Actively managed funds:

the new cost paradigm

A host of challenges face actively managed funds as they decide on what course of strategic action to take, and seek to establish new business models in the post-financial crisis environment. One of the key priorities will be the need to make operations more efficient, selecting the best ways to reduce cost and risk while mobilising resources for growth.

By Gareth Quinn and James Sproule

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As the investment manage­ment industry adapts to pressing investor and regu­latory concerns about li­quidity and capital protection in a new, competitive landscape emerging from the financial crisis of 2008-09, industry business models are in transition. The existing order is changing with the in­vestment management industry dividing into highly commoditised passive funds and higher fee, higher returning, active fund management. High-performance funds are to be distinguished not just by their ability to manage risk and conse­quential returns, but by their operational efficiency which should allow for com­petitive pricing.

In this dual-track environment, there will be on the one side a large number of passive or tracker funds, comprising ap­proximately two-thirds of funds under management. On the other will be a more diverse group of actively managed funds. Within this part of the invest­ment management industry, it will be reputation, past performance and per­ceived potential, which combine to de­termine the framework and scale of fees.

There seems little question that the ac­tively managed fund industry has suf­fered from some short-term distractions, even if they only have taken the form of fending off over-zealous regulation. In the longer term, however, there are sound reasons for optimism over the outlook for investment management generally and actively managed funds in particular. This is driven by the increas­ing realisation that:

• the population of the developed world is aging and most people have made inadequate retirement provisions;

• for many in the developed economies, these are peak earning years and the life-cycle savings model points to greater savings being made in the next few years;

• higher savings and/or returns are needed to compensate for higher taxes imposed on savings by cash-strapped governments saddled with the ramifi­cations of the financial crash on re­duced fiscal revenues;

• the number of global high-net-worth individuals has grown by 8% per an­num over the last decade, while the wealth of this group has grown by 9% per annum. These high-net-worth in­dividuals have often been pioneers in driving financial markets forward.

Actively managed funds are well posi­tioned to pick up more than their fair share of these investment flows. Not only have actively managed funds be­come steadily less exclusive in recent years, the growing number of moder­ately well-off investors are seeking to diversify their additional wealth away from the risk and return delivered by commoditised long-only funds.

This realisation has come at a fortunate time for actively managed funds as their promise of delivering returns whatever the wider financial market conditions may not have proved to be as impossible as financial theory might suggest.

FUTURE IMPLICATIONS

If this vision of the future is correct, what are the implications of the neces­sary and impending structural changes? First of all, the old fee model of 2% of assets under management (AUM) and 20% of any outperformance above a des­ignated benchmark was increasingly il­lusory, even before the credit crunch. Larger investors had long flexed their muscle to press successfully for dis­counts. Greater awareness of these dis­counts is making investors with less lev­erage unwilling to pay high fees for mediocre returns.

At the same time, restrictions designed to help investors have also been falling by the wayside. Restrictions on paying bo­nuses while a fund is below a designated value (high water marks) and redemption restrictions have both proven in light of experience to be either impossible to im­plement or damaging to investors. In­creasingly the focus is becoming one of trading off fees for long lock-in of funds.

For those few funds which have proven track records of success, substantial fees may still be achievable but, even here, the fact that fees are going to be tied to returns is likely to spell the death of the standard fee model. For the rest of the active fund management universe, the reality is that fees are not coming under pressure so much as collapsing.

The collapse in fees is exacerbating an­other concern. Many actively managed funds have found their operational structures are not simply costly; they clearly have not been up to the job. Costs as a proportion of income ratios rose by an average of 75% to 138% during the financial crisis. Clearly these were un­sustainable and while cost-cutting must be part of the solution, blanket cost-cut­ting would not allow a business to thrive in future and cutting costs to meet pre-crisis ratios would result in a business so lean that it starved.

Investors bruised by the financial crash are now naturally more wary and de­manding, while significantly increased regulatory pressures means effective risk management requires clear structures which can identify risks and rewards. Further, issues such as liquidity, which had not previously been fully considered, now must be incorporated into any risk model. Finally, operational models must allow for effective stress testing, includ­ing assumptions about how illiquidity might impact upon a portfolio, and how issues such as redemption risk could be effectively ameliorated.

