Introduction: Different avenues being explored to get through such a muddy circumstance
Fees pressure, combined with continuing rising costs and fastidious regulatory requirements, places fund industry’s operating margins under considerable duress. Struggling to earn profits becomes a never-before-seen tough task for asset managers, several ways have been tried over the previous years to get through this muddy circumstance.
In terms of internalized optimization patterns:
- Process rationalization by Robotic Process Automation (RPA): Operating in a smarter and more efficient way means cost rationalization. The world’s leading IT research firm Gartner says that the RPA software market will grow by 41% year over year through 2022. As for financial sector, 70% of financial companies are already using or piloting RPA, making it a fertile soil for this trend. When taking a closer look at asset management value chain, the RPA has seen different workflows be streamlined across front, middle and back office sections, such as trade execution, reconciliation processing and fund accounting.
- Conception of own operational platforms: Some asset managers are establishing their own operating platforms to cut cost and to share it with other management companies. Here are a few examples: As the European number 1 asset manager, Amundi opens its own operational platforms to medium-sized asset management companies and institutional investors; Azqore, the new brand created by Crédit Agricole Suisse, aims to helping asset managers to reinforce operational efficiency and to ensure compliance with local regulations; The similar strategic proposition is adopted by Lombard Odier, its G2 solution can be integrated with front office, banking operations and accounting services.
In regards to outward-looking strategies:
- Consolidation within industry: Merging with another firm seems to be a booster for asset managers to survive. Nevertheless, since organic growth can only stem from a right operating mode, whether the merger between Rothschild & Co and Compagnie Financière Martin Maurel or the acquisition of Pioneer Investments by Amundi, the M&A might rather be a band aid solution, but never a permanent cure for industry’s profitability problem.
- Offshoring: If industry consolidation is a way to seek a sharp competitive edge through an external procurement of operational capabilities, then offshoring could be another outward scale-pursuit option to bolster cost and operational efficiency. The first wave of offshoring in asset management industry emerged during the first decade of the century to fix inefficiency in back office operations and some middle office functions.
Indeed, either internal optimum patterns or external development efforts, the fundamental solution to maximize asset managers’ profitability, just like the traditional manufacturing sector, is to reduce production costs. Furthermore, as asset management is characterized by its essentially fixed cost structure, once the break-even point has been reached, the net operating margins will increase steeply.
For the time being, given the tight operational margin pressures, the spring-up of Fintech, as well as the rising complexity of capital regulation, the only viable solution to embrace a long-term organic growth would be found in the next offshoring model, a sustainable business model enables agility across the spectrum of front to back activities, thus leading to an optimum cost structure.
Zoom in current asset managers’ cost structure
The AMF published key figures of the French asset management market on December 17, 2019. The operating income fell 11.9 % to €3,165 million at the end of 2018, compared with €3,544 million in 2017. This significant drop is due to the rising operating expenses by 3.7% (compared to 2017) on the one hand and the quasi-flat operating revenue on the other hand.
Focusing on operating expenses, the AMF report reveals the top 3 cost items, which represent almost 90% of the total operating expenses of portfolio asset management companies in 2018:
- Trailer fees recorded as operating expenses: 34.2%
- External charges: 28.9%
- Payroll expense: 25.5%
The remaining 10% is made up of taxes, technical and human resource secondment costs as well as amortization, depreciation and provisions. It is worth noting that trailer fees dropped for the first time during the second decade of the century. This could be explained by the imposition of new regulatory regimes (MiFID coming into effect on 2018) on fees model and the rising attractiveness of passive products. Now that trailer fees are not the root cause for the rising operating expenses, the real contributors are external charges and payroll expenses. More precisely, external charges contributed 71.8% to the increase in operating expenses, which comprise management fees paid for financial management delegations and expenses relating to accounting, administration, valuation, statutory auditors and depositaries of Collective Investment Undertakings (CIUs). As for payroll expenses, it is due to more and more expensive workforce.
Based on the AMF’s statistics, the average operating expense ratio (OER) in 2018 for the French asset management market is 80 %.
