• Welcome
• Building a Winning Model for the Future
• Operational Excellence – The Key to Success?

Welcome

Jervis Smith
Managing Director, Global Head of Client Executive
Global Transaction Services, Citi

Where do the opportunities lie now for global asset managers? What will the winning business model look like in two or three years' time? What are the key changes that have to be implemented to ensure success? In this issue of Spotlight, we report on the findings of a study produced by the consultancy, CREATE-Research, and sponsored jointly by Citi Global Transaction Services and Principal Global Investors, which seeks to answer these and other questions as the asset management industry continues to adjust to a market that has been much altered by the credit crunch.

The study, entitled Exploiting Uncertainty in Investment Markets, is the product of an extensive survey involving 237 asset managers, pension consultants and fund distributors in 29 countries. The survey was followed up by structured interviews. Respondents had assets under management in excess of US$29 trillion.

Not surprisingly, the study paints the picture of an industry in transition: large numbers of firms are revisiting both their products and service propositions. But it also provides an early indication of how asset managers worldwide see their prospects and what they need to do to ensure that a resilient asset management industry emerges from the ashes of the 2008 meltdown.

Exploiting Uncertainty in Investment Markets is available free at http://www.citibank.com/transactionservices/home/sa/2010q2/create/

Building a Winning Model for the Future

Professor Amin Rajan
CEO, CREATE-Research

The study takes a three-year forward view. It asks what will drive the next wave of growth? What regions, asset classes and client groups will lead it? What are the key changes that are being implemented in the current generation of asset manager business models. And what will the winning model look like?

Three key themes emerge from the study. The first is that the crisis has challenged conventional wisdom and forced a rethink on a number of ideas hitherto accepted as axiomatic.

Is East the New West?

The first of those is that the grass is greener in Asia – that China and other Asian markets are the first destination for western asset managers looking to break out of saturated home markets. The reality is that, as a result of legal and cultural barriers, entering the region's disparate markets will be a matter of baby steps, not giant leaps. Given the momentum-driven behaviour of the region's retail clients and the obligatory domestic focus of local pension plans, indigenous managers and banks are likely to remain the dominant players in these markets for some time to come.

As a result, asset managers are focusing their attention on new product and service propositions in their domestic markets. Some 57% of respondents agreed they could grow their home market via better returns and lower fees.

The study explodes a parallel belief – that 'East is the new West'. Only 31% of respondents now hold this view. The East is consuming more and saving less. The West is saving more and consuming less. The US will remain the centre of the global economy and its asset industry in this decade. The continuing closure of defined benefit (DB) plans will bring new money into the next generation of target date funds in the defined contribution (DC) space. Rising investment in equities and bonds by sovereign wealth funds will favour big US managers.

One other notion is dispelled in the study – that, by failing to deliver in the past decade, active management has entered a long ice age. As the survey shows, an opposite view is gaining ground. It holds that uncertainty not only caused major dislocations in various asset classes in 2008, but will remain the prime source of most future profits. This may well be the age of the stock pickers.

New Operating Models

The second major theme of the study is that industry operating models are changing – and the multi-boutique model is in the ascendant. Currently, 50% of asset management firms operate as integrated producers. The study finds that their number is set to decline as they turn increasingly to the multi-boutique or virtual manager model.

Multi-boutiques have emerged in two forms. First, 7% of firms have independent boutiques with their own P&L within a holding company structure. A further 28% have integrated boutiques sharing support services and revenues with the 'mother ship'. Over the next three years, a further 18% of survey respondents will follow suit, making the multi-boutiques the dominant operating model for medium and large firms.

The popularity of the model rests on the fact that asset management is a people business where size creates remoteness and detachment. The multi-boutique model aims to counter that by changing the mindset. It is however proving challenging. Investment professionals like autonomy but not necessarily the accountability that goes with it.

The law of unintended consequences means that autonomy has often bred excessive individualism while increased accountability has bred risk aversion. There have been endless disputes over revenue sharing, while the separation of manufacturing and distribution has left firms with no focal point for innovation. These, however, are the birth pangs of a new model with the potential to deliver a better alignment of interests.

What is the Winning Business Model?

One US asset manager who was interviewed as part of the study put it thus: 'The multi-boutique model runs with the grain of the craft nature of active management, which is inherently unscalable beyond a certain threshold in large non-indexed houses. The model can offer economies of scale in the middle and back offices and economies of scope in the front office.