Post-crisis opportunity
Today, with financial market liquidity recovering and prices at least stabilising, top performing funds are again focused on the future. What they find is that in­vestors increasingly demand more fa­vourable terms than in the pre-crisis world. For the top end of actively man­aged funds, investors are requiring rig­orous hurdle rates (minimum returns before performance fees are paid), and the right to trade their actively managed fund holdings in the secondary markets.

For all funds, top end through to com­moditised tracker funds, investor de­mand for transparency is creating pres­sure for detailed and timely information of their holdings. This pressure will re­quire actively managed funds to do much more than the regulatory mini­mum in terms of frequency of reporting, key financial metrics, and corporate gov­ernance.

One outcome is that investors are seek­ing greater control and clarity through separately managed account platforms, with some funds now seeing 50% of in­vestors opting for this structure. These managed accounts give investors the ability to influence investment decisions, ensure that performance is not hindered by conflicting positions, and help to satisfy investor de­mand for trans­parency.

HIGH PERFORMANCE

Among the challenges facing actively managed funds as they choose what business strategies to adopt, is the fact that investors will insist that actively managed funds adopt or build new busi­ness and operating models that provide more transparent assessments of finan­cial risks.

On a competitive level, investors’ grow­ing focus on cost and transparency will see agile, low-cost funds emerge to chal­lenge underperforming active fund managers. Meeting this competitive challenge, together with the other shifts as described, will demand new ap­proaches.

Business models
Actively managed funds will increas­ingly need to build and manage operat­ing and business models that provide more frequent valuations and more transparent assessments of financial risks. They will also have to respond to investor demand for demonstrably ro­bust structures of corporate governance and operational infrastructure. In the past, when cash flows were apparently inexhaustible, actively managed funds typically managed all system and proc­ess development in-house on a ‘best-of-breed’ basis. However, with costs under scrutiny and a looming demand for sig­nificant upgrading of risk management and reporting systems, actively managed funds are set to shift towards greater use of outsourcing and collaborative part­nerships for operational and administra­tive activities. This would mirror a simi­lar shift already underway in the mainstream investment management in­dustry.

This trend is already manifesting itself in actively managed funds moving away from bespoke systems towards greater use of (ever more capable) reusable and packaged software, and in actively man­aged funds’ growing readiness to use in­dustry-wide utilities for back-office ac­tivities such as legal, compliance and human resources.

The scope for savings becomes apparent when comparing top performers against the wider investment management in­dustry. It has long been the case that as­set managers see much greater variation in such areas as cost income and revenue per employee than is seen within invest­ment banks. As asset managers focus upon operational efficiency, there is al­most certainly scope to drive asset man­ager operational efficiencies towards the tighter control and monitoring tradi­tionally seen in the more mature invest­ment banking industry.

Industry structure
Alongside the changes in the internal operating models of actively managed funds, the wider industry will also un­dergo a shift in the way that the key players in the value chain work together and interact.

Traditionally, the industry has had a tri­partite structure consisting of prime brokers, administrators and actively managed funds. However this industry model has proved fallible, not least after the Lehman collapse, when it emerged that investors’ cash had not been segre­gated by the prime broker. The Madoff affair demonstrated even deeper failings, where a lack of checks and balances with an independent third-party administra­tor meant that the funds’ lack of actual trading transactions went undetected.

Along with administrators, custodians are also playing a greater role in the ac­tively managed fund industry. Adminis­trators hold investors’ underlying assets, while the prime broker holds the incum­bent assets when they are pledged for lev­erage. This structure will give investors greater comfort, reassuring them that the ownership of their assets will be relatively clear-cut in the event of insolvency.

Risk management
The credit crisis has seen events pre­dicted to happen once in a century oc­curring on successive days. The result has been that the best talent in the in­dustry is now undertaking a significant reassessment of value-at-risk (VaR) measures and looking for robust succes­sors. While market and corporate risks have long been appreciated and mod­elled, the extension of risk assessments to areas such as counterparty, liquidity and operational risks all require new ap­proaches and considerations.

