Read article and learn about:
- The changing relationship between asset owners and asset managers
- What investing in the right information infrastructure means
- How insourcing delivers its own information premium
- What insourcing can do to align strategy with operating model
- Avoiding the pitfalls of legacy systems
About the author:
Professor Gordon L. Clark DSc (Oxon) FBA is Director of the Smith School of Enterprise and the Environment, Oxford University.
He is acknowledged as one of the world’s most influential academics for his research on the governance and management of financial institutions. Gordon L. Clark has authored or co-authored numerous papers on the financial services industry since 1996. He is also a board member in a number of funds.
The investment management industry often overlooks the need to invest in information for strategic purposes as much as for managing everyday operations. This article looks at the implications of this negligence and pleads the case for effective information stewardship to ensure that you make the right choice between insourcing and outsourcing your infrastructure.
What is your data worth? With many investment management firms pursuing a false economy of minimizing costs, it is tempting to hoard data rather than put it to good use. Often neglected is the sense of urgency in investing in the right type of dynamic information infrastructure systems to serve strategic goals and not just expedient aims, such as managing day-to-day operations.
The firms that will prevail already know that to be effective in today’s financial markets requires a sufficient proportion of investment in information and knowledge about market performance and structure. Recognizing the possibility of further shakeouts in financial markets post-financial crisis is one thing; another is the realization that there is a premium to be earned on being prepared in advance for more market upsets.
As a consequence, the asset management industry must assume more responsibility for investment strategy in relation to market behavior and dynamics. But to do so will require a revolution in the relationship between asset owners and asset managers and a revolution in the knowledge and information available to asset owners in relation to their asset managers (for a definition of these terms, see box in the side bar).
In our research, we have tackled this issue by reference to the emerging trend among large asset owners to insource the formation and implementation of investment strategy.1 If asset owners bring in-house a significant portion of investment management activities, this could transform the global investment management industry.
Not all organizations are able to do so, as this article shows, even if resources are available in terms of assets under management (AUM). As a first step, we provide some pointers as to how firms can become more effective and astute in their investment strategy approach.
Share the pain – and share the gain
How can asset owners become more effective? One obvious strategy has been to reconsider the contracts binding asset owners with their asset managers, re-making the contract into a means of governing on-going relationships between the parties rather than being simply a mandate for one party to get on with the job out-of-sight and out-of-mind.2
For some, performance contracts with absolute return targets are more preferable than a standard contract with performance benchmarked against market indicators. A more effective strategy is to use contracts that share the pain and share any gain; that is, both parties ought to have ‘skin-in-the-game’.3 Instead of using a standard contract, which is subject to termination-at-will, another approach is to use the relationship embodied by contract as a device through which to learn about investment strategy, options, and prospects.
How to become effective and astute
To become effective and astute, we propose three kinds of investment:4
- One is investment in expertise, transforming into a knowledgeable and skilled partner in a shared enterprise.
- A second type of investment is in decision-making procedures, being able to place an investment manager in the context of an evolving and adaptive investment strategy given the contingent nature of asset-specific and cross-asset relationships.
- The third type of investment is in information, transforming into a skilled partner, and being able to make immediate decisions in an evolving and adaptive investment strategy, requires high-quality real-time information.
All too often, information is diffuse or unorganized, systems of information are unrelated to one another, and information comes from asset managers with long time delays. All too often, information is stored rather than used strategically in a decision-making framework that provides asset owners and asset managers alike with a means of managing investment strategy. Modern state-of-the-art IT systems are now capable of structuring data and making it available in real time to decision-makers, enabling them to increase investment performance based on informed decision making.
Systems at odds with investment aims
In our work with asset owners on the governance and management of investment, more often than not we have encountered situations where information systems have not been able to match their ambitious investment objectives.5
Often we have been led to believe that the data warehouse is at the core of a firms’ investment strategy, only to find that these data warehouses are just a jumble of data with no common reference point. In many cases, external agents provide data according to their own specifications. These types of data stores are jigsaw puzzles without effective means of integration, overlay, and interrogation. Modern investment management systems are capable of structuring these data jigsaw puzzles so that portfolio managers can see the ‘bigger picture’, and make more informed investment decisions.
Worse, because these systems typically carry with them the underlying logic of data providers, any attempts at interrogation are hamstrung by the lack of compatibility between systems rather than the needs of the institution. Integration and overlay becomes a project in its own right focused on specific issues rather than on facilitating the process of investment strategy and management itself.
|MF Global: classic example of information failure|
In a growing market, buoyed by shared expectations and a compliant policy regime, failures in information management slip ‘under-the-wire’, or else are treated apart and unrelatedly, rather than as a larger issue affecting the long-term viability of the institution.
Take, for example, the failure of MF Global in 2011. Whereas public commentary on the bankruptcy of MF Global emphasized management hubris and a lack of accountability, the investigator appointed by the US Bankruptcy Court identified failure in its legacy information systems that turned a crisis into outright failure.
