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Outsourcing
 

Page last updated
February 15, 2003

 

 

I

Outsourcing: The Issues for the 21st Century

It was Pudd'nhead Wilson, one of Mark Twain's more memorable characters, who opined that you should "put all your eggs in the one basket and; WATCH THAT BASKET". Although that advice would probably not go down too well with today's global fund managers as they develop increasingly sophisticated diversification models, Pudd'nhead Wilson may have struck a chord with those who have to administer the assets under management: the middle and back offices.

Outsourcing of administrative functions; whether scheme administration, member communications or global custody - has become an established fact of life for pension funds. In exactly the same way as many schemes delegate their asset management to external specialists, they also outsource other functions to third-party suppliers. As demand has grown, so has supply: whatever the trustees want to outsource, they can now find someone ready, willing and able to do it.

It is easy to understand why outsourcing has become so popular: with the unrelenting pressure to reduce fixed costs and improve margins, asset managers and their clients are looking at every viable alternative to maintaining a large and expensive in-house administration function. Accenture, the management consultants, have estimated that a fund manager with US$100 billion of assets under management could expect to save up to US$30 million a year by outsourcing the back office. That scale of saving demonstrates just one of the key benefits of sticking to the core competencies of your business.

But the short history of outsourcing has been characterised by a piecemeal approach to its implementation. Understandably, pension funds and their managers have taken a cautious line, outsourcing low-value, low-risk functions first to test the concept before moving on to deal with more complex arrangements. Typically, this has led to a situation where an investor can have multiple relationships with external service providers, all of whom have some impact on the way in which assets are administered. Managing these relationships is time-consuming and labour-intensive; precisely the problems that outsourcing was meant to solve in the first place.

Until quite recently, there was simply no solution to this problem. Specialist providers were exactly that: specialists in their field but unable to deliver a broader range of services. Now, however, a new breed of third-party administrator has emerged, offering a full range of operational and information services that give the investor a single point of contact and, more importantly, a single record on the database.

The result of this market development has been nothing short of spectacular: within the last two years, for example, managers with combined assets of more than £1 trillion have outsourced their back office operations to external suppliers. Some of the biggest names in the world; including Barclays Global Investors, Robeco and Merrill Lynch; have signed major agreements that devolve responsibility for operations such as fund accounting, daily net asset valuations and trade processing to specialist administrators.

Unsurprisingly, the lion's share of this business is going to the largest global custodians like ABN AMRO Mellon. As the primary recordkeepers of an investment portfolio, custodians are naturally placed to deliver a full administration service, whether it is for retail collective investment schemes, pension funds, asset managers or insurance companies. Over the last five years, the major custodians have expanded their central securities control function to incorporate a very broad range of added-value services; from depositary, accounting, valuation, transfer agency and pricing services to defined contribution plan administration. A few; like ABN AMRO Mellon; go even further through specialist businesses that can provide employee communication and consulting services, as well asset management, master trust and performance measurement and analysis.

In the UK, the impetus towards a bundled outsourcing solution has not come solely from a desire on the part of investors to reduce cost. Following the 1995 Pensions Act, many pension funds moved away from the traditional balanced management approach to adopt a more aggressive philosophy based on a broader mix of styles, tactics and investment vehicles. Such a shift has almost inevitably resulted in a larger panel of external managers being employed by a pension fund, giving rise to additional burdens for the trustees in terms of information management and administration.

Collating and consolidating portfolio data has become increasingly difficult for trustees as the scope of their investment horizons has broadened and they develop more complex fund structures and asset allocation strategies in an effort to boost performance and respond to changing regulatory requirements. Multiple feeds from external fund managers, custodians, performance analysts and other external suppliers are rarely compatible or consistently formatted, requiring the trustees to cut and paste information that results in delay and the possibility of error. Additionally, the challenge of keeping track of the managers' performance, and their adherence to agreed guidelines and parameters, is both complicated and time-consuming.

As a result, many pension funds have turned to their custodians for help. An increasing number of pension schemes now use their custodian as a central consolidator of all information flows; a role referred to as master custody. The master custodian collates all asset data relating to trades, holdings and corporate actions, consolidating it into a single, standardised format, as well as acting as the primary information liaison point between trustees, their managers, and other custodians holding relevant assets, considerably easing the burden of administering numerous data feeds.

In this central role as an information clearing house, the master custodian is uniquely positioned to provide a wide range of additional portfolio services. These include fund accounting, securities lending, net asset valuations, performance measurement and attribution analysis, cash and treasury management, risk measurement, proxy voting services and regulatory reporting.

The pressure is on trustees from all sides. We have all become used to media stories about pension funds that failed to realise that their fund managers were breaching their Statement of Investment Principles or investment parameters. In part, these lapses may be a result of the growing popularity of the core/satellite fund structure, and the subsequent expansion of the panel of external managers. Faced with these complexities, many trustees have concluded that the fund's custodian could more effectively handle investment compliance monitoring.

Investment compliance monitoring is yet another example of where a custodian can add value to the investment process. Monitoring the compliance of a broad panel of managers against specialist mandates is not a job for the faint-hearted or those without the technological capabilities to ensure that breaches are caught before execution, a task which becomes even more difficult as settlement timeframes contract.

Regulatory reform, best market practice and a continuing squeeze on cost and risk are all combining to enhance the attractions of a total outsourcing solution with a single provider. But does such a bundling of services inevitably mean that the investor will have to make compromises? We do not believe that this will necessarily be the case for investment administration outsourcing. The top tier of providers, who are global players with many years of experience, have all assembled a strong line-up of products and services, and a decision to choose one over the others is less likely to be about product features as it is to be about the quality of client service and the strength of the overall relationship. Although it is hardly original to say so, the decision to outsource is a decision to work with a strategic partner, not a tactical vendor. Major outsourcing arrangements can take months, if not years, to implement in full and can never work properly without the total commitment of both sides of the deal.

The recommendations of the Myners Review have, once again, highlighted the need for trustees to be supported by effective information delivery systems. Information on investments has become almost as valuable as the investments themselves, and many institutional investors are no longer willing to pay the very high price needed to collate and manage that data. Whether you are running a funds supermarket or a superannuation scheme, the need for immediate access to accurate and complete records through an integrated system is the key to success. Bundled outsourcing is turning this requirement from a pipe-dream into reality, and custodians like ABN AMRO Mellon are at the forefront of the revolution.

 

Keith Hallman
ABN AMRO Mellon



 


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