Among the requirements of any new risk assessment system will be the need for greater data analysis, which in turn is highlighting the priority for ef­fective and integrated systems. While none of this is impossible, what it does point to is a need to have risk assess­ment work across product groups and internal silos.

Considerable portions of risk manage­ment, and thus high performance, are not about enhancing returns, but avoid­ing significant losses. To achieve and sustain high performance, actively man­aged funds need to tackle counterparty risk directly and systematically, and em­bed it as a critical and integral compo­nent of their operations.

Best practices
The industry best practices for tackling counterparty risk include making con­sistent internal portfolio and risk assess­ments, using prime broker services such as tri-party account methods, as well as using in-house and independent third-party valuation technology and services. An important shift in counterparty risk is that it is expanding to include not just banks and prime brokers, but other par­ticipants and commercial counterparties in the actively managed fund value chain.

Counterparty risks also link directly to operational risks. For example, the in­dustry has traditionally been served by small and niche software vendors focus­ing on areas such as portfolio account­ing. Many of these suppliers built up their business on the back of a continu­ing flow of new business from actively managed funds.

Today, with the supply of new business constrained, there are concerns over the viability of some niche providers, creat­ing technology risk for their customers. As a result, actively managed funds are turning to larger and more established sell-side technology vendors, on the ba­sis that these providers’ size and invest­ment banking client bases make them more commercially secure.

Bespoke systems may well have highly desirable attributes, but these should be balanced against the advantages of stand­ardised systems, which are capable of in­corporating greater complexity and tai­loring than has been the case historically.

Finally, liquidity should be seen as an opportunity as much as a risk. It is to be expected that actively managed funds will move towards addressing liquidity risks through locking in funds for longer periods of time, allowing them to avoid crystallising losses in a crisis. Moreover, it is likely that many funds will seek, and investors will realise, that accepting illi­quidity risk can be a route to long-term outperformance.

Product regeneration
Investors are not so naive as to ask for returns without risk, but they are sensi­ble enough to demand that they know the risks they are undertaking to achieve their hoped-for returns. What this means in practice is that greater trans­parency will be demanded as a matter of course.

Combining these basic observations with expectations for the wider invest­ment management industry, two conclu­sions can be drawn. First, successful ac­tively managed funds will have to follow a variety of strategies in order to cater for investors’ diverse demands. This means amongst other things the era of the small, single strategy start-up fund is likely to be on the wane. New entrants to active fund management are far more likely to bring their expertise to an es­tablished fund as opposed to setting up on their own as had occurred in the boom before 2007.

Secondly, operating costs as a proportion of revenues can vary by as much as 25%. Such differences should be seen as being as important as returns themselves and a good deal more predictable. In the new, more transparent world emerging, cost-effective operations will be a significant differentiating advantage.

Ancillary Services
For actively managed funds intent on growing rapidly and concentrating on their core expertise, prime brokers have long been a valuable resource. But the needs of actively managed funds have evolved considerably over the past few years.

The credit crisis has highlighted a series of new constraints and problems. Where funds were small, or not sufficiently di­versified from an operational point of view, they were vulnerable to prime bro­kers withdrawing credit lines. Even be­fore this danger became apparent, there was growing concern that overreliance on a few prime brokers would leave actively managed fund strategies exposed and li­able to replication by low-cost funds.

The solution has been to increase the number of a fund’s prime brokerage rela­tionships, which addresses the above problems, but does highlight the need for effective IT systems capable of recon­ciling positions across a multitude of prime brokerage systems.

The credit crisis has also raised concerns about client money rules. The Lehman collapse led to a number of surprises, one of which was that their prime brokerage services did not effectively separate cli­ent monies. This failure is certain to re­sult in new regulatory requirements and (undoubtedly better) systems, which will in turn require new interfaces within ac­tively managed funds.

The wisdom of having an independent ad­ministrator is now so apparent that the justification need be no more than one word: Madoff. While it is to be expected that levels of service will be the key dif­ferentiator amongst administrators, it will be against a background of low prices.

STRATEGIC COST REDUCTION

In the post-crisis environment, the emerging contours of which already sug­gest a more hostile and competitive cli­mate, a focus on cutting costs and in­creasing operational efficiency will be essential. This is not easy. The actively managed fund operating model is being squeezed by a wide range of internal and external demands, and any cost reduc­tion programme must take account of both sets of influences.

