Hate surprises? Well, try this. Four out of five fund managers with more than $1 billion of assets under management – or around a third of all retail and institutional fund managers – are out-sourcing already and two in five are considering out-sourcing more. Or so says a survey and report by Boston-based US technology research house Celent Communications. The opportunity? Firms with $1 billion plus under management have the money to pay for out-sourcing solutions. The driver? Shrinking management fees – down by a quarter on equity funds, a third on fixed income funds and a fifth on money market funds in the last ten years, according to the author – is the main one.
But that is not all. The rising overhead accumulated in the bull market; the lower asset values of the bear market; the growing complexity and risks of cross-border investment; confusion in the face of multiple systems vendors; bewilderment about how to replace legacy systems, especially at firms created largely by merger; and anxiety about the cost of T +1 are the others. According to an Association of Investment Management and Research (AIMR) study quoted by Celent, margins in the fund management industry will drop to just 5 per cent within two years. But bad news for fund managers is good news for fund administrators: if the boom predicted by Celent takes place out-sourcing revenues (mainly in Europe and North America, but also in the Asia-Pacific region) will climb to $30 billion by 2006.
So it is not surprising that Celent found a horde of global custodians (such as State Street, Bank of New York and Brown Brothers Harriman), specialist fund administrators (such as BISYS, Cogent and SEI), systems providers (such as SunGard) and IT consoretia (such as Encompys) queuing up for a cut of $30 billion. Indeed, as the report accepts, fund managers have been out-sourcing custody, fund accounting and transfer agency for thirty years. Where the Celent report achieves genuine lucidity and a degree of novelty is in knitting together the business and technology issues. It points out, for example, that between 1996 and 2000 – just five years – 524 fund managers were either merged or acquired, many of them across borders. Unsurprisingly, they have systems issues.
The Celent report also explores exactly which functions fund managers are looking to out-source, and finds their appetite extends far beyond the obvious – custody, fund accounting, fund administration, transfer agency, trade matching, corporate actions and reference data- to encompass aspects of the investment process itself. Areas where major fund managers are looking at out-sourcing include trade automation, data management and client communications. The report also distinguishes between degrees of out-sourcing, which range from lift-out (complete out-sourcing of middle and back office functions, including staff) through business service provider (mainly technology maintenance and upgrades) to application service provider (technology only). Celent predicts that most fund managers will opt for the business service provider model, because it offers them the benefits of economies of scale without losing control. The firm advises any provider competing for business to establish a dedicated outsourcing group, and warns that the average total (or lift-out) out-sourcing contract takes 18 to 24 months to implement. Perhaps the most telling statistic in the Celent survey is the fact that 60 percent of out-sourcing providers have turned out-souring RFPS away because they looked problematic.
Reassuringly for those out-sourcing service providers who believe nominal costs ought to rise rather than fall when a fund managers out-sources, few fund managers surveyed by Celent are excited about costs. What worries them far more is the commitment, stability and willingness to be accountable of the provider they choose, which means custodians ought to have a head-start over specialised fund administrators and IT firms. (Two out of three fund managers surveyed by Celent describe a prior relationship as “very important.”) Trouble is, says Celent, custodians tend to have asset management arms which compete with potential clients and too many see fund administration as an irritating and costly way to buy custody business. Specialist fund administrators, by contrast, have focus but no financial and technological muscle, but are bound to appeal to smaller fund managers ignored by the custodians.
Celent predicts that IT firms will team up with custodians, rather as Eagle has joined forces with Mellon, Princeton with State Street and Advent, Microsoft, Compaq and Onyx have joined forces with Bank of New York in the Encompys consortium. But Celent says consortia such as Encompys -which so far has just one client, PIMCO – suffer from accountability worries among fund managers: who is in charge and who will pay when something gores wrong? Pure technology providers are more happily placed. Unlike many of their custodial counterparts, it seems that fund management operations chiefs do not regard their technology and skills as a key competitive differentiator, and see systems as a means to an end rather than an end in itself. However, they do worry that out-sourcing might hamper product development.