The memory of failed lift-outs have been banished to the past and outsourcing is now making inroads into the front and middle offices, discovers Nicholas Pratt
It is easy to forget just how successful outsourcing has been in the asset management industry given that 30 years ago many managers used to perform their own custody and 20 years ago administered and accounted for their own funds. Nowadays, custody and fund administration and accounting are almost universally done by third parties and no longer even considered as outsourcing.
The sticky patch came in 2004 and 2005 when a number of high-profile back office lift-outs were abandoned and a number of asset managers suggested that the quality of service provided by outsourcers was being jeopardised by the low prices that intense competition had generated.
In today’s market a more realistic and mature attitude to outsourcing exists and asset managers are beginning to see the benefits in terms of both reduced cost and improved service. The eighth annual Investment Operations and TA Benchmarking Study by consultancy Alpha FMC concluded that asset managers who have outsourced operations have, on average, good or better service levels than those that are kept in-house and also make savings of between 5% and 10% across all operations.
According to Alpha FMC’s director of benchmarking, Bo Lantorp, the study’s results are a confirmation that the initial problems that invariably occurred after a migration or a lift-out have now been resolved and have laid the way for the outsourcing trend to continue. “With many of the first-generation outsourcing deals coming up for renegotiation, there should be further opportunities for asset managers to share the benefits of economies of scale.”
Many of these opportunities lie in the growing trend for asset managers to outsource more middle- and front-office services such as compliance reporting, mandate monitoring and counterparty exposure measurement, as well as the more client-facing tasks such as performance measurement and attribution and client reporting, marking a significant shift from the attitude that outsourcing be restricted to the process-heavy, back-office tasks where the managers’ clients are not directly involved.
“Custody outsourcing was about scale and cost; outsourcing fund administration was about reducing risk; front- and middle-office outsourcing is about reducing fixed costs, which have risen due to the cost of accommodating new instruments and the increase in the volume of trading,” says John Campbell, head of investment manager services, Europe and APAC, for State Street. “Fund managers also want a seamless integrated infrastructure between back, front and middle offices and this is easier to achieve by outsourcing.”
Fund managers are also realising that once they outsource other parts of the business like the record keeping and administration, they no longer hold the accounting record so it makes little sense to attempt the performance measurement or quarterly fund reporting in-house. “Why should a fund manager have a whole team of people doing client reporting when the third party is providing all the data?” says Campbell. Outsourcing client reporting should not necessarily affect the relationship between a manager and their client, he says. “We have some clients, often boutique managers, who are protective of their clients and will take all of the data we provide and then deliver it themselves to the client. But we have other clients, often the larger managers, who are happy to let us do it all, including the delivery of the reports.”
Outsourcing holds an additional attraction for asset managers, particularly in relation to front- and middle-office services like performance measurement and fund valuations, and that is independence. “I believe the independence element is pretty new and is a largely a result of the financial crisis,” says Olivier Laurent, director, of alternative investment product management at RBC Dexia. “Asset managers want to show independence in terms of how they measure the risk that is being taken and to the valuation of their funds, particularly any OTC [over-the-counter] derivatives.”
Maintaining independence from the investment banks that create and sell OTC derivatives can become increasingly challenging, says Laurent. “As the underlying instruments become more complex and less liquid, it is harder to get the relevant market data without having to rely on data provided by the investment banks. We have a team of quantitative analysts in Luxembourg and France that are able to build volatility curves and volatility matrices on data provided by the likes of Bloomberg and then we can run the calculations in-house. I think the fact that we can demonstrate our independence is key for asset managers.”
The importance of independence is a new dynamic in the outsourcing world. Whereas previous outsourcing trends have been fuelled by the fund managers’ desire to either lower their cost base or improve their operational efficiency, the demand for independent valuations is coming from investors and regulators. The financial crisis highlighted the uncertainty within the OTC derivatives market, both in terms of who was exposed to what and also what the exact value of these instruments were. Consequently the old practice of relying on a counterparty’s price to value the instrument is no longer acceptable.
However, despite the demands for independent valuations, the rate of adoption among managers appears to be disappointingly slow. According to findings from the eighth version of the annual Alpha FMC Investment Operations and TA Benchmarking Study, only 50% of participants use independent sources to price OTC derivatives, and only a handful use more than one independent price. In particular there is still a significant reliance on counterparties as the only pricing source for the more complex instruments.
“Given the central role that derivatives played in the recent market turmoil, we would have expected most asset managers to have improved their pricing processes and reduced their reliance on counterparties,” says Stuart McNulty, a manager at Alpha FMC. “While there have been improvements, they have not been of the scale or speed that we would have expected. However, we anticipate that the process towards price source diversification will continue and that next year’s study will show most managers have taken significant steps towards a more robust pricing model.”
Outsourcing providers have generally adopted one of two approaches when delivering independent valuations for OTC derivatives – the first involves taking the clients’ positions and then sending them to a number of valuations specialists before aggregating the results and sending them onto the client. The second approach involves the outsourcing provider creating its own pricing model and combining it with raw data to calculate an independent valuation from first principle.
The advantage of the second approach is that it allows asset managers to agree and approve the models and methodologies used by the outsourcing provider, a benefit which might be denied them if the outsourcing provider is relying on the models of a specialist provider keen to protect its own intellectual property. And despite the fact that the second approach will be more costly, the greater transparency is likely to prove alluring for asset managers.
JP Morgan, for example, provides valuations for OTC derivatives that are calculated through its own in-house pricing engine. “We agree the methodology with the client and calculate it ourselves,” says Susan Ebenston, global funds services business executive at JP Morgan Worldwide Securities Services. “These are difficult assets to price and I think you have to be able to create the price and methodology independently and with transparency so that the client can see the working behind it.”
Other providers are keen to stress the lengths they will go to in order to calculate a valuation. “If we can observe market data we can model the values,” says Ron Tannenbaum, managing director of GlobeOp. He talks of building a multi-dimensional matrix of position valuations based on an array of market data inputs such as rating agency spreads, counterparty spreads, market data vendor spreads and a manager’s own spreads. Then the consistency of any price produced is checked against other prices and in line with the tolerance levels set by the client. Additionally, all of the data used is then made available to the client for auditing purposes and peace of mind. “There is an enormous amount of data and you have to be able to provide access to that data back to the client through clear exception-based reports so that they can see how the valuations have been constructed.”
Given that outsourcing trends take longer than expected to come to fruition but often go further than expected, the question for the future is just what will remain in-house rather than what will be outsourced. “No manager is going to outsource their investment decisions, but outsourcing is about everything that happens after the execution of a trade,” says GlobeOp’s Tannenbaum. “It is our job to take that burden away – from what happens after the buy-sell decision all the way to the investor reporting.”
State Street’s Campbell has similar sentiments. “I think in the future outsourcing can be extended to risk and compliance, collateral management, OTC processing and even trading. Discussions around outsourcing the trading function have been going on for a long time but they are being discussed again right now. Similarly there is a lot of talk around providing front-office applications to support the investment process. Investing is becoming a more complex and expensive operation and many fund managers do not want to carry this burden.”©2010 funds europe