Outsourcing in the Asset Management Business


New York, NY – In the second half of 2008 and the first quarter of 2009, the asset management business experienced one of the industry’s most challenging periods in history.  In the wake of this tumult, a number of questions remain, including whether the industry has learned from the mistakes of the past and positioned itself to better withstand financial market crises in the future.  One lesson learned by many investment managers is the value that scale and increased efficiency can have on their ability to succeed in difficult market environments. 

The following white paper, written by Andrew Houston, co-founder of knowledge process outsource (KPO) provider, Amba Research addresses the role that outsourcing can play in improving the efficiency of asset management firms.  Below, we have included two excerpts from this white paper (the Executive Summary and a section on Research Outsourcing).  Click the following link for the entire text of this report.  Outsourcing as a Profitability Driver in the Asset Management Industry


Executive Summary

The asset management industry has just passed through one of the most testing years in living memory. Investors and regulators are both likely to subject asset managers to much greater scrutiny than they have in the past. Managers cannot rely upon consistent price appreciation in asset markets as the key driver of profitability. It has become imperative for firms to simultaneously achieve improvements in their business models:

1.     A cost-effective distribution model that can help grow AuM on a consistent basis

After staff compensation, marketing and distribution is the single-largest cost category in most fund managers’ profit and loss accounts. Outsourcers can release onshore staff time that is currently devoted to repetitive tasks and use this time to focus on identifying specific factors that will make the firm’s products a compelling solution for each prospective client.

2.     A state-of-the-art risk management platform and associated internal and external reporting

Institutional asset managers need to be able to satisfy regulators and potential investors that their reporting systems provide a clear picture of the aggregate exposure and risks undertaken by all operating units within the firm. Outsourcers can help with the heavy lifting required to reconcile reports produced by incompatible legacy systems.

3.     Active managers must do everything they can to sustain the majority of their funds in the upper two quartiles

Portfolio managers and buy-side analysts need to be relieved of tasks that are not directly related to the generation of alpha or benchmark out performance. Research outsourcing can deliver the specific bespoke information needed to support an investment decision, as well as ensure that consistent valuation standards and investment methodologies are applied and documented for each investment style.

Managers need to examine how much their daily activities contribute to the delivery of value for the firm. It may be the case that onshore seniors could deliver more value if they outsourced repetitive and lower value added tasks. Identification of investment ideas and exercising judgment based on experience, and consistent application investment method are the key activities of investment seniors.

In addition to reviewing back- and middle-office activities to obtain the optimal in-house vs. outsourced services mix, fund managers should also review risk management and front-office activities such as funds marketing and research support to determine whether or not additional efficiencies can be gained by taking advantage of outsourcing in these areas.


In a world of lower asset price appreciation, efficiency matters much more

We believe that one of the lessons learnt in the past decade is that asset price appreciation can no longer be relied on as the primary driver of asset manager profitability. During the golden years of the 1980s and 1990s, when interest rates steadily declined and globalization delivered a surge in market size, the S&P 500 rose 1,350% between January 1988 and January 2000.

High fiscal deficits in the major industrialized economies will remain a drag on growth over the next few years. Hence, many firms in developed markets are not likely to sustain high growth of revenues and profits in the next decade. In a world of stable or rising interest rates, valuation multiples cannot expand as rapidly as they did in the golden era of the 1980s-90s. It would be foolish to base a business strategy on the basis of a rosy scenario of assumed double-digit market asset price appreciation each year.

In the next few years, asset management firms will therefore need to focus more than ever on their ability to attract incremental funds under management and on the efficiency with which they can deliver their service.

The most important thing for active managers remains the achievement of fund performance in the top two quartiles. However, cost efficiency in delivery of service and raising of new funds will be the key to sustained high levels of profitability.

Outsourcing is part of the solution

Asset managers should consider outsourcing functions where either scale economies are not enjoyed or best-in-class operational efficiencies cannot be achieved due to the absence of a technology platform or a dearth of skills.

Some aspects of asset management outsourcing are well established and we will not address them in this paper. Most senior managers of asset management businesses will be familiar with global custody, securities lending, client servicing, accounting and settlement of trades in complex financial instruments, which are now in the mainstream of outsourced services.

