Serving the front office

Banks must open up or lose out to fund supermarkets

Eric Macy, marketing manager at Brown Brothers Harriman

‘European banks that adopt open architecture, will need technological support’

– Macy

There are now many more funds in the US market than there are stocks. Europe is following the same trend.

The US experience has shown that those banks that did not embrace

technology or an open architecture environment lost significant market

share.

In the US, 30 per cent of funds bought are sold through the banking

channel. In the early 1980s it was 80 per cent. In Europe, it still is.

Of the funds sold through US banks today, 10 per cent are in-house

funds. So not only are these banks not selling third party products,

they have also lost their higher margin business of selling in-house

funds.

Fund supermarket platforms and online services filled the void in the

US market that was created by banks’ resistance to embrace “best of

breed” structures and banks have never recovered.

For the banks in Europe that do adopt open architecture, they are going

to need technological support. There are more than 50,000 funds in the

world. Even if you are good at fund selection, you could be horrible at

asset allocation.

The problem with clients coming in and saying “I would like this

Invesco fund” is how do you fit it into their portfolio. For this

reason advice will become the product. It will be delivered through

special structures, such as wrap programmes.

This new business structure will leave banks managing a sub-custodian

network of their own. The operational costs will be huge. There will be

no standardised methods of trading and reporting, considerable risks

and costs due to manual processing and a lack of economies of scale.

Outsourcing to a service provider can simplify the back office

processing and execution. The provider can also supply asset allocation

and fund selection tools. It also allows the bank to benefit from the

provider’s economy of scale, lowering operational costs.

Searching for scale-related benefits

Bill Hookings, head of retail funds product development, The Bank of New York

‘Outsourcing the back office can be a very positive experience, but only if you choose the right partner. ’

– Hookings

Going into open architecture is far more complex than traditional,

proprietary funds distribution. Volumes sold by direct investor

supermarkets such as Egg and Fidelity have not been huge, although

those aimed at independent advisers, such as Cofunds, taken off. Yet it

is difficult for any fund supermarket to act profitably.

The requirements of the back office mean you have to do everything you were doing with proprietary funds and more.

In addition to dealing, settlement, banking, regulatory and client

reporting, you need to bulk orders placed with external fund managers.

This has to be in line with service agreements with managers, so you

have to get information through every day.

There is more transfer agency work in terms of corrections and reversals with more funds, leading to higher potential losses.

We need electronic platforms to provide reconciliation and electronic

messaging so that real straight through processing is possible, with a

provider’s information going straight through our system and out at the

other end. No-one should touch it in between, it shouldn’t come in

through the internet and shouldn’t have to be re-keyed.

Over the last three years, transfer agency providers have vastly

improved the situation. Before that, we call claimed to be among the

best three providers, but none of us were really any good.

But we need to work harder to transfer deals electronically. Cogent and

EMX were not interested in the past. But we now have enough major

players to do this. The question is who will pay for the system?

Outsourcing the back office can be a very positive experience, but only if you choose the right partner.

Harnessing the fund supermarket

Richard Wastcoat, managing director, UK, Spain and Nordic, Fidelity Investments

‘Pragmatism leads most banks to favour a segmented approach’

– Wastcoat

Are fund supermarkets a threat to banks In Europe? Only in as much as they challenge existing business models.

Pragmatism leads most banks to favour a segmented approach, offering

different products and services to different types of clients – retail,

mass affluent, private banking clients and so on.

This segmented offering could be in very separate parts, which would

make a customer’s graduation up through the ranks complicated.

A funds platform can solve this problem because all the products are on

the same system. The platform has the flexibility to allow propositions

to change over time and even to merge.

The decision to outsource to a platform is not about cost versus

control. It has more to do with partnership and it is up to the bank to

decide how far to integrate a platform into their offering.

At one end, the bank can use the platform merely in order to offer

access to funds – just to offer the entire range of funds in the

background.

At the other, a bank can adopt a highly sophisticated integration

model. Here, the platform manages front office capabilities, such as

fund information, transactions and valuations; middle office

capabilities, like customer record keeping and order aggregation; and

back office capabilities – account structures and fund provider

relationships.

