8th December 2003

"Towards a leaner, meaner machine"

By AMIN RAJAN

Towards a leaner, meaner machine - In the second of a fortnightly series, Amin Rajan highlights what fund managers are doing to develop business focus.

Fearing a huge market correction at the height of the dotcom boom, the chairman of a large UK fund management house observed that "we're a fixed-cost people business that can't be leveraged in a cyclical market: we don't have factories that can be moth-balled".

This conventional wisdom was turned on its head in February this year when the market rout before the Iraqi war intensified the cost pressures. "Focus" became the new mantra and a car company became the role model.

Toyota's lean production methods are world renowned, producing a market cap higher than its three bigger competitors put together: GM, Ford and DaimlerChrysler.

In fund management, the early shoots of lean production are evident. To start with, large companies, such as Merrill Lynch Investment Management and Deutsche Asset Management, are streamlining their product and client portfolios. Bells-and-whistles products with limited shelf life are being phased out. So too are clients generating low-margin business. The focus has shifted from assets under management to profitability.

The change is making the economics of portfolios more transparent and business decisions more rational. The best firms are concentrating on those areas of strength with the potential to deliver added-value to their clients. Above all, they are integrating the back office systems to realise the scale economies long enjoyed by index houses such as Legal & General.

According to estimates compiled by Create and KPMG, the professional services group, one in four firms on both sides of the Atlantic are developing a scalable business model in order to increase their resilience in what is likely to be a low nominal return environment. For them, the process, however, does not stop with improving the product economics. The cost base, too, has come under a strategic onslaught. Wasteful items are chopped and other items are being switched to variable costs through a series of devices: outsourcing of non-core activities, re-centralisation of core activities and reform of the pay system.

What has long been second nature in other industries is now being recognised by fund managers on both sides of the Atlantic: the recognition that customers want more for less. That means doing fewer things and doing them well on the back of a slim-line cost base. But why has it taken so long for the fund management industry to realise this?

There are three big reasons. First, it is one thing to talk about a more focused product portfolio, it is quite another to notch up alpha year after year. To produce winners every year, it is necessary to follow the laws of randomness favouring more dispersed bets.

Second, the bear market has hugely depressed revenues in many firms. The instinctive reaction has been to go all out to protect the existing revenue stream rather than grow a new one at the time when many investors remain so nervous. It takes a special nerve to jettison products that can potentially provide a buffer.

Third, and most important, many pension fund consultants continue to be influenced by short-term performance when recommending their choice of fund managers. In this environment, consultants' reaction has taken precedence over rational business rules.

Nor can their reaction be easily overlooked: the accelerating trend towards specialist mandates is enhancing the consultants' role well outside the US and UK. The irony of the current situation is that a growing proportion of fund managers want to grow their business by pruning it first. But they cannot jettison the old ways of doing business if the consultants continue to apply the old rules.

When Toyota ran into problems with its intermediaries, it found ways of dealing directly with the end customers. There is ample evidence that large fund managers are increasingly inter-acting with pension trustees directly.

Indeed, there is a notable body of opinion that believes that balanced mandates are not history; they are just out of fashion. It also believes that factors that are promoting the importance of consultants are the ones that will eventually undermine their position.

Next time round, when fund managers' performance is poor, consultants will find it hard to duck for cover.

Amin Rajan is chief executive of Create, a research consultancy specialising in new business models in financial services: amin.rajan@create-research.co.uk.