The investment management industry is undergoing a transformation. Fueled by changing buying behaviors of asset owners, stagnating growth of managed assets and increasing demand for multi-product, multi-jurisdictional solutions, the business and operating models of asset managers are under significant pressure.
Other industries have experienced similar transformations and once-prominent industry leaders who were slow to adapt found themselves struggling or completely shut out of the market. For example, in the smartphone industry, just three years ago, RIM had the pre-eminent position as the producer of the indispensable mobile communication device for professionals. Yet, the introduction of some game changing technology platforms like the iPhone and iPad as well as buyers' desires to converge business and personal communications have resulted in RIM struggling with a 50% decrease in their market share over just one year.1
Will the same happen in the investment management industry? Will technology limitations run aground of buyers' increasing demands for change? Well, think of the operations and technology infrastructure as a "platform". Most traditional, long-only investment managers' platforms were initially established to support a single asset class (e.g. equities) and/or region (e.g. U.S.). Some investment managers made significant investments to develop efficient, fully functional platforms to support their original business models. These platforms have done a good job supporting vertical growth, allowing firms to readily add assets, accounts and clients to their existing products and strategies. Now the question is - how readily can an operations and technology platform adapt to support horizontal growth, the addition of new products, strategies, vehicles and markets?
Factors Driving Change
Environmental factors are driving traditional, long-only investment managers to: (1) expand their asset types and product offerings with a particular focus on Alternative and emerging/frontier markets and (2) expand and diversify their distribution channels and markets. These changes can stretch the capabilities and capacities of investment managers' "platforms." A number of rapidly changing market dynamics are at the heart of this challenge for investment managers.
Stagnation in the growth of managed assets has been brought on by a number of factors including increased allocations to government debt, an increase in bank deposits and direct investment in private assets. According to The Boston Consulting Group, from 2007 to 2011, total investable assets grew from $127.7T to $138T, but, interestingly, assets managed for a fee remained flat at $49.7T2. Investment managers actually lost ground during this period, with their share of investable assets shrinking from 39% to 36%.
As plan sponsors search for greater returns, the demand for Alternatives continues to increase. In the past five years, Northern Trust's Universe of institutional plan sponsors shows that endowment funds' allocations to Alternatives have increased from 25% to 40%. According to McKinsey and Company, global Alternative investments across retail and institutional segments have doubled in assets under management between 2005 and 2011 to $6.53 trillion, which represents a compound annual growth rate of 14%.
But that's not the only change occurring. As retirement plan sponsors seek greater efficiencies, they are moving more of the management of their portfolios in-house. At Northern Trust a number of existing and prospective custody clients are demanding more "middle office-like" services to support the in-house management of their portfolios. This is happening across a broad spectrum of asset owners including large corporations, public pension funds and sovereign wealth funds. A prime example of this trend is the California Public Employees' Retirement System who is in-sourcing wherever possible, managing 91%4 of its portfolio internally in 2011.
Hedge funds are also infringing on the traditional, long-only market. According to a recent Financial Times article by Sam James, hedge fund firms such as Lansdowne Partners, Egerton, Odey Renaissance Technologies, CQS, Two Sigma and GLG Partners are all growing their long-only businesses. Given the increased demand for access to Alternatives, hedge funds are well placed to cross-sell into the long-only market as a natural extension of their business model.
As a result of all of these environmental factors, investment managers are seeing their core foundation for assets under management diminish as investors move a larger percentage of their assets into Alternatives. The Boston Consulting Group estimates that in 2003, the Active Core Equity asset class accounted for 63% of all managed assets globally. By 2011, that number had dropped to 49%. On its own that shift is significant, but even more so when you consider that Active Core Equity has historically been one of the most profitable products offered by investment managers.
Adapting to Changing Market Dynamics
Do these changing dynamics present a bleak picture for the traditional asset manager? Not likely. Investment managers will adapt in order to exploit these changing market dynamics which represent the "new normal." Long-only investment managers will consider expanding their strategy and product mix to include Alternatives, solutions (i.e. Target Date and Absolute Return Funds) and emerging/frontier market mandates products.
Senior executives in the front office will find ways to launch these new strategies, potentially acquiring a specialist boutique firm, hiring an established portfolio manager or developing talent organically. However, the greater issue may be whether or not an operations and technology platform, originally designed to support a single asset class, region or product type, will be able to quickly and efficiently adapt to support horizontal growth.
So, what does it take to adapt?
First, a clearly defined strategy is needed. A firm's leadership team must be fully engaged regarding its future direction and the implications that horizontal growth may have on the firm's infrastructure. Adding a new strategy or product type requires thoughtful planning and timely execution to successfully implement the required changes.
Second, a realistic assessment of a firm's operational infrastructure is crucial - analyzing people, process and technology. The firm needs to know which components of its infrastructure are extensible and which are hardwired to support its current product mix. This assessment should be completed across all core processes including trade management, investment accounting, reference and market data management, reporting, performance and analytics. Additionally, the process should consider the likely products, strategies, markets and vehicles a firm may enter.
A comprehensive assessment will help to evaluate a firm's readiness to support a particular strategy or product. If senior management is trying to decide between expanding into Global Equities or Alternatives, the level of operational readiness must be a consideration as it will have a significant impact on the time-to-market and, ultimately, profitability.
Of course, the question may not be how quickly an infrastructure can adapt to support horizontal growth, but whether or not it can or should.
When no is not acceptable, when time-to-market is critical and when the challenge is multi-product and multi-jurisdictional, a firm may realize that extending an existing infrastructure is not the best approach. Doing so could take too long, cost too much and lead to missed opportunities.
In order to support horizontal growth, increasingly more investment management firms are considering middle office outsourcing. A middle office outsourcing solution provides a platform upon which an investment management firm can execute its horizontal growth strategy. Asset servicing firms, like Northern Trust, who have developed and employ a single, global operating model, are best placed to support multi-product, multi-jurisdictional growth strategies. These asset servicers have well-designed, fully functional platforms that have been built to support an investment management firm's needs. Their platforms are time-zone, domicile and product agnostic. They offer solutions that can get a firm where it needs to be, when it needs to be there, with all the necessary capabilities ready to be leveraged.
Changing market dynamics are impacting the investment management industry; firms that are proactive and realistic about their capabilities can turn these challenges into opportunities. In addition, middle office outsourcing provides a platform through which asset managers can execute their strategy.