Challenges or opportunities?
Top industry professionals assess upcoming year for investment management
In the aftermath of the financial crisis, the investment management industry today stands on a threshold. As 2010 draws to a close and thoughts begin to turn to a new year, top industry professionals assess the daunting challenges as well as the promising opportunities that will characterise the near-term future for the industry.
By Michael Metcalfe
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In the wake of the financial crisis of 2008 and market turmoil of 2008-09, the investment management industry has had to contend with a seismic shift in the financial landscape. Declining investor confidence, reduced transaction volumes, falling asset values, greater risk sensitivity and sharper regulatory scrutiny are just some of the heightened pressures weighing heavily on the industry. It comes as no surprise therefore that many industry players have been obliged to reappraise their business strategies, operating models and supporting technology. Some of the motivating considerations here are curbing costs, making risk more transparent, and adding more flexibility to infrastructure and technology.
The immediate financial crisis has abated, equity and credit markets have recovered, and most major economies came out of recession in the last quarter of 2009. But this recovery was possible only as a direct result of the public policy response – quantitative easing, bank recapitalisations, exceptional central bank liquidity support, and so on. And yet despite these measures, most developed economies suffered a severe recession in 2009. Recovery is still fragile and many weaknesses and uncertainties remain as a result of the leverage built up during the boom years.
Against this background, a number of challenges as well as opportunities await the investment management industry in 2011. "Investors are becoming ever more discerning and delivering value is going to entail more than just the right investment strategies," comments Gareth Quinn, Director of Alternative Investments, Accenture Capital Markets, part of the management consulting, technology services and outsourcing company Accenture. Whatever the state of the wider financial markets, excellence in execution, flexibility to respond to a changing environment and efficient operations are crucial for everything from effective risk assessment to competitive fees. Adds Mr. Quinn: "The difficulty is that what is seen as a challenge today will become expected practice in years to come, a situation which will favour those who are prepared."
STRATEGIC INITIATIVES
Whereas during the recession, investment companies implemented tight cost controls, especially in IT, and only took on programmes to reduce cost or better manage operational and investment risk, starting in 2010, companies began to take on the backlog of strategic initiatives as well as to begin new projects. To meet the upcoming challenges facing the industry, in the opinion of John M. Clark, President and CEO of benchmarking research and consultancy group Cutter Associates, companies are undertaking the following initiatives to improve their systems and operations:
• improving operational efficiencies and better managing costs;
• improving client reporting to include more information and analysis about performance and risk;
• restructuring how IT is managed;
• enhancing valuation capabilities;
• improving data management;
• enhancing front office capabilities.
"To achieve the goal of improving operational efficiency and better managing costs, companies are consolidating their systems, evaluating and implementing outsourcing solutions as well as workflow systems, developing global IT and operational strategies that leverage local expertise while consolidating investment processing, and enhancing data management programmes," argues Mr. Clark.
In addition to improving client reporting by upgrading or replacing performance measurement and risk analysis systems, as well as improving workflows and data management processes to ensure timely and accurate data is delivered to clients, companies will have to restructure how their IT is managed. According to Mr. Clark, to realise this aim, companies are: "organising so that IT works more closely with the business; assessing a wider range of sourcing strategies; enhancing the role of the Project Management Office (PMO) to improve and better control projects; and implementing metrics and benchmarks to measure the value and performance of IT".
Best practices in IT solutions and applications will only be sustainable with a strategic match between business strategy and operational platform strategy, argues Jacob Elsborg, Head of Technology at Danish pension fund ATP’s investment department. "We will see an increased focus on developing and aligning the operational platform with business strategy, as a strategic approach to management of the operational platform is beneficial in terms of development, stability and cost," adds Mr. Elsborg.
No matter what the future direction in the investment management industry, there is a clear and absolute need to focus on efficient operations and controlling costs. The benefits are not to be achieved through simply slashing headcount or technology budgets without heeding the effect on capabilities. "What is required is smart, nimble cost reduction that boosts agility and transparency, while simultaneously positioning the business for renewed strong growth as the commercial environment continues to recover," observes Mr. Quinn.
