Levels of interest in in-sourcing trading and asset management functions have risen significantly over the past couple of years among the largest pension funds, insurance companies and sovereign wealth funds. Disappointing and inconsistent returns from asset managers, coupled with the increasing dominance of low-fee passive investment strategies, have all led to asset owners seriously questioning why they should pay third-party managers.
The need for greater oversight of trades and to get closer to their assets has spurred many large asset owners to assess the costs of using an asset manager as opposed to managing the portfolio themselves.
The $230 billion California State Teachers’ Retirement System (CalSTRS) recently revealed that in 2017 the cost of managing its internal assets was $30 million. However, it paid a total of $1.8 billion, including incentive fees, for outside managers to invest the pension fund giant’s money. Just over half of CalSTRS’ assets are managed externally, while 44% are internal.
In Australia’s superannuation fund industry, a recent study by Northern Trust showed that many super funds are restructuring their asset allocation, taking on the active investment themselves and then selecting cheaper passive funds that cost as little as seven basis points.
Other noteworthy asset owners that have insourced include the Abu Dhabi Investment Authority, which in 2015 took around $70 billion out of the asset pool available to the world’s global investment firms. Elsewhere, around 80% of Canadian pension funds have managed their assets in-house.
“We had 70% of our assets externally managed, but we went through a business transformation where our focus was on bringing the right technology and skill sets onboard so that we can make decisions on what we continue to outsource,” said one chief operating officer at a recent investment operations conference in Florida. “We looked at people, processes and technology from front- to back-office and at the opportunities of insourcing versus outsourcing. Now, 70% of our assets have moved from being externally managed to internally managed, because we think we can do it better ourselves. We are looking for that to grow to 90% over the coming months.”
Many asset owners are now revamping their internal front- and middle-office platforms in order to accommodate this in-housing project. Last year, 80% of trading technology firm SimCorp’s new clients were from the asset owner side. These include Willis Towers Watson’s investment business, a £142 billion fund, which is using the vendor for its front-office, investment accounting and client reporting platform.
“As our business evolves to meet the growing needs of our clients, it is vital that we continue to invest in our technology capabilities,” says Kemp Ross, global head of delegated investments, Willis Towers Watson. “We are delighted to work with SimCorp on enhancing the technology infrastructure of our delegated investments business in order to better manage risk and create greater value for our clients.”
There are, however, cost implications that may not be immediately obvious with such decisions. Where asset owners are bringing asset management in-house, operating costs are rising. A study by KPMG in 2017 found that in Australia, the average super fund experienced a 6.7% increase in total operating costs over the year. Similarly, a report from Greenwich Associates found that costs on buy-side trading desks are set to rise by a further 10% in 2019.
Following this trend, asset owners are increasingly demanding that custodians alleviate these costs and provide services that can support their active trading operations. “They [asset owners] are saying they need data in near-real time, cash projections, performance and analytics, because they are making decisions every day about how to invest available cash and changes to portfolio allocations, which is a whole different world,” says Marc Mallett, director of strategy for asset servicing, Northern Trust. “For a traditional pension fund that looks to a custodian to aggregate investments that they had outsourced to third-party asset managers, that was one level of service where they were not making day-to-day trading decisions – they were making monthly or quarterly allocation decisions. Now they are saying they need data in near real-time.”
With these trends in the buy-side community, many custodians have restructured certain business lines with a heightened focus on servicing asset owners. Last year, Northern Trust combined its global fund services and institutional investor group in North America to create a new asset servicing division. State Street has also made a number of key appointments in recent months to bolster its asset owner capabilities.
At the same time, asset owners are becoming increasingly sophisticated in their requirements. Ron O’Hanley, chief executive and president of State Street, believes this opens up another opportunity for State Street to increase its market share. “We’re taking that offering that we have for the high-end asset manager and tailoring it for those asset owners,” he says.
Furthermore, as custodians continue to position themselves closer to the point of execution – as with State Street’s acquisition of Charles River – there are new opportunities to integrate their capabilities with asset owners’ trading desks. Ian Stephenson, global head of product for asset owners and managers, HSBC Securities Services, says custodians need to ensure they can integrate their world with asset owners’ front-offices and their choice of tools. “We need to ensure the information is flowing freely to deal with the downstream processes,” he says.