Using a fund supermarket allows banks to compete in an open

architecture world by delivering a competitive and electronically

efficient service.

Supporting the growth of third party fund distribution

Pierre Slechten, head of product management for fixed income, investment funds and collateral management, Euroclear

‘The customer service level that can be achieved with the current state of the industry can only be low’

– Slechten

The third party fund revolution is just beginning. In Europe today

E400bn of funds are third party funds, in other words 10 per cent of

the market. In four years it will be E2000bn – 25 per cent.

The customer service level that can be achieved with the current state

of the industry can only be low. It is currently hardly possible to get

timely and correct information on fund investments.

There is not such a thing as a trade settlement standard in the funds

industry, in contrast to the direct equities and bonds world. Funds

transaction costs are five or six times that of equity transactions.

In this context, the growth of third party fund distribution will mean:

the development of ad-hoc solutions between different counterparties,

additional manual processes, increased processing and settlement risks,

requirements for more operational and IT staff and rising operational

and infrastructure costs.

To avoid this, the European fund market needs to organise itself to

support the growth of third party fund distribution by improving: the

quality of information by creating a central fund database; the

communication between players through straight-through processing and

reporting; the settlement processes through standardisation across

providers; the handling of trailer fees and commissions by distributors

being more open about charges.

The overall effect will be the reduction of back office costs.

Furthermore, third party funds will become more attractive to

distributors and funds in general will become more appealing to

investors.

Mastering multi-manager

Shamindra Perera, director, private banking services, Frank Russell

‘If you limit your universe you can’t compare a manager as thoroughly as possible’

– Perera

Multi-manager investing – investing in multiple manager mandates –

is a lot more complicated than many of us think. It requires

considerable resources. Therefore you have to ask how core manager

selecting is to your business. If it’s not, you have to ask whether you

can afford to divert precious resources to it and whether the business

risk of getting it wrong is worth taking.

There is a clear shift from stockpicking to advising. If your core business is client advisory, how does a multi-manager fit in?

First ask whether you have an information advantage. You’ll need one if

you’re going to build your own multi-manager proposition.

If you are merely doing quantitative analysis of widely available

information, that won’t give you everything you need. It is also

dangerous to apply a quantitative screen at the beginning because you

limit your universe.

So where do you start?

Quantitative analysis, for us, is confirmation of what we think about a manager. It comes in later.

If you limit your universe you can’t compare a manager you are interested in as thoroughly as possible.

What about constructing an optimal multi-manager portfolio? If all the

managers in a fund are operating in the same space in terms of size and

style and so on, is it just creating costs to put them all in the same

fund?

Well, if you can identify managers with different processes to arrive

at buy or sell decisions and if they all arrive at the same decision

you can be even more certain about their decision.

Manager monitoring must be ongoing and dynamic. If you see another

manager doing the same thing better, then bring them into the

portfolio. There must be daily reviews, weekly conversations with

managers, monthly performance reviews and a more formal quarterly

review of managers’ process and organisational issues.

Multi-manager outsourcing is not an investment decision, it’s a

business decision. The idea that it will cost you more if you outsource

because now you have another mouth to feed – the manager of managers –

is wrong. It ignores the cost and quality benefits of scale that the

manager of managers brings.

The Art of due diligence

Tom Rutherford, head of multi-manager advisory service, JPMorgan Private Bank

‘A bank should have a B-list ready, just in case a fund manager goes next door’

– Rutherford

Promoting a particular manager can result in huge flows to that

funds house, so correct levels of due diligence are absolutely vital.

It is best to meet face to face with fund managers at least twice a

year and with a member of the senior investment team every month. You

also need to meet with the compliance, training and risk management

teams in the early days.

We don’t look at a third party provider in isolation, but whittle down 12,000 funds to 50 during the selection process.

Although we are a qualitatively biased house, we spend up to 40 per cent of our time on quantitative analysis.