He adds: "Those that doubt streamlining of operational efficiency is possible on a scale necessary to make any meaningful difference need to consider the wide variations in efficiency and productivity ratios within the asset management industry. There is no doubt that top performers are going to realise the potential for significant operational efficiency gains."
Realising this potential will call for an appropriate growth strategy. According to the ‘Global Investment Management Growth Survey 2010’1 by SimCorp StrategyLab, the independent research arm of SimCorp, most (84%) of the businesses surveyed indicate that they have a growth strategy and that this strategy is reviewed at least once a year. More than half see growth as having increased strategic importance, while almost all (87%) see IT infrastructure as important in supporting growth.
SOPHISTICATED CONTROLS
In this climate of reappraisal and reassessment, certain trends in the industry continue, such as the expansion in the use of derivatives in investment strategies and the increasing complexity of products offered to investors. These, in turn, require companies to have more sophisticated controls over investment risk and internal operations. Here, enhanced valuation capabilities come into play. To achieve this, companies are focusing on improving the independence and transparency of valuations, especially for derivatives; evaluating and implementing analytics tools as well as solutions from pricing and service providers.
One trend expected to continue for the foreseeable future is the expansion of alternative investments. By alternative investments is meant private equity, real estate, timber, agriculture and other tangible assets (i.e. fine art, wines, etc.). "Of course, derivatives are also expected to continue to grow in use; however, at present many companies have adopted a ‘wait-and-see’ attitude. They are waiting to see how financial regulations will be crafted, and how that will affect derivatives as an investment," foresees Mr. Clark.
The expansion in the use of alternative investments and their increasing complexity require companies to have more sophisticated controls over investment risk and internal operations. Alternative assets have a very different lifecycle than cash instruments, and traditional investment systems are not equipped to handle the nuances of their lifecycle. Like derivatives, the valuation of alternative assets is challenging, and there are no standards that can be applied. In addition, they can be risky investments for the managers who do not have substantial experience with them. What makes alternative assets so unique is the manner in which they are discovered, researched, selected, and then accounted for.
To support this, a fully functional investment system must contain strong front-, middle- and back-office capabilities. In Mr. Clark’s view, front office functionality should include components such as deal pipeline management, due diligence workflow support, Contact Management (CRM) and extensive document management. "It will also provide robust cash-flow forecasting, ‘what if?’ analysis, and flexible reporting dashboards with drill-down capabilities," he adds.
For the middle office, the system should provide valuation functionality, data governance, deal support and performance measurement. Finally, for the back office, the platform should provide a robust general ledger with a flexible chart of accounts and sub-ledger support, operating level support, drill-down capability from asset to holding to operating level, and support multi-country GAAP and IFRS requirements. The system should also provide deal oversight/compliance to assist in managing risk.
RISK MANAGEMENT
The protection of client money and assets must be considered fundamental in sustaining or indeed rebuilding investor confidence in investment management companies. This means ensuring that clients’ money and assets are safe, and remain safe. However, there are nagging concerns that company controls over client money and assets do not always achieve the appropriate level of protection. Failure to comply with basic regulatory requirements may result in clients losing money. Companies must be able to (and to be seen to) demonstrate that they understand and are in compliance with their obligations regarding the protection of client money and assets.
In the view of Bob McDowall, Research Director, Europe, at research and consultancy company TowerGroup, the ability to manage risk is assuming far greater focus in addition to technology and people resources for investment management companies in the post-financial crisis environment. "After 2012, the nature of and needs for risk management will be dramatically altered by changes in the financial services marketplace, the business models of financial services institutions, and a raft of new regulations," he foresees.
Mr. McDowall argues that the challenge for financial institutions is to demonstrate the will and ability to provide leadership and the management acumen to follow through in making risk management the responsibility of every business unit and internal function. However, he foresees some potential backsliding in companies giving risk management the prominence it deserves. "In short, even with spending on risk management forecast to grow faster than overall IT spending through 2012, the future role of risk management within the organisational structure of enterprises in the financial services industry remains uncertain," he adds.
Mr. Elsborg argues that breaking down risk in the right classes and ensuring the accurate calculation of accumulated risk will be key considerations in risk management as the product risk and regulatory environment becomes more complex. However, he stresses that complex software to calculate complex risk on complex products is no remedy in itself: "The software has to be clearly understood before being used, or else the value added equals zero."
