Other issues uncovered reveal a more fundamental issue with the business model of a firm. A basic requirement of any asset manager is to demonstrate a clear segregation of duties between front and back office staff. Barings and Nick Leeson was a prime example of where a lack of segregation of duties can bring disastrous consequences. As the front office trader, Nick had influence over the back office, which allowed trades to be hidden in the now infamous 888 Account. All too often asset managers allow some individuals to both execute and confirm trades, breaking down the fundamental segregation of duties between doers and checkers vital to maintaining the integrity of the investment process and reducing the risk of mistakes or fraud.
The insights learnt from Madoff are not the only reason investors are increasing their scrutiny of back offices. Regulators are increasingly introducing rules and regulations to force investors to look beyond the investment process when appointing an asset manager. For some regulators, it appears to be a knee-jerk reaction to the financial crisis, whereas for others it forms part of a longer-term plan to increase the level of investor responsibility on reviewing all aspects of their investments.
In addition to greater regulation, many investors realise good housekeeping can help them save money and therefore are increasingly trying to find efficiency gains within their investment structure to lower costs. The phrase “what does not get measured does not get managed” has really struck a cord with many investors. Historically the only measurement was assessing portfolio performance against the index. Now investors are increasingly taking a keen interest in execution performance, often referred to as transaction cost analysis (TCA) and custodian performance analysis (tax reclaims, proxy voting, interest rates) as a means of increasing efficiency within their portfolio.
The effect of the present
With investors looking more indepth at asset managers, the managers themselves are being forced to evolve and change their business models. Asset managers are increasingly reviewing their operating structures to ensure they meets the standards required by institutional investors. Firms are also ensuring they have comprehensive policies and procedures as evidence of the necessary processes and controls in place.
Although structural changes and policy implementation require human efforts there is limited cost involved. However, there are other areas of an asset manager’s infrastructure where investors are demanding change , which requires the asset managers to dip their hand in their pocket. Unsurprisingly changes where cost is incurred require the firm to carefully assess the benefits of implementing the proposed changes. The decision is a complex one and asset managers need to consider not only the immediate benefits of the change, but also whether the changes have long-term benefits as well.
The main areas of change required by investors centre on greater levels of automation in process driven activities and market leading trading systems. These changes put increasing pressure on firms to invest ever more in technology. Asset managers who have not been keeping pace with the technological changes within the industry are now facing the prospect of spending potentially millions of additional dollars to bring their technology infrastructure in line with market standards.
Whilst asset managers are grappling with the immediate demands of institutional investors, it does create questions on the kind of trends likely to appear in operational and trading activities over the next 3-5 years.
What might the longer-term future hold?
After the tech bubble burst, a number of asset managers outsourced some of their operations, control and support functions to try and reduce costs. Hindsight has demonstrated not all of the outsourced deals actually achieved the cost savings the asset managers were hoping for. Now with investors looking more to the operations, control and support functions, asset managers are again considering whether outsourcing is the preferred route. The major difference this time around is the outsourcing arrangements are being considered from a process improvement perspective rather than as a way of cutting costs. A specialist outsource firm has to keep up with the latest advances in middle and back office to remain competitive, and their scale allows them access to a significant technology budget.
An alternative to outsourcing is for larger asset managers to leverage their operations, control and support functions by making it available to other asset managers for a fee, i.e. they become the outsource provider. Whilst this has found some traction in a few markets it has yet to be embraced, however it does offer a credible alternative solution to outsourcing. Although outsourcing allows firms to pass on the problem of keeping on top of middle and back office advancements to someone else, it is not the panacea. With outsourcing comes a loss of control which can often provide its own set of issues.
It is not just back office processes that are likely to change. With the explosion in trading venues there is an increasing need to have the latest trading technology to provide access to all areas of liquidity and to ensure low cost execution. Over time the reliance on phone trades will diminish and be replaced by electronic trading. For developed equities this has largely taken place, but other asset classes including fixed income, are moving in the same direction. The sheer number of liquidity providers has seen a move to program driven trading as the human without the appropriate tools is no longer able to ensure best execution. Again, this requires firms to spend more on technology, although some of this cost should be offset if more efficient trading can be achieved.
Large investors are increasingly looking to the idea of a central dealing desk for all their asset managers as a potential solution to reduce costs. If an investor has several asset managers operating in the same asset class there are times where those managers will both be buying the same security or where one manager is buying a security another is looking to sell. The concept of the central trading desk is to remove these inefficiencies, and provide smarter trading. We are just starting to see firms offer specialist trading desks, although if this concept does take off it will be a number of years until we see it being used more extensively.
In hindsight Madoff has resulted in some positive developments in the investment community, with the whole event really making investors ask whether they were doing enough to reduce the risks of losses in their investments and reduce costs where they could. For the asset managers I believe it will result in closer relationships with clients and more focus on providing high quality operations, control and support functions not just focussing on the quality of the portfolio managers.
Asset Managers’ Middle and Back Office: A New Focus for Investors
