New SimCorp StrategyLab volume on cost management and operational control: an introduction

A new SimCorp StrategyLab volume discusses new ideas on key strategic asset management industry issues concerning processes, costs, productivity and operational risk, with a particular focus on their interrelationships and the trade-offs between them.
by Professor Michael Pinedo and Editorial Assistant Mette Trier

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The global asset management industry can be divided into two broad categories: institutional asset management and retail asset management. Through a number of phases, the asset management industry as a whole has undergone some major changes over the last two decades.

Firstly, from the early 1990s until about 2008, the world witnessed how the value of assets under management (AUM) sky-rocketed due to the high liquidity in the global financial markets. This in turn was caused by abundant credit and ever-increasing asset valuations, among which the most widely known are real estate prices. This first phase also fostered the creation of hedge funds that continue to play a major role in the financial markets.

Before the crisis, most asset managers were not too worried about operating costs or operational risks, as ever-increasing prosperity made the value of their AUM grow steadily. Excessive costs and disproportionate numbers of errors were buried under the constantly rising revenues from a growing asset base and under the solid profits generated by high returns. The winds have changed, however, and today, the industry is working under quite different conditions. Many of the largest asset managers have suffered a drop in the value of AUM by 30-40%, not only due to a decline in asset prices, but also from clients withdrawing their money. The crisis also brought regulatory failures to light, such as the Madoff case, one of the largest operational risk events in history.

Currently, the asset management industry finds itself in a new phase of major change. Since the credit crisis, the sector has suffered from plunging global financial markets and from liquidity becoming either highly restricted or non-existent. Even with a market recovery, former levels of liquidity and wealth cannot be expected to become the norm again.

SETTING A NEW AGENDA: PROCESSES, COSTS AND RISKS

The new reality has forced asset managers to develop a much stricter discipline in their operational processes, in particular with regard to their costs, productivity and risk management. These factors have only recently begun to gain recognition as playing an important role in asset management, and their interdependencies and trade-offs have not yet been thoroughly analysed. For example, a reduction in costs, implemented without proper planning, may substantially increase exposure to operational risk. Processes, operational controls, costs, productivity and quality control have been studied extensively in other industries, in particular the manufacturing sector. It seems that the financial industry can learn a great deal from these studies. For example, the procedures used for Total Quality Management (TQM) in manufacturing and services turn out to be very similar to procedures that can be used in the management of operational risk in financial services.

In financial institutions as a whole, it has become clear that even institutional asset managers with large trading operations have to keep their costs under control. The most important cost and operational risk factors in asset management can be summarised as, firstly, the costs and risks with regard to human resources; secondly, costs with regard to client contact centres and distribution channels; and thirdly, costs with regard to systems development and transaction processing.
 
In this new volume, the contributors consider all the cost and risk factors mentioned above for retail as well as institutional asset managers. It is evident that the first factor is important for both categories of asset management firms. The second factor is clearly more important for a retail firm than for an institutional firm. The third factor is equally important for both categories of firms.

From various perspectives, the authors illustrate how the operational performance measures of interest in global asset management are mainly concerned, on the one hand, with costs and productivity and, on the other hand, with quality management and operational risk. Moreover, they discuss issues related to the obvious trade-offs between costs and productivity, and quality control and operational risk.

TWO PERSPECTIVES REPRESENTED: INDUSTRY AND ACADEMIA

The main body of the volume has been divided into two parts representing industry and academic perspectives respectively. Six chapters have been written by authors closely connected to the asset management industry who give their views on general managerial, technological and cost models that are pertinent to the challenges faced by today’s global asset management firms. Four chapters by more academically orientated authors are based on their collected data, which lead us to valid new conclusions and recommendations.

A best practices framework for operational infrastructure and controls
Providing the first set of industry perspectives, Ümit Alptuna, Manos Hatzakis and Reha Tutuncu from Goldman Sachs present an operational and control policy framework that incorporates industry-wide best practices and reflects current thinking as shaped by the 2007-2009 financial crisis. Especially in the rapidly expanding area of alternative investments, they emphasise the importance of strong governance in effecting these best practices and discuss operational elements such as robust infrastructure and controls, reliable valuation, and a holistic approach to risk management. Finally, the authors examine under which conditions the cost-effective strategy of outsourcing operational asset management functions can be successful for both managers and clients.