"The uncertainties of the future will drive leading industry players to continuously re-evaluate their risk positions and risk appetite to realign risk with the institution‘s goals and objectives," adds Mads Gosvig, Chief Risk Officer at Danish pension fund ATP. Vendors will need to continuously improve their tools and techniques, especially for visualisation to serve a broader, less technical business-user base, enabling users to quickly understand the nature of emerging or potential risks. Moreover, regulators will also demand these same capabilities.
In addition to restoring investor confidence with the help of a greater emphasis on risk management, Mr. McDowall rates asset valuation as a key consideration for investment management companies to consider in the post-financial crisis environment. How assets in a fund are valued impacts the investment performance calculation, the setting of prices at which investors buy and sell units in funds, and the fees of the investment management companies. "A robust, reliable and consistent approach to valuation of assets is an essential part of the management of clients’ portfolios and collective investment schemes," observes Mr. McDowall. Failure to value assets correctly could result ultimately in litigation or reputational damage to companies and impair investor confidence at a time when it is in dire need of being rebuilt.
As a consequence, investment management companies will continue to increase their spending on risk management through 2012. This spending will correlate with the unfolding of new global regulatory regimes and requirements, which will be more closely aligned with actual risk management and yet not completely devoid of less effective regulatory oversight approaches that will demand multiple reporting capabilities.
PRODUCT INNOVATION
Investors appeared to recover some of their appetite for financial risk during 2009-10, particularly in the retail sector. On the back of low interest rates and changing perceptions of value, retail investors put more money into the retail funds sector than in any previous year. They favoured corporate bond and absolute return sectors in particular, also with a strong showing by the property sector in the final quarter. Generally speaking though, the resurgence of the fund market has been relatively broad-based and would seem to provide a strong platform on which to build.
Sustained growth in the fund industry is likely to come not only from the sale and retention of holdings in existing products, but also through the introduction of new products. States Mr. Quinn: "Fund managers have a particularly important role to play here. Many investors close to retirement have been particularly impacted by the current downturn. Many are facing the prospect of much lower retirement incomes than they expected a few years ago. Their pension pots are typically smaller than they were and pension annuity rates have fallen steadily to an all-time low."
In responding to these and other pressing consumer needs, it is to be anticipated that innovation in fund management products will come about both as a result of product development at the more established and traditional companies, as well as through the arrival of new and regulated product providers, including those from other parts of the market. Bernard Delbecque, Director of Research and Economics, at the European Fund and Asset Management Association (EFAMA), the representative association for the European investment management industry, observes that a key facilitator for product innovation is increasingly proving to be the broad flexibility of regulated fund forms available to managers. In Europe, and indeed globally, UCITS III is providing fertile ground to new entrants in the funds market.
This flexibility means, for example, that access for a significant proportion of actively managed funds to the broader spectrum of traditional fund management clients is achievable, if not already a done deal. However, compliance with the UCITS framework is likely to require investment in systems and controls to meet the specific requirements of these highly regulated structures. "While asset managers may delegate various functions, they retain ultimate responsibility for compliance with the quite detailed requirements of UCITS III and, soon, UCITS IV," notes Mr. Delbecque.
With increased momentum in the proliferation of new investment strategies in familiar wrappers, there are inevitable concerns about how to identify whether the retail market operates in such a way as to deliver products that address real consumer needs and deliver good consumer outcomes. In a retail market where consumers struggle to understand their own needs and to assess value for money in their product purchases, this is a perennial challenge.
The altered financial environment will call for a much deeper understanding of company business models, to identify the core strategy and the drivers of income and profitability going forward. According to Peter De Proft, Director General at EFAMA: "Industry players will have to be far better informed about where the industry is and where it is going next in response to market and regulatory developments and assess what risks to consumers may arise from companies’ responses to these factors."
VALUE CHAIN
As a result of this, the focus will increasingly be on the entire investment value chain including upstream processes – product development and design – as well as downstream activities like marketing, distribution and post-sale handling. "Players will also have to ensure that they have the right incentives at each step in the value chain to produce products that add value and address real client needs," states Mr. Quinn. Put another way, the days are numbered for products produced with little consideration as to the likely benefits that will accrue to the client, and where much more attention has been paid to the value that will be added for the company by introducing them.