Suffice it to say that there are indications that asset managers are taking a more aggressive approach to mainstream outsourcing. State Street grew its asset servicing business by 11% to a record USD1.66tn in 2008. BlackRock Solutions, with its proprietary leading investment platform and associated risk analytics and advisory services, grew revenues by more than 100% in 2008 and now generates revenues of more than USD100m per quarter. Northern Trust grew its trust investment and other servicing fees by 3% in 2008 as new business offset the lower market valuations. Furthermore, its foreign exchange revenues were up by 75% in the same period.

The three major factors influencing decisions taken to outsource are:

  1. Scale: Revenues associated with a product or geography do not justify fixed costs associated with supplying the product to clients
  2. Skills: The outsourcer has proprietary skills that deliver a better cost/quality mix than an in-house solution
  3. Technology: The outsourcer has a technology platform that not only reduces risk and improves quality but also lowers costs compared with an in-house built solution

Most commentators agree that asset management outsourcing started in back-office accounting functions before moving to the more complex, technology dependent middle-office.

Less well known are some of the more recent developments in outsourced services. These include offshore support for front-office services like funds marketing, a costly key to raising AuM, and research support important for maintaining active fund performance. The other hot topic of the day is risk management, an area all fund managers need to review in the current climate.

Therefore, research support, fund sales and marketing, and risk management are the three key areas of focus for outsourcing.

Research outsourcing

As sell-side research has shrunk over the past decade, asset managers have been faced with some hard choices about the provision of adequate research on which to base their investment decisions. Larger asset managers have, until recently, had enough funds available to increase their in-house research capabilities. This has been a less viable option for small- and mid-sized asset managers. Fund management firms, however, need to demonstrate the rigor and consistency of their investment process if they are to find their way on to the consultant’s recommended list. Hedge funds have to date relied on the skills and experience of their senior principals and when it fit their strategy, they concentrated commissions on sell-side firms that provided them with the best access to research. However, hedge fund seniors often find themselves with insufficient time to research all their ideas in sufficient depth to support a high- conviction trade.

Independent research has flourished in some niches; however, most firms have struggled to build sufficient revenue streams to support broad coverage with high-quality fundamental research. The independent sector is therefore a mixture of niche providers who focus on larger sectors and data providers which provide more information than in-depth analysis.

Facing a less certain future post 2008, many managers should consider outsourcing as a means of plugging the gaps in their research needs at an acceptable cost. Onshore seniors will always retain ultimate responsibility for security selection, but they may be able to make better decisions with better resourced support. Active managers have a wide variety of investment styles, and therefore there can be no “one size fits all” prescription with respect to offshore research support. Vendor selection should be based on:

  1. Domain expertise and the ability to understand the client’s investment process and objectives
  2. Staff training, employee qualifications and the ability to leverage in-house sector and technical expertise
  3. Compliance process plus physical and IT security
  4. Transparent delivery process
  5. Communications plan, including a clear feedback loop

There are a wide range of services available in the market, some of which are listed below to provide a flavor of the range of services that can be delivered from offshore locations. Equity research services available from the major specialist research outsourcers include: 

  • Idea validation: Specific investment theses can be researched in depth and supporting data gathered
  • Coverage initiation: Coverage initiation and maintenance on sectors not adequately researched by the sell-side
  • Portfolio management: Stock news alerts and monitoring can be established to enable managers to stay on top of their portfolios. Screening of broker research, stock universe screens and independent support for company visits

Credit research support can include: 

  • Fundamental research: Fundamental research on investment grade, high-yield, and cross-over credits. Capital structure analysis and the creation of automated bond screens
  • High yield and distressed debt: Cash flow modeling, application of shadow rating models, LBO and M&A modeling, valuation of hybrid instruments, recovery valuations, covenant monitoring, and indenture scanning
  • Structured finance: CDO monitoring, CDO constituent analysis, and ABS/RMBS monitoring

Quantitative research is a promising area for outsourcing due to the constrained supply of experienced professionals onshore. The Indian subcontinent has a depth of talent available in computer programming and pure and applied mathematics. Where this expertise is harnessed by an outsourcer with expertise in capital markets processes, the combination can make for compelling value vs. onshore alternatives. Outsourced services in this space cover a wide range of domains including: 

  • Equity services: Creation of automated screens, factor selection and back testing, portfolio simulations, and model building
  • Index research and data management services: Index construction and maintenance to data validation, and aggregation
  • Mathematical modeling services: Monte Carlo simulations, time series econometrics, and statistical analysis
  • Technology solutions: Database design and development, customized application development, and process automation.

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