For top asset managers, who are usually subsidiaries of large banking groups, they possess a better OER when compared to the benchmark. This is not all thanks to their capacity to amortize the fixed costs (economies of scale), but also enormous advantages being taken from their offshoring practices.
The table below describes the actions being taken in their offshoring strategies:
It is not difficult to find that even for top players opting for offshoring, their OER ratios are not far beyond the actual market average level. A point worth mentioning here is that their offshoring activities have being concentrated in traditional offshoring activities, like IT and banking operational processing. This partially explains the reason why French fund industry’s OER stabilized around 80% over the past 3 years, as offshoring model remains at a status quo and can no longer meet the changing market environment.
Eco-offshoring: Economical benefits can be generated by Eco-Systematizing the whole value chain
The squeezed operating income is the difference between the operating revenue and operating expenses. Then as shown below, in order to maximize this discrepancy, we can expand two axis: the horizontal one “Investment value chain’s extent of offshoring” and the vertical one “Application level of technology”. Getting a boost of the dual axis simultaneously would help to achieve an even better profitability.
On the whole, half of the investment value chain’s activities have not being offshored yet. Except for the core business activities, i.e. research and portfolio management, they lie largely at the upstream value chain, as well as a small portion in transversal functions:
- Asset gathering: As explained before, the asset management industry has typically a fixed cost structure. For example, managing a fund of € 2 billion costs almost the same as a fund of 1 billion, whereas the revenue, all things being equal, doubles for an asset manager. Due to the unfavorable global market environment in 2018, the total assets under management for French portfolio asset management companies dropped by €164 billion compared with 2017, representing a falling of 4.3% . Therefore, the asset gathering capacity is becoming more and more essential for profitability issue. Then, why not expand offshoring by opening offices in key wealth growth drivers in Asia? Firms operating in Hong Kong have forecasted 5%-10% AUM growth over the next five years, far beyond 3% for French market over the last 10 years. Although Hong Kong become less optimal due to deteriorating geopolitical and volatile market conditions, 14% of Hong Kong’s HKD 7.62trn ($970bn) private wealth market were sourced from the mainland of China. In addition, as Hong Kong plays a strategic role in China’s national development blueprint since 1997, setting up its Asia arm in Hong Kong can be a springboard to penetrate Chinese mainland market. Another potential investment offshoring hub is Singapore, when considering its existing financial infrastructure, friendly regulatory environment and attractive tax policy. Moreover, its future offshore inflows appear particularly promising. According to a report (2018) of Asia Private Banker on the role of Singapore as an offshore wealth management hub, 86% of the increase in Singapore’s offshore inflows will come from Mainland China in the next 3 years, due to economic growth and tightening capital controls and regulation. To summarize, in contrast with traditional offshoring which aims at cost-cutting, offshoring to hunt for assets by heading to fast wealth growing countries makes the market cake bigger.
- Products, Sales and Marketing Distribution: AMF statistics of 2018 showed that trailer fees accounted for 34.2% of operating expenses. Though annual service commission paid by the mutual fund manager to the mutual fund sales representative began to show a downward trend under the pressure from both compliance and commercial sides, there is still room to do more to lower this primary cost by product specialization and advanced analytics. Specifically, product specialization refers to passive products, such as ETFs, for the most part, they are less costly than mutual funds. A report published by Moody’s Investors Service on November 2018 points out that ETF funds will drive European passive funds towards 25% market share by 2025. Besides, there is an ever-increasing interest in SRI (Socially Responsible Investing) ETFs, because more and more assets are attracted by lower fees combined with positive direction of SRI goals. When accumulated to a certain level, these assets will create a scale effect, which can make fees lower again in return. As to advanced analytics, based on a vast database of client characteristics, asset managers are able to redesign their distribution model, which helps to target the right clients by the right channels at the right time. The predictive algorithms of advanced analytics have the power to achieve 5% to 30% higher revenues in sales and marketing, as indicated in a report published by McKinsey on March 2019.