Mr. Delbecque notes the importance for providers to understand their distributors’ information needs and ensure, as far as possible, that distributors are getting the right messages about what particular products do and how they might reasonably be used.
Pushed hard by the European investment management industry, the EU Commission has launched an examination of the effectiveness of regulation of retail investment products across the banking, insurance and fund sectors, with a particular focus on the rules governing selling processes and pre-contractual consumer disclosures. "Essentially, these proposals aim to introduce a level playing field for all investment products sold in the European retail market, irrespective of their legal form," states Mr. De Proft. The EU Commission has dubbed these products ‘Packaged Retail Investment Products’ (PRIPs) in order to distinguish them from straight securities.
There is still some work to be done here to determine which products are genuinely substitutable. Although the EU Commission’s preparatory work on the dossier is not yet complete, there are likely to be two main strands: a requirement for a simple product disclosure document (which may look similar to the new UCITS Key Information Document); and standardised conduct of business rules (which will be based on relevant MiFID requirements).
The investment management industry should be well placed to work under this new regime. In particular changes are to be anticipated in the way companies compete with other types of retail investment products in the pan-European market. "The philosophy of PRIPs is that across Europe all products that offer similar investment goals will become subject to the same standards," comments Mr. De Proft. From the client’s perspective, clear benefits are to be derived from a more consistent cross-sectoral approach. "Globally, the consumer is being championed by the regulators with the distribution changes potentially leading to a major change in the product mix created by the retail investment industry," states Mr. Clark.
Looking at the substance of the reforms themselves, and the potential future effects on the investment management industry, one of the drivers for the reform package was to allow greater exploitation of economies of scale to reduce costs to investors. There has been a mixed reception from industry to the proposals regarding fund mergers; although this is the most obvious way to rationalise fund ranges and increase fund size, there remain genuine unanswered questions about the tax treatment of cross-border fund mergers.
REGULATORY CHALLENGES
Legislation is clearly to be expected from the EU Commission on UCITS depositaries, following their extensive consultation. There will undoubtedly also be feedback from the final form of the AIFMD, concerning the presence or not of differential standards for retail and professional investor funds. Perhaps there may be a move to extend UCITS-eligible assets to include real estate, and even commodities – the two major asset classes outside UCITS that retail investors can currently access through national retail fund regimes that will now be subject to the AIFMD. Added to all that, there will be a number of areas within UCITS IV where the new European Securities and Markets Authority will be encouraged, or made, to adopt binding technical standards to realise a more harmonised approach to implementation of the directive.
Whether UCITS IV, AIFMD or suchlike, the main regulatory and prudential challenges facing the industry in 2011 will require investment management companies to escalate IT spending to conform. The key question here is to what degree. The three basic tenants of all of these regulatory challenges are:
• providing protection and proper disclosure to investors;
• providing insight and controls around systematic risk in the financial markets;
• providing streamlined procedures to deal with failure.
This regulatory agenda will drive the industry to increase standards in the area of data and high-level metrics. In order for the regulatory bodies to do their part, the industry will have to adopt common data models and nomenclature to properly analyse systematic risk. Additionally, investment companies will have to conform to these changes to continue to do business with the same freedom they have today. Unlike some other industry mandates, most of the proposed changes will succeed in some fashion because the investors are demanding it.
Financial reform will spawn cost pressures for many companies and vendors over the next years. Driving this cost is the current lack of data standards for the investment community. Several efforts have been underway for years in the area of industry-specific XML and other protocols. However, these communication standards are often implemented through cumbersome translations leaving the company but are not prevalent inside the companies.
States Mr. Clark: "It is to be hoped that the recent regulations and reporting requirements will force more generic representation of data throughout the system. These associated costs, driven by reporting, will vary for firms based on the robustness of their internal data management programmes. It should be also noted that these changes are not static and will continue to evolve as the financial market evolves."
The extent to which IT applications will play a role in achieving operational excellence for investment management industry players will depend on a number of factors. Clearly the role will be important but perhaps it is more interesting to examine precisely what kind of role they will play.
