Traditional Service Providers : Going Contemporary
By David Goodman
The growth in scale of many large- asset owners, the failure of financial infrastructure during the GFC (Global Financial Crisis), the move of custodians into investment management administration, and cheapening access to trading and portfolio management technology is creating the environment for a substantial change in the financial services industry. David Goodman, Head of Portfolio Solutions, Macquarie Securities (Australia) Limited, explores how this change will have a dramatic effect on the way traditional service providers relate to their largest customers.
Funds can definitely consider internalising certain aspects of their investment management process. The large funds will not necessarily withdraw externalised functions in certain asset classes in total, they will look to internalise only those functions where it can be done efficiently. Before considering the detail of the impact of these changes it is necessary to understand that the drivers for change at a fund, as well as a fund’s view of efficient production, may differ to that held by other market participants.
The effect of scale in a market where there is a general model of management fees charged on the basis of NAV is well understood. For an index fund, there is an asset size above which the cost of internal production is cheaper than outsourcing. Passive equity fees are very low to reflect this and extremely large scale is needed to consider this move. When one considers the operational risk involved in passive management, outsourcing of this risk also has value to a fund. Funds can often consider internalising this type of activity when it is seen as a step in the direction of internalising other related mandates.
One of the most powerful drivers for change surrounds the experiences of various funds during the GFC. For many funds the greatest disturbance that occurred to them involved the failure of financial infrastructure that drove the structuring of many of the perceived lower risk (but larger value) assets in their portfolio. Redemption issues in index portfolios are still problematic for some funds due to frozen (now slowly thawing) collateral pools backing stock lending aimed at enhancing the returns of the fund. Some enhanced cash portfolios were involved in assets central to the GFC. Investors in long/short extension funds can now understand rehypothecation. For an asset owner these events may initially be a powerful driver to withdraw from these types of activities. Medium term it could be the case that this will cause funds to want to internalise the management of the pipes that froze during the GFC. Internally managing collateral pools and cash assets are related and now supportable by easily accessible technology and services. The GFC has created an incentive for asset owners to want to have more control over where their assets are.
Many large, traditional asset custodians to pension plans around the world have been actively seeking and winning mandates to provide back and middle operations support to large investment managers. These investment managers have adopted varied approaches and this has created the need for the custodians to segment the services they “in source” from some potential clients who are not looking for a full service solution. These services have great scale. An asset owner who has appointed a custodian to hold custody of their assets can now reach in and access the technologies that are provided to their investment to manage such things as collateral pools at a very effective price. This may enable asset owners to continue to enrol in securities lending programs (or ones they directly manage themselves) with a far higher degree of comfort and control over the operational risk they are running.
Broker supplied EMS technology has been abundantly available for a significant period of time. The above trends relating to investment managers outsourcing functions to custodians have provided services such as OMS and Portfolio accounting systems at an efficient price into which the EMS can be plugged.
So after establishing that it is now easier for funds to “in source” parts of their investment process and that they have powerful internal control reasons to do this, what will be “in sourced” and what are the implications for service providers?
As discussed above, aspects of listed equities could be internalised but the counter proposition exists that it maybe more efficient to externalise passive management and to internalise control of the operational risk surrounding any return enhancing activity undertaken. Assembling a team of high quality investment analysts capable of developing processes that can identify and capture sources of alpha in the long term is an expensive process. Using quantitative techniques to identify the betas that potentially drive these returns and internally implementing portfolios to create these returns is more likely. This would mean potentially lower allocations to managers whose returns are correlated to these systemic betas and higher returns to managers who can show uncorrelated alpha generation. Brokers will need to provide quant based product in exchange for implementation flow and structured product solutions that enables portfolio construction.
In addition to the ever cheapening technology required to support internalisation, an investment in human capital is required that would be sourced from traditional buy-side and sell-side firms. Money and geography are factors to be considered. Asset owners are more geographically spread than the large buy-side and sell-side firms and many have strong connections with their local communities and governments. Attracting experienced talent for these funds to internalise could be a significant barrier to entry.
Once an internal funds management team is created it can be employed to re- internalise aspects of other processes that may have been previously out sourced.
The management of trading costs is necessarily an important focus for investment managers as they seek to efficiently implement internally generated investment ideas and manage fund liquidity. Investment managers employed by asset owners see only their part of a client’s total fund. Investment managers are normally not aware of potential internal market liquidity that could exist in other asset pools managed on behalf of their clients fund and excess trading costs could accrue to the asset owner from “missed” internal crossing opportunities. An asset owner would normally have a better view of the cash flow profile of a fund, recognising times when it needs to raise or invest cash. In a fully externalised environment over trading could occur if cash flow moves in a different direction to cash needs. Some asset owners may take the view that they are better placed to manage the after tax performance of their fund centrally, than a number of external managers all trying to be internally tax efficient.