'Via greater autonomy and discretion, the model inherently encourages innovation and entrepreneurialism. It seeks to replace the bureaucracy of a large, vertically integrated house with the agility of small, horizontally-linked business units. We have a clear business strategy for the 'mother ship' as well as for individual boutiques, with clear pre-agreed business goals, their resource implications, their metrics, their accountabilities, their incentives, and their time lines. Incentives have aimed to promote external as well as internal alignments. Pension advisers like that.'

The emergence of virtual asset managers is another trend apparent from the study as more private banks, large wealth managers and pension consultants adopt multi-manager platforms that rely on alliances with best-of-breed external managers. Asset gathering will become their core competency. However, the pace of change here is slow.

The Need for a Fiduciary Overlay

Whatever business model firms adopt, the study suggests that one winning element will be the adoption of a 'fiduciary overlay'. This is the third big theme to emerge. The credit crunch has exploded the myth that asset managers and pension consultants possess rare insights. Past promises have not been delivered. But asset managers can regain client trust by developing a fiduciary overlay that more clearly links the interests of the firm, its professionals and its clients.

One global asset manager interviewed for the study commented: 'We start with three ultimate ends and their immediate means that deliver a three-way alignment – between us and our clients (via low base fee and performance fee), between us and our investment professionals (via profit sharing), and between our investment professionals and clients (via co-investing).

Industry Interdependencies

'We try to share the pain and the gain with our clients by addressing a number of questions. Are we close enough to our clients to understand their dreams and nightmares? Do our clients share our time horizons? Are we sharing investment risks with our clients? How meritocratic are our fees and charges? Do we seek to deliver consistent returns that eschew the feast and famine mentality? Do our investment professionals have skin in the game?'

Sharing the pain as well as the gain with clients is only part of the answer. The fiduciary overlay should also ensure openness on risks, charges and product integrity. It should stop asset managers from selling products that are not fit for purpose. And it should support its professionals with operational structures that allow them to replicate success.

Clients now want to be assured that their asset managers are financially viable, intellectually credible and operationally sustainable – that they understand the changing nuances of the investment landscape as much as the heartbeat of the client. As a global asset manager puts it: 'No model is worth the candle if it does not put clients first.'

Operational Excellence – The Key to Success?

Bernard Hanratty
Managing Director, Investor Services
Global Transaction Services, Citi

One of the key findings of the report is that asset growth will increasingly rely on the likes of sovereign wealth funds, national pension funds and central bank reserve funds – as well as defined contribution funds in Asia, Europe and North America. This shift to a more professional client base has big implications for the asset management industry.

The new clients, says the report, will be more demanding: 'Mostly, they will invest with asset houses that are organisationally stable, financially viable and prudentially ethical. Investment, operational and reputational risks will top their agenda.' They will demand accurate and timely reports, regular communications, prompt responses to queries, frequent valuation and investment reviews, performance attribution analysis, product suitability checks and independent stress tests on new products.

Outsourcing is a Must

In a world where there are only limited pools of new money to tap, this puts a premium on operational excellence. Outsourcing, says the report, is becoming a cornerstone of that excellence. Already an established feature of the back office, outsourcing is set to spread into the middle office – in areas such as derivatives pricing, complex valuations and risk, collateral and data management. More than 90% of survey respondents said they had already outsourced or intended to outsource custody and settlement. Half said they had either outsourced or will outsource the valuation of illiquid investments, while 28% had either outsourced risk management services or were intending to do so.

The report features a case study based on an interview with the manager of a global index asset management house. It highlights the changing nature of outsourcing – from an initial focus on cost savings to the development of operational excellence which promotes a stronger alignment of interest between asset managers and their clients. 'Alignment is no longer just about fees and charges,' says the manager: 'It's also about having a distinctive competitive advantage in the marketplace which outwardly generates tangible and measurable benefits for clients and their managers alike.'

Service providers are responding in three areas. 'First they are improving the quality and line speeds of traditional activities like custody, settlement, transfer agency, FX management and fund accounting. Second, they are creating capabilities for a raft of middle office functionalities: tax planning, securities lending, cash management, trade processing and execution.

'Third, new services are being introduced, with asset managers and service providers working as innovation partners. They include derivatives processing and pricing, the valuation of illiquid assets, collateral management, risk management services and data management.

'Sponsors want to be satisfied that their money is placed in houses with a strong culture of excellence: both investment and operational. No longer do clients go by past performance numbers. They want assurance that the numbers can be replicated in an environment where asset managers partner with best-of-breed service providers to understand, protect, anticipate and enhance the interests of end clients.'

Exploiting Uncertainty in Investment Markets is available free at http://www.citibank.com/transactionservices/home/sa/2010q2/create/.