The exigencies of stricter and more complex financial regulation will inevitably mean that buy-side firms will need to develop and/or enhance IT applications and infrastructure to extract operational data from their various systems and repositories and deliver the data in standardised semantics, syntax and formats. The effort incurred by individual companies will depend on how mature and transparent their systems and data platforms are in terms of meeting these requirements. For example, companies with a higher mix of derivatives will be impacted more.
DATA MANAGEMENT
Another discernible trend is the increased maturity of vendor product offerings, which has allowed buy-side firms to shift more towards the ‘Buy’ option as opposed to the ‘Build’. This would entail reduced IT effort in custom application development and increased effort in vendor product integration. "On a related front, in recent times, we have seen a few vendors with bundled front-to-back offerings, which have the potential to reduce integration efforts as well," adds Mr. Clark.
As companies seek to focus on their core competencies and leverage specialised third-party providers for non-core functions, middle- and back-office outsourcing has been on the rise in the past few years. This again marks a shift in IT expenditure from maintaining systems for middle- and back-office processing to integration of the outsourcer’s environment to the companies’ core investment systems.
A common feature of requirements for the trends outlined above is the increasing investment in data management. "Needless to say, we will see an increasing focus on data management, process management and information management in which an integrated process will be essential," foresees Mr. Elsborg. IT will be required to continue to enhance data management applications and infrastructure. While the emphasis of earlier data management efforts was on facilitating operational processing and reporting, the focus in 2011 and beyond will be on enhancing the quality of data needed to support better investment and operational risk management, meeting regulatory requirements and facilitating data and application integration.
In the view of Martin Buchberger, CEO of AIM Software, a leading provider of data management solutions for financial markets, best practices in IT solutions and applications will be key to ensuring that this development remains sustainable. "In addition to the need for sustaining the cost reduction that had to be done during the crisis, investment management companies now have to cope with further regulation and increasing trading volumes with less human resources in many areas. Best practice solutions can help institutions keep costs low by automating most of the previously manual and, most of the time, error-prone processes," Mr Buchberger argues.
In this increasingly vigorous environment, defining the main constituent elements to ensuring operational success and continued expansion will be crucial. What makes operational success and continued expansion so challenging? In the words of Mr. Clark: "There are fundamentally two different types of challenge. First, making your routine better, quicker and cheaper and second, being agile and reacting swiftly to demands for change being initiated both internally and externally."
INCREASED AUTOMATION
For the first, the challenge is related to process engineering, akin to other high-volume standard processes with the most important key performance indicators (KPIs) relating to efficiency and risk. One important strategy is maximum possible automation of the end-to-end process through IT and exception-based workflows. In addition, scale is a critical element in operational success and many investment management companies have decided that partnering with a large service provider (or providers) is the best way to continually drive down ongoing costs without increasing operational risk.
For the second, the most important KPI is simply implementing the change when needed (i.e. supporting a new product launch or complying with new regulations). Initially this needs to be done in a safe way with efficiencies coming later. A variety of strategies can help, but particularly important are:
• using vendors and service providers that have the widest possible coverage;
• decoupling the different aspects of the operating model as much as possible to localise the scope of the change;
• strong change management and leadership;
• an adaptive corporate culture that recognises that an ever-increasing velocity of change is the norm.
Finally, there is often another fundamentally different type of problem: embedding the change that was sometimes implemented very quickly in a very agile fashion into the routine standard operating model. According to Mr. Clark: "For example, to migrate off that spreadsheet that was implemented to quickly support the new process. Here a strong change management function within the firm is the key - otherwise it will simply not happen."
OPERATIONAL PLATFORM
Mr. Elsborg argues that constituting the main components to ensure operational success and continued expansion will be strategic management of the IT operational platform in which an essential part of the process will be the ability to measure effectiveness and the degree of alignment through correctly and appropriately defined KPIs. "Only in this way can you produce a cost-efficient platform that utilises resources in the best manner," he adds.
