24 January 2005 "The law of unintended consequences"

By AMIN RAJAN

"Our clients fall into two categories: frustrated and horrified," mused the CEO of a large US fund manager.

"We no longer confuse the bull market with brains," he added. He is not alone. His peers in all regions recognise that the business model that worked in a bull market is now a recipe for disaster.

This much is clear from the latest research study from research comapany Create and financial consultants KPMG*, involving 300 fund managers in 29 countries, with assets worth Euros 25,000bn. Two in every three of them are taking strategic action, typically in four areas: investment performance, operational excellence, operating costs and corporate brand.

In each case, actions run with the grain of common sense. Does this mean that we shall soon see a growing number of revitalised firms capable of running their business like a normal business: from peak to trough to peak? If that happens, it will be more by luck than judgment. Equally, if it does not, that will not be for want of trying. The harsh truth is that designing a new business model that spends less and earns more is one thing; implementing it is quite another.

The room to manoeuvre is limited for two reasons.

First, in the large majority of firms, the necessary mindset shifts have proved only as durable as the crisis that provoked them. The brief rallies in the latter part of 2003 and 2004 not only drew audible sighs of relief. They also eased the tailwind behind essential business re-engineering.

"Our senior managers can't resist mental bungee jumps that reverts them back to their old ways at every possible opportunity," observed the chairman of a large global house. The magnetism of the past remains powerful.

Second, and equally important, even seemingly sensible actions have involved painful trade-offs. These have inadvertently raised costs: far from the cost income ratio coming down in response to widespread cost cutting, it has soared, at least in Europe (see chart). Is this a sign of rampant inefficiencies or pain before gain? Our research study suggests more of the latter.

For example, improving the investment performance has been the top priority involving a number of changes, each bringing in its wake adverse side effects for revenues or costs.

One of the most widely implemented changes has seen the creation of a boutique structure in large and medium-sized firms.

These product-based groups are meant to give greater autonomy to research analysts and portfolio managers in a small team environment in which they are pushed to the limits of their thinking, while generating new ideas.

On the downside, however, these structures have required expensive information systems. Likewise with the product range: it has been narrowed to achieve scale in the back office. In turn, this has made it difficult to notch up product successes year after year. Also the laws of randomness help less and less, making it difficult to meet client needs at different stages of the market cycle.

Similarly, cost cutting has relied on outsourcing of back office activities or sharing overhead services with parent companies. In both cases, it has been a matter of jam tomorrow: the management time and transition costs have diluted the immediate benefits.

Indeed, the bulk of the savings are more likely to come from not having to upgrade the operational infrastructure in future.

On the branding side, the story is similar. As is well known, the key ingredients of a great investment brand are consistently good performance backed by quality service, realistic charges, risk controls and regulatory compliance.

Costs in each of these areas have come well ahead of benefits. Brand development has also inadvertently promoted the star culture, since individual discretion matters more than investment process in generating high returns.

"Is it surprising that we agonise about every good idea in case it's a bad idea?" - wondered the CEO of a major French house.

These and other adverse knock-on effects reflect a number of inherent paradoxes. First, fund management is a highly cyclical fixed-cost people-based business: it cannot be leveraged readily in a downturn.

Injudicious cost cutting can only ensure that the cure is worse than the disease, as the experiences of some of the global houses show all too clearly. Furthermore, if markets recover markedly over the next three years, the much needed structural change will slow down because, thus far, change has proved a mixed blessing.

Finally, some of the trade-offs are self inflicted, since an overwhelming majority of fund managers do not as yet have a culture of strategic thinking and personal accountability: four out of five fund managers have yet to hold their senior managers individually responsible for delivering strategic goals.

Professor Rajan is the CEO of CREATE, a consultancy specialising in strategic change in financial services

*Available from amin rajan@create-research.co.uk.

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