The New Year will bring another round of soul searching at hedge funds and among active fund managers. Not only did major stock indexes hit record highs again, but 2017 was also marked by remarkably low volatility, which hurts hedge fund performance, as managers continued to put money to work after years of quantitative easing policies. Yet again, many portfolio managers will have the unenviable task of having to justify why their fees were worth it when a low-cost ETF that mirrors the S&P 500’s performance may have beaten them.
As performance data is compiled and fund reports are distributed to clients in late January and early February, there will be discussions of how asset managers can improve margins. While asset managers hope for a return of volatility in 2018, discussions within firms will inevitably turn to identifying how to trim costs.
Do they have multiple legacy systems that can be combined into one system, perhaps using cloud hosting? Can certain back- and middle-office costs be entirely eliminated? Can new technologies — cloud computing, artificial intelligence and blockchain — eliminate certain functions rather than just streamlining existing processes? Can analytics help make front-office decisions faster?
These questions are discussed in a new paper from the Asset Management Group of the Securities Industry and Financial Markets Association that imagines how to transform operations for the next generation. The paper publishes the results of a survey of executives at asset management firms, banks, insurance companies and service providers. Among the survey’s findings are that 56% of respondents believe the pace of industry change in the area of operations has been too slow. That’s understandable since these firms must move the world’s assets around safely.
However, increased regulations over the past decade have increased the urgency to streamline the operations effort needed to meet those rules as well as to ease the exchange of data among firms. Now, operations managers want to cut costs for their firm and clients, reduce operating risk and counterparty risk. Specifically, 80% see significant opportunity for innovation in data management, 78% see potential in collateral management, 69% in trade matching and reconciliations and 62% in cash and security settlements.
Two areas where many firms can immediately trim costs are reconciliations and accounting. Most firms undertake a tremendous effort performing multiple, disparate reconciliation processes with the myriad broker-dealers they interact with, so that every trade adds up. Migrating that effort to a common platform that performs that function at an industry (rather than a firm) level is one obvious way to cut costs and improve efficiency. Likewise, the industry expends a great deal of manpower on portfolio accounting — an effort that can be performed by a third-party firm. Such approaches can save firms more than 30% of back- and middle-office costs.
The industry has already seen how collaboration can produce substantial change. A great example is the Financial Information Exchange protocol, which started in the early 1990s for communications between Fidelity Investments and Salomon Brothers but grew into a uniformly used protocol that standardised how trades were conducted.
SIFMA’s paper, which gathered views from leading asset managers, encourages firms to work together to find common ways of cutting costs. It suggests firms look at the issue from both a short- and medium-term perspective. In the short-term, it advises the industry to; 1) leverage what it already does well; 2) use tools that facilitate collaboration and interoperability between firms to eliminate common processes; 3) work with shared service providers; 4) develop common platforms to standardise workflows on non-differentiating processes, and 5) establish incentives for firms to work well together. Over the medium-term, the industry should embrace new technologies, and look outside for industry service partners. In addition, each firm should identify processes that can be eliminated or automated by applying new industry-wide solutions.
All this will require a cultural shift: Asset managers must stop making small, incremental changes that will soon be overtaken by more substantive change. Instead, they should seek out more efficient ways to do things with new technology, and cut explicit costs by using shared-service providers.
Executives are already leveraging industry associations such as SIFMA to identify common pain points and solutions to solve them. For example, members of the Futures Industry Association and SIFMA AMG are discussing problems with exchange-traded derivatives and OTC-cleared workflows. These meetings have already highlighted three common problems: 1) trade confirmations are antiquated and not standardised, causing reconciliation challenges, 2) updates of commission and fee schedules are not centralised, and 3) the communication of margin calls is not standardised. Solving such small, specific problems is the first step to the disruption of back- and middle-office operations of asset managers.
In the coming years, asset managers that want to generate exceptional returns should standardise non-differentiating functions to cut costs and allow the firm’s brightest minds to instead focus on boosting investment performance. That effort will result in an asset management industry that is less transaction-based and more thoughtful and analytical. It will also make the business less concerned about comparisons to major stock market indexes.