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Fund administration, the plethora of back and middle-office functions that are vital to the running of any investment manager's business, has increasingly come to be outsourced to specialist providers and custodian banks in the last few years. About two-thirds of UK fund managers - more in the US, fewer across the EU - now pay another company to do the admin.
What prompts fund managers to pay someone else to do aspects of their normal work for them? The answer is increased competition.
Take the UK as an example. In the last few years, Britain has seen a substantial increase in competition in the asset management world. Anyone who notices the amount of fund advertising to the retail sector will know that the audience for managed investment is far wider than ever before. A need for private pensions, an increased awareness on the part of 'ordinary' people of the opportunities that equity investment gives have contributed to a massive increase in the size and scope of asset managers - and, of course, in the competition between them. The same has been true for the US over the past decade; and the same will be increasingly true for Continental Europe in the upcoming years.
As a result, there has been an equal pressure to increase efficiency in back office functions, and to control costs. Outsourcing fund administration is a way of doing this.
The business today
Outsourcing fund administration has grown strongly and, it seems, inevitably in the last decade. But it has taken off sharply in the last three years. For instance in, 1989 slightly over 30 per cent of UK unit trust groups outsourced some or all of their administration work, according to the UK Fund Industry 2000 review. By 1999 that figure had grown to 62 per cent and by last year it was nearly 65 per cent.
Third-party fund administrators undertake over 20 separate back and middle office functions for asset managers, ranging from calculating a fund's net asset values - daily, weekly, quarterly, or whatever the fund requires - to investor record keeping, general fund accounting, transfer agency work, multicurrency accounting, trustee services and even some fund marketing services.
The Unites States has led the way in outsourcing, but Europe is catching up fast. State Street, one of the big outsourcers along with the likes of Citibank, Chase Manhattan and Bank of New York, was appointed as Scottish Widows' fund administrator earlier this year, for instance. Cogent, one of the specialist outsourcing fund administrators, got Aberdeen Asset Management's business at about the same time. Schroder Investment Management has outsourced to Chase Manhattan Global Investor Services (GIS) in 2000, while JP Morgan turned over its back office to Bank of New York in 1999.
One senior Chase Manhattan executive said at the time of the Schroder's deal: "From the moment the trade is confirmed, the responsibility for reporting the portfolio information into Schroder's front-end system and accounting for the resulting changes, will be the job of Chase GIS."
And that, in a nutshell, is the attraction of outsourcing for a fund management company, and is the reason why the business has taken off so dramatically in the last few years.
The reasons why
For a start, fund managers don't want to have to invest in information technology all the time. Staying ahead in a dramatically competitive market requires big system spending. Moreover, the market changes so quickly that systems upgrades cannot be done quickly enough - even after big system spends in the years leading up to the Y2K non-disaster. And there is the added benefit of releasing capital for expenditure elsewhere - for a big financial services company, balance sheet is all.
A second reason is to do with asset managers' cost bases more generally. According to a KPMG survey, outsourcing is unlikely to make the business cheaper. But it does make costs far more predictable since asset managers are paying a fixed fee to outsourcers, rather than paying endlessly for their own systems. Administration is one of the big fixed costs of the industry.
Aside from cost, managers are realising that concentrating on core competencies is the only way forward in a heatedly competitive market. Why be distracted from the main business of making investment decisions?
T+1 trade settlement, on its way throughout the European Union, is another reason why employing a specialist to do back office work makes sense. Again, big, expensive and complex back office systems are required to make the trade cut-off date - an outsourcer is in a better position to effect this.
Finally, in the UK specifically, the introduction of stakeholder pensions, with a set minimum fee for the manager of just 100 basis points, makes efficient and cost-effective back offices imperative.
The custodians' story
Going along with this shift in the fund management industry has been a related shift in the business of custodian banking.
Custodians have upped their service levels considerably in the last decade or so as fund managers faced increased competition themselves. Once upon a time they used to be little more than glorified safety deposit boxes and file-index card systems. They looked after shares, bonds and other investable securities, and kept track of them for clients.
There were also quite a few banks that did this work - dozens, in fact.
And then the world began to globalise. US mutual funds and pension funds bought more and more international stocks and shares and began to demand a level of service equal to their new ambitions. Custodian banks thinned out; competition levels increased; what was previously on offer in terms of service began to look like small beer in the new environment.
