The decision whether to internally handle mutual funds' back-office administrative tasks, such as fund accounting, transfer agency and communications with shareholders, or hand these tasks over to outside service providers is far from new. The debate continues, however, heatedly in this prolonged market downturn, over whether outsourcing or "insourcing" of routine yet important services provides more efficiencies and cost benefits continues.

Desperately Seeking Returns

With asset levels and fee revenue significantly down, and fund advisors desperately seeking to reign in operating costs, fund firms are again evaluating the wisdom of their choices and calculating which approach provides the biggest bang for the buck.

According to a January 2003 report from the TowerGroup of Needham, Mass., service costs account for one-quarter to one-third of a mutual fund's total expenses and, consequently, directly impact fund returns. "Firms have to look at their core competencies and what their expectations are for managing their businesses," said Gavin Little-Gill, senior analyst with TowerGroup.

Beyond the usual outsourced functions, fund firms are carefully considering which additional functions and services that they've traditionally handled themselves may best be strategically outsourced. Where new markets are created, such as with hedge funds, offshore funds, 529 college savings plans and managed account programs, fund sponsors are carefully considering whether they could or should provide the servicing internally through affiliated companies or opt for external servicing from the get-go.

Outsourcing is often a solution adopted by those fast-growing fund firms that become victims of their own success at attracting assets. Many times fund firms will start off handling the administration of a new program themselves, said Jim McCoy, director of sales and marketing for the managed account program at PFPC of Wilmington, Del., the servicing unit of PNC Financial Services Group of Pittsburgh. "But as they get enough assets on the books, it becomes obvious that it's difficult to achieve scale," he said. "Clients often want a variable cost structure that will align with their variable revenue."

"It's a scalability issue," said Michael Delfino, president and CEO of ING Managed Account Group in New York, which earlier this month hired The Bank of New York (BONY) to manage the 30,000 accounts and $7 billion in assets under its managed accounts program.

"When we viewed the past two years' growth rate, we saw that we had more than tripled the number of accounts. But our principal business is not really managing a back-office operation," Delfino added. So ING struck the outsourcing deal with BONY under which 50 ING employees would be transitioned to the bank as employees.

"This seriously gives the managed account [sales] group the ability to focus on the core business," Delfino said.

It often comes down to the client's desired focus, noted Andrew Bell, SVP with BONY. "Do they want to be bothered with Y2K fixes, decimalization changes, Euro conversions? Do they want to deal with all of the technology and operational issues - or manage assets?" he said.

Looking Deep Within

Fund company executives are also analyzing whether even such core services as the distribution of fund shares, might benefit from an alliance with an outsource partner.

In some cases, fund sponsors have decided to reach beyond the usual outsourcing service contracts and are now hiring many of the same outside organizations to handle rather mundane but important investment portfolio-related tasks, technology development and day-to-day operations.

One early pioneer was the famed fixed-income shop Pacific Investment Management Company (PIMCO), which in May of 2000 decided to hand over the reigns of its mutual fund operations in Newport Beach, Calif, including a staff of 300 employees, to State Street Corp. of Boston. After a 10-year administrative outsourcing relationship with State Street, PIMCO executives decided to further relinquish control of certain tasks such as pre-trade research and trade settlement, to focus solely on managing assets, putting State Street in the driver's seat at its West Coast operating facility.

A similar agreement was inked between State Street and J. & W. Seligman of New York this past Spring. In May 2002, after a 14-year outsource relationship, Seligman additionally turned over its trade support and settlement, portfolio recordkeeping and custodian communications for settlements to State Street, but strategically chose to retain control of all client service and communications. Previously, State Street had provided fund accounting, fund administration and custody for Seligman's domestic and offshore funds with $16 billion in assets.

Right now, Seligman is being migrated to a new technology platform and its operation is being moved to Princeton, N.J., where a staff of 40 technology professionals now reside, noted Tom McCrossan State Street EVP. There's been a lot of talk about outsourcing, driven by the deterioration of asset bases, rising costs and opportunities to shed expenses, he said.