In such an environment, it is vital to un­dertake strategic cost reduction that does not just cut costs, but cuts the right costs. To stay competitive, many actively managed funds need to achieve cost re­ductions of up to 50%, levels the indus­try has not experienced previously. Moreover, it is notable that asset man­agement cost-to-income ratios average 75%, while investment banks have achieved a cost-to-income ratio of 65% (both figures are pre-crisis).

While one-off, tactical costs programme will deliver some of the required answers and results, such an approach will not achieve the savings on the scale required. So nothing short of a strategic approach will be sufficient.

However, efforts to cuts costs by tack­ling the major traditional cost levers such as IT spending require signifi­cant up-front investment that may well not be available in the current en­vironment. So the optimal first step is to identify and exploit a mix of short- and medium-term activities. These can then be used to fund longer-term and higher-impact initiatives, in turn leading to a need for more structured organisation and approach.

Key cost levers
We have identified what we believe to be the six key cost-efficiency levers in an ac­tively managed fund. These levers are: customers; sourcing; process; technol­ogy; people; and products. Each of these levers is accompanied by key questions, reflecting the fact that each cost lever can be broken down into specific areas of analysis that enable the identification and removal of cost while enhancing the business-critical capabilities.

These cost levers each provide a cost-effi­cient focus on the relevant capability, creating a point of departure for the achievement of market-leading results in each capability, and supporting the or­ganisation’s progress towards high per­formance. Throughout, each specific cost reduction initiative is based on the delivery of immediate benefits through the minimal investment.

The most successful cost reduction pro­grammes will have an open mind as to potential approaches, including the use of outsourcing for a wider range of ac­tivities. The result will be that the aware­ness of outsourcing processes and sup­pliers will increase, driving forward the willingness of actively managed funds to consider an ever-widening range of mid­dle- and back-office functions which might be outsourced effectively.

Revenue drivers
To achieve and sustain high perform­ance, actively managed funds will also need to revisit their revenue streams. This means fees. The exact fees charged and structures of fees are likely to re­main an opaque area of actively managed fund activities, with large investors often able to negotiate better deals. What the credit crisis has shown is that fees, and the accompanying restrictions, were not sufficiently stress-tested to be realistic in a downturn, and investors will certainly demand change.

At the top of the actively managed fund management tree, the old hedge-fund fee model of 2% of AUM and 20% of any outperformance was at times caricatured as a compensation scheme with some fund management attached. Worse, for large funds, the 2% ended up being suf­ficiently generous that the outperform­ance fee ultimately did not prove a sig­nificant incentive. Even for long only funds, where fees were more likely to be in the order of 1.5%, funds were often large enough that performance was not an immediate concern.

Already we are seeing glimpses of what might well become the new model, with outperformance fees rising, but AUM fees falling, in some cases to zero. Such a fee structure would allow actively man­aged funds to compete effectively against tracker funds where fees are levied upon AUM and overall returns remain rea­sonably constrained.

OPERATIONAL EXCELLENCE

We have every reason to believe that while the future of active fund manage­ment is bright, at the same time, the re­wards will go to those that meet the con­siderable challenges. Successful strategies may deliver outstanding re­sults, but efficient operations are crucial for everything from effective risk assess­ment to competitive fees, whatever the state of the wider financial markets.

With an increasingly professional, more diverse and more demanding client base in evidence, actively managed fund managers are already going about to im­prove their product proposition by en­hancing capabilities in asset allocation, absolute return and product innovation. Further, they are improving service standards and raising technical collabo­ration with consultants and fund plat­forms in efforts to broaden distribution.

Over the course of the next few years, the number of actively managed fund houses operating as integrated producers will likely decline and multi-boutiques could well become the dominant operat­ing model among medium and large in­vestment managers. Creating a small company mindset in a large company en­vironment helps to foster principles of meritocracy, personal accountability and leadership.