As competition increased, custodians began to fall by the wayside as competitors tacked more and more bells and whistles onto the their service packages to retain clients who were not getting any less choosy. They began to offer extras to their clients like proxy voting (so that a fund manager would not have to bother about going to company meetings to vote on resolutions) or cash management (so that, again, the fund manager would not have to worry about what to do with its spare cash). There were other aspects to this increased service, but all of it was intended to take on functions that fund managers previously did themselves so as to free the manager up to concentrate on its core competency - investing.
Fund administration has become a key aspect of this upped level of service.
Possibly the major impulse behind custodians' move into back office competence was simple fear. Fear of every banker's nightmare: disintermediation. Why would an asset manager need a custodian to look after stocks and shares if the world's stock markets became electronically sophisticated enough to allow computers to do it for them? One group of custodians (there is another group that has gone for volume and cost, and another that has become niche) has looked to move up the food chain, and offer to undertake fund managers' administration work for them. As profits from the old settlement and safekeeping work began to fade, so the new area of back and middle-office provisioning has begun to take its place.
The marketplace
The outsourcing marketplace is split between existing custodian banks and specialist outsourcing companies. In the UK, specialist fund administration company Cogent takes the lion's share of the work - just under 70 per cent. In the US the picture is more mixed, with custodian banks such as State Street and Bank of New York cutting into the market more deeply.
But funds don't care which type of provider they go to, as long as they can cut costs and maintain standards.
So where next?
The industry for third-party fund administration has grown fast in the last few years in the Britain and the EU and will continue to grow as the commercial pressures outlined above bite ever more deeply. Already, some 65 per cent of fund managers' back offices are outsourced. If the experience of the US is anything to go by, that percentage will grow to nearer 80 per cent. In the US, ever the bellwether of the securities and banking industry, all but the very biggest fund management groups (who are rich enough not to have to worry much about the cost systems upgrades too much) outsource.
Even so, the path may not be smooth and it is not totally clear yet whether all fund managers will outsource. Rothschild Asset Management, for example, removed its fund administration from a leading custodian last year. Rothschild, along with other asset managers, was worried about the loss of control that outsourcing inevitably brings. Many if not most customer queries and complaints are to do with administrative details. Because of that, some managers may want to retain the ability to control and monitor back offices.
Yet that fear is offset somewhat by the now standard practice of fund managers setting up monitoring groups to make sure the back-office function is still done properly. Moreover, any custodian or specialist outsourcer worth the name will allow fund managers to have full access to all their systems. Some have on-site managers seconded from clients.
The future
The third party fund administration business is developing rapidly in what it can provide.
One mode of service that is emerging is provisioning internet fund supermarkets. The asset managers involved would, in this case, run the marketing of the site with a third-party provider running the IT side as well as the administration. Moving further into clients' front offices is another theme, and is moving up the agenda. Customer queries, for example, which are often to do with back office issues, could be handled by dedicated units with outsourcers. They, after all, will be the ones who know what is going on. Even passive fund management has been mentioned as an industry trend.
Offshore
Elsewhere in the industry, servicing offshore fund managers is growing in importance. Hedge funds are a key factor of all offshore asset management - but they are complex and expensive. Hedge funds based in the Cayman Islands and Luxembourg (by far the biggest offshore fund domicile) and elsewhere have the growth of a vigorous third-party fund administration industry offshore. Dublin and Bermuda have also seen strong growth in the business. Fund managers and third-party administrators have begun to complain, though, that the technological and telecommunications infrastructure offshore is not yet up to the standard of mainland Europe or the US. But that is changing as a number of the leading offshore centres - Gibraltar and the Isle of Man most recently - put telecommunications upgrades in place.
Conclusion
Custodians don't like to call themselves custodians any more. They like to be known as 'securities service providers' to emphasis the fact that they do far more than mere settlement and safekeeping. The demarcation between the investment decisions that are taken by asset managers and the administration work that is undertaken by third-party administrators will grow. One senior custodian banker who manages client relations for his bank's fund administration unit said recently, "in the last six months we have started discussions with five institutions which two years ago would have been in my list of the top ten that would never want to talk to me." It is a big business that is getting bigger.