One concern has been that outsourcing doesn't provide an immediate cost saving, but in most cases that isn't true, McCrossan said. "This is still the wave of the future. Asset managers will come to the conclusion that managing space and people is not core, and that it takes a huge investment in the business," he said.

In other cases, all-important distribution has now also been put under the microscope, much the way proprietary investment management has been scrutinized over the past few years, with some well-known fund groups deciding to hire sub-advisers to manage their funds rather than manage assets themselves.

Some fund groups have decided to partner with more traditional back-office servicing companies for deeper or broader services. Not surprisingly, these service firms not only eager to please, but are downright salivating at the chance to build up a panoply of services that include strategic consulting and distribution channel evaluations.

The Armada Funds, the $16 billion proprietary mutual fund unit of National City Corporation of Cleveland, Ohio, is a perfect example. Late last month it announced it had hired PFPC to provide several services, including distribution support services for its mutual funds. Those distribution services include technology, product strategy, marketing support and campaign management - services that PFPC is happily parlaying into a whole new line of business. "You need to be careful about what needs to be in-house," said Kathleen Barr, SVP. managing director of Armada Funds. "If you can outsource, and [still] keep your employee headcount to a reasonable number, then that's okay."

"In Armada's case, the company has internalized its wholesalers but wants to house them in our facility where we provide training. But they are still working for Armada," said Clayton Burton III, EVP and head of the client advocacy and distribution office at PFPC. "We believe our wholesalers who are covering National City channels such as broker/dealer, retail and charitable organizations, should be employees of Armada," said Barr. "That way, they care about our clients and our stock price," she added.

New Needs, New Services

PFPC is broadening its services to meet customer needs and offer a fuller line of services from which fund clients can mix and match, Burton agreed. New services include more tactical ones such as doing strategic analyses to determine if a product is right for a specific channel, or if it's important to offer a certain class of shares, he said.

While there continues to be a strong trend toward outsourcing certain functions fueled in large part by funds' poor performance, service companies are increasingly being asked to unbundle their services so that fund firms can cherry-pick best-of-breed service provides, said George Evans, EVP at BISYS in New York. Furthermore, service firms are being asked to step up and help with other services, Evans said. "Funds are asking Can you help me raise assets?'" he added. More and more funds are asking for consultation services related to distribution or strategic decisions, he said.

Of course, outsourcing of services is not for everyone. Most of the largest mutual fund complexes, including Fidelity Investments of Boston, Vanguard Group of Valley Forge, Pa., and T. Rowe Price of Baltimore, prefer to handle all of their funds' back-office servicing in-house. "It allows us closer supervision and cost control," said Brian Mattes, principal with Vanguard.

On the other side of the mutual fund universe, several small to mid-sized fund sponsors, faced with rising outsourcing fees and a sense that they are neglected by service companies which, they charge, cater to the larger, more profitable fund group clients, have begun considering taking some services back in-house.

That presents an opportunity for small to medium sized players such as Global Investment Systems (GIS) of Hackensack, N.J. "Some firms have decided to insource because they find that it's cheaper," said Peter Muldoon, director of client services at GIS. Often, it's also the more personalized service that smaller firms crave, as well as that nagging feeling that they've lost touch with their clients that drives firms to wrest control of services back from outside providers, Muldoon added.

In some cases, where an acquisition takes place that weds a mutual fund firm fond of outsourcing with one that performs all of its own back office functions, a compromise must be hashed out. Case in point was the January 2002 merger of outsourcer Lutheran Brotherhood with insourcer Aid Association for Lutherans (AAL) to form Thrivent Financial for Lutherans. AAL had been internally using GIS' fund administration and accounting systems.

A thorough analysis revealed that the combined firm's funds insourcing of services could realize $1.1 million in annual cost savings, according to a GIS case study. Savings would be realized through a combination of fixed fees per fund, versus the basis point fees charged on each fund's net asset value, and the extra charges the service firm charged for multi-class, multi-currency and daily dividend funds, noted GIS.

Copyright 2003 Thomson Media Inc. All Rights Reserved.

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