As Northern Trust’s Mallet hinted, many of the large asset owner firms are adopting new data strategies to keep up with their investment decisions. To support decision making, more asset owners are turning towards big data and enhanced data management services to create new opportunities in their investments. “Asset owners are looking for big data-type capabilities to look forward and to run scenarios on their portfolios to manage risk and measure performance,” says Mark Schoen, head of asset owner solutions, BNP Paribas Securities Services. “The ability to run return models that are forward-looking is a major change. Putting in the technology and tools on top is prohibitive for smaller and medium-sized funds, so finding a partner that can do it is invaluable. I believe we are two years away before it becomes mainstream.”
Schoen provides an example where the French bank has partnered with one Asia-Pacific sovereign wealth fund to meet its big data strategy. He says even though the French bank does not act as the custodian for the over $100 billion of assets, it is acting as a data consultant, managing all of the data across its other custodian and fund administrators. “We bring in records from other custodians and fund administrators, so the client can then run queries and create model scenarios against its existing book of records. That is just going live with phase one and phase two will include more modelling,” Schoen adds.
Daron Pearce, chief executive of asset servicing in EMEA for BNY Mellon, says the bank has also invested in its data and analytics toolset, including performance attribution and analysis services, for asset owners when they are not the custodian for that client. “If a big asset owner has a portion of its money managed internally and some managed externally with multiple asset managers, and consequently it has assets spread across a few custodians, it can use BNY Mellon to consolidate its portfolio data and provide analytics across all of its assets. Our largest Dutch pension fund client, for example, manages north of 50% of their assets themselves, and are taking a broad data set from us by pulling it through APIs for individual functions multiple times a day, and that is informing them on a consistent basis.”
In addition to using custodians for performance and risk analytics, asset owners are increasingly relying on them for vital data on their environment, social and governance (ESG) strategies. A survey from BNP Paribas Securities Services earlier this year showed that over 65% of their asset owner respondents are aligning their investment framework with the UN’s Sustainable Development Goals, which have provided a “new compass” for ethical investing.
The research also showed a stronger commitment to ESG investment compared to 2017, with 75% of asset owners and 62% of asset managers holding a quarter or more of their investments in funds incorporating ESG, compared with 48% and 53% in 2017, respectively. Over 90% of respondents predict that more than 25% of their funds will be allocated to ESG strategies by 2021.
When asked about ranking custodian services for supporting an ESG strategy, 43% of asset owner respondents valued ESG analytics and benchmarking as the most important. Earlier this year, BNY Mellon launched a range of reporting tools to track investments based on ESG issues and the UN Global Compact principles. The data used for these is sourced through an agreement with Arabesque S-Ray, an ESG consultancy that uses machine learning and big data to score the ESG rating of the world’s largest companies.
“Where we have an active role, we can provide good insights into portfolio profiles. Some pension funds are using ESG as a buying criterion and are therefore turning to us to provide that data for those investments. ESG is becoming a differentiator in mandates with asset owners,” Pearce adds.
The trends in the buy-side community signify a shift in power between asset managers and asset owners, not just with the large firms but also the smaller and medium-sized funds. Asset owners need to demonstrate consistent returns for their members, with regular profits and cash flow to pay out over the long-term. As custodians look to bolster their asset owner divisions, this might mean a change in priority in the type of client on which they focus.
As asset owners continue to expand in size and scale, it could mean both a shrinkage of assets managed for a fee by third parties and potential job cuts. Several of the most well-known investment managers, including BlackRock, State Street Global Advisors and AQR, have announced large redundancies this year.
With pension funds and insurance companies looking to take active trading in-house, does disintermediation mean the end of asset management for these clients? “Some of this is cyclical and asset managers will have to adapt their product set to meet the changing environment,” says HSBC’s Stephenson. “Asset managers may be selected to support passive strategies and other specialists to support active strategies. Asset managers will evolve to look for new revenue streams.”
The changes could also force asset managers to turn to new cost-effective measures in order to retain institutional money. These could include outsourced trading and dealing to specialised custodians that are utilising a front-to-back model. “For asset managers, maintaining a strong performance will help, but it won’t be enough because the real focus is on cost. You have to become more efficient to compete. Automating processes, outsourcing and reviewing compensation are the most effective ways of reducing costs,” Mallett adds. “Those that can reduce costs will create a disincentive for asset owners to insource.”
What these trends among the buy-side signify is an even more active role for the custodian in providing outsourcing services to both asset managers and asset owners for aspects of their operations. Chief operating officers and chief investment officers will have a more intimate relationship with the custodian going forward. It may also mean greater competition among custodians. They will have to constantly demonstrate intent to upgrade services and improve technology as firms look to operate in the most efficient and cost-effective way.