If you’re doing your job properly, you shouldn’t be surprised if a

product underperforms. You need to examine what the market is doing.

You don’t emphasise a product when it’s underperforming. You’re only

saying it’ll perform in the right conditions.

A bank should always have a B-list ready, just in case a fund manager

goes next door. Sometimes you need to pull the money straight away, but

usually you have time, as the manager has probably introduced a system

that will work for at least a few weeks in his absence.

But should you go to a new house? This would mean new meetings, a new

request for proposal and an entirely new approval process, so there

should be no rush. But de-stabilised houses are generally

un-satisfactory. If managers are leaving through the back-door and

going elsewhere, then you could have a problem. The same is true with

corporate changes.

The due diligence team must also take ownership of all pricing matters.

Private client managers have responsibility to their clients. They

should not pick an expensive product when there are many others

available. Many costs are hidden in the total expense ratio (TER).

Normally, managers promote products on the basis of their management

fees, but this is disgraceful, as costs are hidden. We compare on the

basis of TER and retrocession rates.

Finally, you should also ask whether you can access cheaper institutional asset classes.

Supervising the style mix

Bogdan Sinescu, head of quantitative research, Louvre Gestion, HSBC Private Bank France

‘The skills of the manager can be analysed through the quality of stockpicking’

– Sinescu

When choosing a fund, you must look at the risk profile – the beta

level – so you can tell when a manager has decided to be more

aggressive or defensive. In a fund of funds, this allows you to analyse

the style mix immediately after a tactical asset allocation switch.

Our process uses 23 managers selected for fund performance and style

consistency. Both funds of funds and funds of managers are used.

We analyse different style ratios relative to the fund’s benchmark and

analyse the style exposure of the fund in a dynamic way, using in-house

tools based on the Sharpe model. The skills of the manager can be

analysed through the quality of stockpicking.

Although we run funds of funds, we have a preference for funds of

managers. The process of selection is more complicated, but we have a

special relationship with the managers. We have access to all the

information relating to a portfolio, allowing us to do a complete

analysis. The manager can then explain this strategy to clients.

It is easier to conduct a style analysis of a fund of managers. We can

control the exposure of a fund and supervise the style mix. This is not

always the case in a fund of funds, where you don’t have access to all

the information and cannot control the fund.

A fund manager takes a decision and time lapses before you see the

portfolio information. Performance is also better for a fund of

managers – that’s the reality.

Taking past performance with a pinch of salt

James Tew, European head of ratings, Standard & Poor’s

‘Knowing an investment manager’s style really explains the performance’

– Tew

The purpose of a rating is to help investors make better informed

decisions about funds that allow them to meet their needs more

effectively than performance data alone.

Letter ratings A to AAA signify levels of added value. They are based

on an evaluation process and absolute and risk-adjusted performance

measured over three discrete years.

This compares with star rankings, which are based entirely on the performance data and therefore don’t tell you as much.

Past performance information can allow you to make a more informed

choice, undoubtedly. But knowing an investment manager’s style explains

the performance.

It’s not so much the fact of past performance that is useful, but rather how it happened and why.

The rating process includes in-depth interviews with the fund managers.

The investment styles value and growth are useful terms, but you need

to understand what the fund manager understands by value and growth.

Intensive analysis examines portfolio construction, performance and

consistency. The initial findings are subject to a review process. A

committee of senior analysts reviews the quantitative and qualitative

information in order to determine which funds qualify.

The ratings given are then reviewed regularly based on manager, fund group, style, performance and portfolio construction.

Past performance must of course be taken with a pinch of salt. As John

C Bogle, the founder of Vanguard, said: “Time and again it has been

demonstrated that the relative return achieved by an equity mutual fund

yesterday has virtually no material predictive value for tomorrow.”

But he also said: “In developing a long-term investment strategy,

remembering the past is essential, because it can help us understand

the forces that drive security prices.”

Past performance helps us understand market conditions, investment

style, investment objectives and fund manager experience. Furthermore,

a number of tools can be derived from performance data, such as

volatility measures, the Sharpe ratio and tracking error.