8 October 2006

ASSET SERVICING: "Dealing with complexity BUSINESS MODEL: Outsourcing is a 'silver bullet ' that can hit strategic targets."

By AMIN RAJAN

"The first wave of outsourcing aimed to kill two birds with one stone: tackling the cost spiral and exporting "problem children". The nascent second wave aims to enable fund managers to turn the conventional wisdom on its head by creating a business model that produces more for less, according to a new global study jointly sponsored by Citigroup and T. Rowe Price.*

The key driver is the growing complexity of front office activities, fuelled by explosive growth in the use of derivatives; reinforced by the emergence of new asset classes; and sustained by proliferation of new investment strategies in pursuit of absolute returns.

"Whereas favourable macroeconomic fundamentals have powered the global markets in the last three years, client demand has increasingly shifted towards complex products," says Neeraj Sahai, global head of securities and fund services at Citigroup.

As asset managers have diversified into them, fee compression has been one unintended consequence. The other is cost escalation, as mass customisation and mounting regulation have required state-of-the-art technology to underpin novel approaches to support functions like valuation, performance monitoring, processing, compliance and risk management. Outsourcing of the back office functions is increasingly viewed as a means of tackling this double whammy.

Operations and technology not only dominate the non-staff costs; they can also potentially de-rail client service and senior executive attention. "Relentless ingenuity going into product innovation at the front end is only as good as the infrastructure that supports it at the back end," adds Mr Sahai.

Accordingly, fund managers can either build proprietary operational platforms or form strategic partnerships with external service providers: strategic in the sense that each party totally relies on the co-operation of the other to succeed, as in a three-legged race.

Their choice depends on factors such as growth expectations, product complexity, risk tolerance, the state of existing integration, the compliance environment and, most importantly, the size of their assets.

Unsurprisingly, some of the largest asset managers have chosen to do these operations in-house by building proprietary platforms. Their experience suggests that the scale benefits are real so long as products are simple. But as complexity increases, outsourcing pops up as a silver bullet that hits two seemingly contradictory strategic targets: economies of scope and economies of scale.

New strategies in the front office overtly seek to expand the product range to meet emerging market demand. On the downside, their complexity renders them unscalable in the front and back offices, being unconducive to a factory environment.

Not surprisingly, administrators of hedge funds, for example, are now an integral part of the front office of their clients; being involved at the outset, not just at the processing phase. This frees up managers to invent new strategies and widen the scope of their business. They also reduce unit costs in back office activities by partnering with best-of-breed service providers operating at the higher end of the experience curve, in view of the multiplicity and diversity of their client base. More generally, these developments are symptomatic of pressures on fund managers to re-engineer their business models so as to deliver a clear value proposition centered on investment performance and quality service, backed by a value-for-money fee structure. In this age of transparency and endless choice mandated by regulators, there will be zero-tolerance towards poor returns. So, 'focus' is the new mantra.

"No longer will it be possible to be a jack of all trades and master of none. Not only will fund managers return to their craft origin at the front end. They will also create structures in which complexity and exceptions will be dealt with by outside experts with significant operating leverage," says Mr. Sahai.

Indeed, this is already happening and will accelerate over time as fund managers target benefits that go beyond cost savings and extend into value added services being supplied on an la carte basis. Thus, the current infrastructure of skills and technology will undergo a significant transformation.

A new generation of blending techniques, risk tools, and delivery channels will transform the current generation of products; thereby bringing into play platforms that provide seamless support across the value chain. "So powerful would be their integrative role that they may well act as one of the principal conduits of the new generation of innovations," concludes Mr Sahai.

Fund management is, thus, in the throes of a major transition. The winners will be those smart enough to develop solutions that chime with client needs at the front end and operational excellence at the back end."

Amin Rajan is the chief executive of Create, a UK-based research consultancy

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