An efficiently integrated and managed platform reduces demands on flexibility and scalability and thereby costs, thereby ensuring the success of business strategies that are geared to growth. Here the main contributing factors are in Mr. Elsborg’s view:
• integration of asset and liability management on a single platform;
• a well-defined operational platform;
• process management, not only as an IT solution, but as a fully integrated part of daily business management;
• enhanced data management;
• focus on system management based on understanding of processes and calculation of all products.
In the current climate of uncertainty and change, one factor is certain: the investment management industry must be adept in adapting to the new operating environment. The current economic situation requires a strategic approach to cutting IT costs. High-performance businesses must successfully reduce overall costs sharply and for the long term, shifting spend toward IT capability and business growth while stepping up IT performance at the same time. The most successful investment management companies will be those that anticipate or identify industry changes when and as they occur and respond early to be able to meet the considerable operational and technology challenges that arise.
2011 Q & A
Essential considerations for investment management
The Journal of Applied IT and Investment Management asked top professionals from selected investment management industry circles to assess the challenges and opportunities for the upcoming year.
# Question: Where do you see the investment management industry headed and what are its main challenges?
Answer: Whatever the state of the wider financial markets, excellence in execution, flexibility to respond to a changing environment and efficient operations are crucial for everything from effective risk assessment to competitive fees.
Gareth Quinn, Director of Alternative Investments, Accenture Capital Markets, London, UK.
# Question: What initiatives are companies taking to improve their systems and operations?
Answer: Companies are consolidating their systems, evaluating and implementing outsourcing solutions as well as workflow systems, developing global IT and operational strategies that leverage local expertise while consolidating investment processing, and enhancing data management programmes.
John M. Clark, President & CEO , Cutter Associates, Rockland, Massachusetts, USA.
# Question: How can best practices in IT solutions and applications contribute to ensuring success?
Answer: We will see an increased focus on developing and aligning the operational platform with business strategy, as a strategic approach to management of the operational platform is beneficial in terms of development, stability and cost.
Jacob Elsborg, Head of Technology, Investment Area, ATP, Copenhagen, Denmark.
# Question: What role will assessing and managing risk play in future industry considerations?
Answer: The uncertainties of the future will drive leading industry players to continuously re-evalate their risk positions and risk appetite to realign risk with the institution's goals and objectives. Mads Gosvig, Chief Risk Officer, ATP, Copenhagen, Denmark.
# Question: How will investor confidence in investment management companies be restored?
Answer: The challenge for financial institutions is to demonstrate the will and ability to provide leadership and the management acumen to follow through in making risk management the responsibility of every business unit and internal function.
Bob McDowall, Research Director, Europe, TowerGroup, London, UK.
# Question: What will be the main regulatory and prudential challenges facing the industry in 2011?
Answer: Industry players will have to be far better informed about where the industry is and where it is going next in response to market and regulatory developments and assess what risks to consumers may arise from companies’ responses to these factors.
Peter De Proft, Director General, European Fund and Asset Management Association (EFAMA), Brussels, Belgium.
# Question: To what extent will product innovation play a role in creating opportunities?
Answer: Innovation is a major source of true competitive advantage in the development of products that meet the true needs of individuals. From this perspective, ageing populations create major opportunities for the industry which has the expertise to offer households specific product solutions to supplement their retirement income.
Bernard Delbecque, Director of Research and Economics, European Fund and Asset Management Association (EFAMA), Brussels, Belgium.
# Question: To what extent will IT applications play a role in achieving operational success?
Answer: Best practice solutions can help institutions keep costs low by automating most of the previously manual and, most of the time, error prone processes.
Martin Buchberger, CEO , AIM Software, Vienna, Austria.
Prepare for growth with future-proof and adaptable IT–solutions In the current climate of uncertainty and change, one factor is certain: the investment management industry must be adept in adapting to the new operating environment. The most successful investment management companies will be those that anticipate or identify industry changes when and as they occur and respond early to be able to meet the considerable operational and technology challenges that arise.
Michael Metcalfe is Co-Editor of the Journal of Applied IT and Investment Management. A financial journalist by profession, he has worked for such publications as The Economist, Financial Times and International Herald Tribune. Based in Germany, he also worked in the Luxembourg financial sector for 10 years, including tenures with Nordea Investment Funds S.A. and Lombard International Assurance S.A.
