business model and operating platform are correctly aligned, can managers be sure that their organisational structures, data management processes, business processes, technology infrastructures and business systems are appropriate for their business strategy.
A four-point model for investment management firms
The traditional model for describing an investment manager contains a front office, a middle office and a back office. This has always been an imprecise model, but in the future it will prove inadequate and problematic.
When analysed correctly, it is clear that the business model for an investment manager contains four distinct ‘service components', not three:
• Investment services is where true value for investors is created. It is where the real intellectual capital of the business resides. It is the primary source of a manager's unique selling proposition (USP). The critical success criterion for this area of the business is the existence of a set of specialist skills and techniques that differentiate the manager from others.
• Client services is where managers ensure that they sell investment products that are the most appropriate solutions for their clients' needs, and that they deliver the required levels of client services. It is where client relationships are created, maintained, retained and leveraged, to create new sources of revenue and protect established ones. It is a secondary source of the manager's USP. The critical success criterion here is customisation by client type, by distribution channel and by geographic region.
• Business support services is the component responsible for providing direct support to investment services and client services. Most of the services provided will be shared by the two front-line service components; for example IT, data management and performance all support both investment services and client services. The value delivered to investors is not created here, nor is it enriched. However, the functions in this service component are tightly coupled, and fully integrated with the value-creating and value-adding business functions. As the needs of the front-line service components change, business support services must be able to adapt in a timeframe and at a cost that is appropriate for the scale and nature of the change. The functions here need to be tailored to the requirements of individual managers, according to the book of business each is running; they are not generic in nature. The critical success criterion here is the ongoing delivery of value-for-money services tailored to the specific needs of individual managers.
• Operations services does not create value for investors (although it could reduce it) nor is it an area where it is necessary to customise processing according to a manager's clients or its book of business. The services provided here are generic; they are industry standard rather than manager- or client-specific. The critical success criterion here is the ability to execute high volumes of processing, without operational errors, in a cost-efficient way. In other words, the watchwords are standardisation and economies of scale.
The four-point model above challenges some of our traditional views of investment managers. For example, dealing desks have always been seen as part of the front office; using the above model, however, they might be more appropriately placed within operations services. It may not be purely coincidental then that some managers have begun to look seriously at outsourcing their dealing functions.
Those investment manager that adopt this business model will be better placed to adapt their value propositions to keep them aligned with changes in the client and distribution landscape. They will be able to decouple the four components of their businesses and take each one down a separate evolutionary path:
• Investment services in the direction of specialist value-creation.
• Client services in the direction of client-centric customisation.
• Business support services in the direction of tailored support, for an appropriate cost, to the needs of the value-creating and value-adding business functions.
• Operations services in the direction of scale and standardisation.
One central point emerged from our research: it will be harder for managers to make money in the future than it was in the past.
Some traditional sources of revenue will, to all intents and purposes, disappear; others will become harder to retain. These changes will not happen overnight, but they will happen. For example, DB schemes will remain a significant revenue source for managers for some time to come, but not for ever. The key question is: when will the revenue stream will dry up?
Investment managers need to adapt their value propositions to ensure that they remain profitable in a world that is not just more competitive, but one in which firms compete in ways that are different to the traditional lines of battle. Some managers will just need to fine-tune their value proposition; others may need to re-engineer it, and re-position themselves on the investment value chain.
Peter Ellis is managing director at Investit