Furthermore, a fiduciary overlay will come to differentiate the winners from the losers. Success will require active fund managers to exercise due diligence by developing a fiduciary overlay that delivers five key drivers for growth: con­sistent returns, a deep talent pool, excep­tional service, a value-for-money fee structure and a sophisticated integrated infrastructure. This overlay will seek a three-way financial and non-financial alignment between: active fund manag­ers and their clients; active fund manag­ers and their professionals; their profes­sionals and clients.

Multi-boutiques are effective in deal­ing with two primary issues facing in­vestment managers. First, they can af­ford to build strong, consultative relationship management teams to work directly with clients in finding appropriate solutions to meet their needs. This aligns boutiques well to compete in a world where clients desire a more consultative approach to doing business. Second, they can effectively manage the diseconomies of scale con­fronting managers. This means that they are less prone to running out of capacity in capabilities of interest to cli­ents.

Enhancing this trend will be third-party administrators, who are now building a new generation of platforms, with en­hanced line speeds, scalability and multi-product capabilities. Consequently, they are emerging as strategic partners, using their critical mass of clients to deliver op­erating leverage, delivering economies of scope enabling their clients to enter new markets in Asia, Europe and Latin America via UCITS funds.

In the post-crisis environment, opera­tional excellence is about doing new things to cope with the new reality, while also doing old things better. It is about ensuring that active fund manage­ment remains a quintessential craft busi­ness, but with professional overlay of skills and infrastructure to exploit the opportunities created by the crisis.

GROWTH OPPORTUNITIES

New growth opportunities are expected from increased institutional customers’ demand for tailored and regional offer­ings. These developments will be ac­companied by increased standardisation efforts in the front-office environment to balance the additional investments through simplification of internal proc­esses and IT. Middle- and back-office departments are focus areas to stand­ardise and centralise processes. While the search for initiatives to improve ef­ficiency and lower costs has been an area of continuous attention in the past, and is expected to remain so for these de­partments, standardisation and centralisation is a relatively new trend for the front office.

Especially in today’s financial markets, established product-oriented IT plat­forms, organisational and/or reward structures will be substituted with cross-product structures. Additionally, the or­ganisational boundaries between differ­ent business divisions in large active fund management groups are becoming more permeable. This trend can be lever­aged by intelligent operating model set­ups, which realise group-wide synergies.

By way of conclusion, three distinct trends in establishing a new business model geared to reducing cost and risk while mobilising for growth will characterise actively managed funds going forward:

• funds will more clearly articulate risks undertaken to achieve expected returns; performance-related fees will depend on a consistent delivery of these returns;

• the commoditisation of significant parts of the industry will leave large players with dominant positions in certain areas, while allowing greater opportunities for smaller and more niche players (multi-boutiques) to evolve;

• differing strategies will require differ­ent operating requirements, with technology becoming a key differen­tiator for strategies where risk is short term or market related.

In summary, actively managed funds will have three ways to improve profits in the new, more hostile competitive land­scape: increase management fees; lower costs; and enhance performance fees. The first is under pressure, while the last is subject to increasing scrutiny and claw-backs. Only the lowering of costs remains completely within management control. Wide variations in efficiency and productivity ratios within the in­vestment management industry overall point to the potential for significant op­erational efficiency gains, not only gen­erally but in the specific area of actively managed funds.

Gareth Quinn is Director of Alternative In­vestments within Accenture’s Capital Markets Practice, based in London, UK. His previous roles include: Managing Director for Alterna­tive Investments at SunGard; CEO of Trade Stream Global; and various global assignments with Deutsche Bank, Lehman Brothers and Morgan Stanley.

James Sproule is Global Head of Capital Mar­kets Research for Accenture, based in London, UK. Prior to joining Accenture, he worked for over 15 years as an economist for a variety of investment banks including Bankers Trust, Dresdner Kleinwort and Augusta & Co.

Accenture is a global management consulting, technology services and outsourcing company. Combining experience, comprehensive capabilities across all industries and business functions, and extensive research on the world’s most successful companies, Accenture collaborates with clients to help them become high-performance businesses and governments. With approximately 204,000 persons serving clients in more than 120 countries, the company generated net revenues of US$21.6 billion for the fiscal year ended 31 August 2010. More information at www.accenture.com.