Managing costs at investment management firms
Another significant industry angle is provided by Adam Schneider1 of Deloitte Consulting, who focuses on the operations and costs in an investment management firm from a value chain perspective. The investment management industry is now challenged by volatile markets, changing revenue models and substantial issues of client faith and trust. Many investment management firms are facing revenue declines, product performance and the need to adjust strategies to these changing conditions. For the first time in many years, cost control is important to investment managers. Mr. Schneider provides a framework for an analysis that allows firms to compare their cost performance with others in an effective manner. It is based on the results of a wide variety of cost control projects conducted over the past 20 years throughout the investment management industry and covering a large number of firms.

Lean Six Sigma in asset management
Focusing on the concept of Lean Six Sigma in asset management, Klaus Arfelt from SimCorp outlines what is needed to maintain high productivity in conjunction with high quality control. Initially, his reason for looking deeper into the Lean Six Sigma idea was motivated by the highly impressive results that have been achieved in the manufacturing world. To illustrate this, the author looks at the automobile industry, where the concept was introduced and where the most revolutionary consequences of process optimisation have been observed. Finally, the advantages and positive side effects of Lean Six Sigma implementation are discussed. The chapter demonstrates how a lean organisation has obvious competitive advantages when it comes to employee competencies, operational transparency and a mentality of continuous improvement.
 
Management of risk, technology and costs in a multi-line asset management business
In his chapter on the multi-line asset management business, John H. Biggs, retired chairman of TIAA-CREF, discusses responsibilities at the different levels of the corporate structure as far as risk management and technology management are concerned, along with the effects on total costs. In order for an asset management firm to function well, he concludes that risk management and technology management functions should not be kept at corporate level, but rather delegated down to the line managers.

Strategic and tactical cost management in asset management
Zeroing in on both strategic and tactical cost management, management consult-ant and adjunct professor at New York University Marcelo Cruz studies the types of cost reduction efforts that have been tried over the past few of years in the industry. In his corresponding analysis of strategic cost management, Cruz analyses the trade-offs between levels of corporate expense with levels of operational risk exposure.

Cost effectiveness in the asset management industry: an IT operations perspective
Concluding the part on industry perspectives, Kjell Johan Nordgard from SimCorp and Lars Falkenberg of SimCorp StrategyLab discuss the effect of information technology on cost effectiveness in the asset management industry. The significant conclusions of the impact report analysed are based upon a recent survey of 100 interviews conducted among leading asset managers around the world.

Cost structure patterns in the asset management industry
The first of the second part’s academically orientated chapters is written by Professors Dennis Campbell and Frances Frei of Harvard University, who focus on the relationship between annual revenues and annual selling, general and administrative (SG&A) expenses in the 2001-2008 period. The authors find that indirect costs related to SG&A appear to be increasing when revenues climb, often rising at a faster rate than revenues. On the other hand, these indirect costs remain relatively fixed when revenues decline.

Transaction costs and asset management
Yakov Amihud of New York University and Haim Mendelson of Stanford University go on to analyse transaction costs, the variable costs of trading securities, in the asset management industry. They demonstrate how trans-action costs affect the values of assets. For any given level of risk, securities with higher transaction costs tend to have lower prices. The authors study the effects of transaction costs on asset management and introduce the different types of transaction costs, study their structure and show how they affect asset prices. Finally, they examine the implications of these relationships for asset managers, showing how transaction costs affect portfolio construction, fund design, trade implementation, cash and liquidity management, client acquisition, development strategies and trading frequencies.

Does strategic outsourcing create financial value?
Posing this question, Anitesh Barua and Andrew Whinston of the University of Texas at Austin and Deepa Mani of the Indian School of Business in Hyderabad study the value of strategic outsourcing. The authors describe the risks and managerial challenges in strategic outsourcing. They have analysed the 100 largest outsourcing initiatives implemented between 1996 and 2005 and determined the number and value of the sample contracts over time as well as reasons behind outsourcing failures.

A stitch in time …
Finalising the section on perspectives from academia, adjunct professor at Columbia University Kosrow Dehnad, who works for the Samba Financial Group, compares the trading processes in financial services with the production processes in manufacturing. He contends that procedures similar to those used in TQM in manufacturing can improve risk management processes in financial services considerably. He provides four examples of error detection procedures based on TQM thinking and discusses the importance of automation and IT investments in the implementation of such procedures.

Title Operational control in asset management: processes and costs Editor Professor Michael Pinedo, Stern School of Business, NYU No of pages 220 Publisher SimCorp StrategyLab Publication date 7 December 2009 Price €45 Available from amazon.co.uk

The editor, Michael Pinedo of the Stern School of Business, NYU, focuses in his current research on the modelling and analysis of service systems, with an emphasis on Total Quality Management (TQM) and operational risk. He has written, or jointly written, numerous technical papers on these topics and is the author of several books.