According to group chief operating officer of Schroders, Markus Ruetimann, the relationships between investors, asset managers and outsource providers are changing. Are you prepared?
Prescriptive regulation, macroeconomic challenges, low investment returns, decreasing profit margins and increasing operating costs are changing the relationship between investors, asset managers and outsource providers.
Operational agility and efficiency have become vital business competences, many of which are embedded in operations. More commonly known as back offices, these departments are now at the forefront of innovation as they devise the technological processes and solutions that support new investment instruments, strategies, products and an insatiable demand for data from clients, regulators and business partners.
Asset managers and outsource providers need to expand and selectively upgrade the DNA of their talent pools as well as their technological capabilities in order to ensure regulatory compliance and accommodation of new client requirements at sustainable, market competitive operating costs. These economic and operational challenges are blurring the boundaries between the buy and sell sides of the financial services industry, as providers begin not just to price services and liquidity, but also operational risks and liabilities.
Many firms have mandated C-level leaders to champion operational readiness to new regulations, as well as to liaise with clients to ensure they are aware of the company's long-term response to the changing regulatory landscape. Close coordination will be required between risk, compliance and financial reporting functions to ensure the efficient management of capital and liquidity implications.
Substantial investment in technology will also be needed to facilitate the automation of some of the regulatory processes, and regulatory changes will be on the agenda of C-level leaders for many years.
New challenges, new opportunities in asset management
The asset management industry is preparing for an environment of low economic growth in the developed world, depressed demand from retail and high-net-worth investors and future pricing models that are influenced by regulation. Multiple forces are likely to drive fees down and operating costs up.
This might well turn out to be a secular trend during which Darwinian natural selection paradigms are likely to be tested. 'M&A parachutes' are being sought to facilitate a quick exit and a safe landing for smaller asset management firms that are unable or unwilling to overcome financial and regulatory pressures. Mergers are challenging though, as cultural alignment and assimilation of investment processes can be difficult to achieve.
Increasingly, outcome orientated products will prevail. These require investment talent and operational scale to be economically sustainable. Furthermore, some investment strategies, government bond products for example, might no longer be viable after fees are taken into account.
Conversely, opportunities may arise as banks slim-down, and long-term vehicles find favour among some of the retail clients. The asset management industry can benefit from the fact that savings will increase worldwide, provided it can manufacture the products that deliver a decent investment return and some protection against inflation.
The war for talent and the need for productivity and sustained profitability will see winners and losers among asset managers. Industry consolidation, long predicted and some say, long overdue, is likely to be upon us. However, finding willing buyers for the many fund management houses being sold by their banking parents will not be easy.
Prescriptive regulation is here to stay
Regulators are about to issue the final versions of rules aimed at increased investor protection, such as RDR, AIFMD, and UCITS IV, as well as mitigation of risks for certain products or instruments, such as Solvency II, MiFID II, OTC Derivatives Central Clearing, and increased regulatory reporting imperatives, such as FATCA.
The cost of compliance with this wave of new regulation will not only challenge existing market participants, but may also become a deterrent for new entrants.
Some have commented that the regulatory responses are excessive and do not necessarily protect investors from loss any more than prior to the financial crisis. Others back the merits of prescriptive regulations because they create transparency about the potential risks and rewards, raise the bar for those who provide investment advice, and they will somewhat reduce counterparty risk through collateralisation of certain transactions. All of this comes at a cost that will have to be absorbed by service providers or investors.
Financial revolution or evolution?
Hedge fund, property and private equity fund managers are likely to experience a regulatory revolution in the coming months. The introduction of the Alternative Investment Fund Managers Directive in 2013 will force firms, many of which have not been regulated thus far, to introduce new risk management functions and supporting technologies.
Governance structures must also change because these risk functions have to be undertaken independently of portfolio management. The new risk management framework needs to be able to identify, measure and manage a multitude of risks, including credit risk, counterparty risk, liquidity risk, market risk and operational risk.
Traditional and alterative fund managers are now redefining their risk appetites and conducting risk management exercises to test their readiness for potentially the most challenging stress test ever - the eurozone crisis.
In view of this challenging operating environment, asset managers continue to deepen their outsourcing arrangements in search of cost savings, to transform fixed costs into lower variable costs and to gain access to other companies' operational and/or technological competences. The question is no longer whether to outsource, but what and to whom.
Asset managers and pension funds of modest size will find it increasingly difficult to comply with new regulations and to invest sufficiently in technology and talent. Many will conclude that they need to outsource major parts of their operation if they haven't done so already. Key, however, is to retain sufficient knowledge in-house to monitor the service quality of the external providers.
For larger asset managers and pension funds, they will supplement their outsourcing arrangements in asset servicing with opportunities to co-source competences such as IT application development, support and infrastructure. Co-sourcing requires a relationship beyond the client-service provider model, because an external provider becomes integral to the internal team.
Dialogue between asset managers and their clients has intensified and the topics are not only investment performance and investment risks, but also regulation and operational agility. Knowledge transfer between fund managers, actuarial consultants and institutional clients is now taking place regularly, strengthening relationships and building trust.
Outsource providers are also benefiting from a much closer relationship with their clients because both parties have to explore opportunities for operational leverage and readiness in order to find cost savings and comply with new regulations. As a consequence, the traditional client/service provider relationship will need to be gradually replaced by a joint venture approach where both parties' commercial and strategic ambitions are aligned.
The cost of regulatory compliance and the threat of low economic growth for a prolonged period of time are testing many financial services firms' willingness and ability to continue doing business. Consolidation, long predicted, is now with us. It is likely to create a two-tier asset management industry with substantial asset managers as well as boutiques that specialise in specific components. As Mark Twain famously stated: "For the majority of us, the past is a regret, the future an experiment."
For those asset managers that have a strong culture, a diversified talent pool, efficient investment and risk management processes as well as modern technology, the future will be testing, but bright.