In the Report of Investigation of Louis J. Freeh, Chapter 11 Trustee of MF Global Ltd, US Bankruptcy Court for the Southern District of New York (April 4, 2013), the following findings were noted:
Clearly, MF Global was not fit for purpose in today’s financial markets. Lack of investment in its information systems made it vulnerable to calls on its positions and its commitments that required reconciliation in a timely and efficient manner.
More to the point, it became apparent that its information systems were inadequate in the face of other institutions’ information systems. There was always a chance that its lack of responsiveness in time and on issues that required precision with determination would mean that it was vulnerable to more proficient market agents.
The legacy debate
MF Global is the perfect example of the pitfalls of legacy systems and the importance of investing in up-to-date information infrastructure. Legacy systems may be capable of supporting business requirements in the short term but are unlikely to prepare firms for possible market shocks. MF Global had $42b AUM and yet was unwilling to secure those investments with a modern IT system. Such an upgrade project may have been a lot of work, but it may also have meant that they were still around today, rather than being assigned to the history books for their epic collapse.
Design and management of consistent information systems
In our research on insourcing, we have encountered asset owners whose ambitions for insourcing asset management were not matched by a similar commitment to information systems.
Whereas insourcing is often justified by reference to the advantages of managing investment strategy on a ‘whole fund basis’, if the capacity and structure of information systems are not consistent with that ambition, then it is not simply a question of inefficiency but, at the very worst, an issue concerning the viability of the institution itself.
|4 insourcing issues in the design and management of consistent information systems|
1. Insourcing is, more often than not, a process of building up capabilities and resources in specific asset classes, claiming back assets from external providers, and implementing an investment process that matches the institution’s investment strategy.
2. Insourcing requires portals allowing for the transfer of information from the institution to market and related intermediaries.
3. Insourcing requires skilled professionals who know about the information being imported from providers and who are knowledgeable about the platforms or systems that receive the information.
4. The success of any insourcing project depends on integrating different sources of information into one system. In some cases, insourcing on an asset class by asset class basis simply introduces to the institution disparity between unrelated information systems.
Source: Clark and Monk, 2013.
One of the challenges of insourcing is the design and management of information systems consistent with the goals and objectives of the institution. Four issues loom large here (See box below).
Whether the goal is to become effective and astute, or shift from outsourcing to insourcing investment strategy and implementation, the timely integration of information is an essential ingredient in achieving success.
At stake is not whether one specific asset class, one particular provider, or one office internal to the organization forms an effective component of an institution’s investment strategy. Rather it is whether the constituent parts of an investment strategy can be brought together on a real-time basis to treat the institution’s organization on a whole-fund basis.
This means being able to integrate the information received externally or internally on a common platform that enables the framing of an investment strategy that takes the whole of the investment portfolio into account.
Information systems as core strategy element
One of the great lessons of the global financial crisis is surely that, in moments of market crisis and uncertainty, the promise of portfolio diversification and successful performance can evaporate as risk measures fail and information systems lag behind, or indeed buckle under, the disruptive force of market behavior.
As suggested earlier, information systems comprise a fundamental and dynamic element in any successful investment strategy. There is a premium on information, and on the system that manages it well. There is a premium on integrating your investment strategy with your operating model and your management. That obviously applies to insourcing as well.
But, as also suggested, too often information systems are seen as a separate activity distinct from framing and implementing investment strategy. In part, this is because information systems have typically developed within the investment management community and are, more often than not, specific to investment managers and even asset classes.
Insourcing is really all about matching strategic capacity with implementation capacity. That requires aligning what you seek to achieve in the investment strategy you pursue with the operating model you adopt. Just as an effective investment strategy must be adaptive to new market realities, so too must asset owners and asset managers alike boost their competitiveness with aligned operating models that are:
- integrated rather than disparate, and
- at all times responsive in real time rather than held in some passive legacy system that places a priority on storage rather than retrieval.
The revolution that is taking place in information management seeks to transform the provision of information systems from being a subsidiary issue specific to investment managers to becoming an industry in its own right. This empowers a response to the challenge of disruptive market behavior with consistent and alpha-driven performance. Only then can insourcing deliver its own premium.
1. Clark, G.L. and Monk, A.H.B. 2013a. The scope of financial institutions: in-sourcing, outsourcing, and off-shoring. Journal of Economic Geography 13(2): 279-298.
2. Clark, G.L. and Monk, A.H.B. 2014. The geography of investment management contracts: the UK, Europe, and the global financial services industry. Environment and Planning A 46(3): 531-49.
3. Chemla, G. and Hennessy, C.A. 2014. Skin in the game and moral hazard. Journal of Finance 69:1597-1642.
4. Clark, G. L. and Urwin, R. 2008. Best-practice pension fund governance. Journal of Asset Management 9(1): 2-21.
5. Clark, G. L. and Monk, A.H.B. 2013b. Financial institutions, information, & investing-at-a-distance. Environment and Planning A 45:1318-36.