- Trade execution: Confronted with MiFID II’s calls for standard of best execution, market abuse monitoring and market transparency, asset managers must rethink their in-house execution function to improve the trading capacity. Historically, investment managers are in charge of orders execution. However, as the dealing is not the source of alpha and with increasing complexity of market infrastructure, how to free managers from execution without retaining a costly internal trading team is becoming more and more crucial. For small and mid-sized asset managers, it would be 40% cheaper to hire an external trading company than employ two traders themselves according to interviews conducted by Reuters with executives from more than a dozen asset managers, banks and brokerages, as well as industry experts. Whereas, larger asset managers, who are usually subsidiaries of large banking groups, can profit from their own “outsourced” dealing solution provided by their custody banks, such as BNP Paribas Securities Services. Unlike “sell-side” trading operations which simply execute trades on a client’s behalf, outsourcing dealing solution for buy-side investors, like asset managers, includes all analysis, administration and compliance services an in-house team would provide. Over the last 20 years, firms have tried to set up dealing functions in other geographies to ensure 24 hours dealing capability and geographical coverage, then a hybrid outsourcing-offshoring model would not only realize considerable cost-reduction (office space rent, additional payroll expense, local regulatory premises, etc.), but also provide a better access to liquidity and big broker networks to better comply with “best execution”. Aside from the hybrid model, technological advances (i.e. machine learning) can also help to identify the most effective means of execution by making trading recommendations, leading to a cutting number of brokers and dealers, as well as reduced commission rates.
- Risk & Compliance: As a supporting function, it continues to generate inflated costs in recent years with regulatory changes coming in waves. The French Asset Management Association indicated that the compliance and control functions represent on average 8% of French asset management companies’ workforce, which is equivalent to 2.6 men. More in detail, the annual cost varies from companies employing 1 to 5 people for 70 K € (around 0.6 Full Time Employee) to companies employing 20 to 100 people for 375 K € (around 4 FTE). Maintaining a permanent and specialized compliance team is expensive, cost pressures have led to firms farming out this function. However, a tricky point relies on the fact that compliance is generally to be done onshore, owing to local legacy reasons requiring a domain expertise and its critical role preventing from potential sanction breaches. This is the reason why offshoring for compliance is not that widespread as traditional processing functions. Hence, outside of offshoring more rules-based components, technology would rather be a more effective way to look for flexibility across the compliance spectrum. For example, tech-based solutions, such as face recognition, blockchain and machine learning, can help with KYC (Know Your Customer) and AML (Anti-Money Laundering). With respect to regulatory reporting, some RegTech software allow for an automated management of prospectus and KIIDs (Key Investor Information Document). Several firms are even convinced by the power of advanced analytics to uncover market misconduct by monitoring traders’ activities and cross-checking transactions with personal and external data.
If a combo of offshoring and technologies gets fund managers to focus on their core business competencies to a maximum extent, then why not move back to the origin of those traditionally offshored activities? Indeed, they could become a derivative from core business to bring additional revenues, especially for larger investment managers. Offering own fully integrated operational platforms to other market players like Amundi Services (a strategic business line of Amundi) and BNP Paribas Securities Services can lead to an improved scalability in fund industry’s cost structure: fixed costs will be absorbed by different market players while revenues continue to climb.
How to fix and address potential risks of eco-offshoring?
As every coin has two sides, eco-offshoring is a two-edged sword. While investment activities can be offshored by moving up the entire value chain, risks within offshoring spectrum must be chilled down.
In the framework of risk management, risk can be dealt with 2 dimensions: severity and its occurrence probability. They help to categorize offshoring risks into 4 types and 3 levels, as shown in the following risk heat map:
- Acceptable risks to be retained: This level refers to risks with a minor severity and a low probability, such as Corporate Social Responsibility (CSR) and employee layoffs. The best way to handle this kind of risk is to retain them in full, as the risk control needs do not justify the costs of managing them and the advantage issued from highly skilled, low-cost labor in specific offshoring locations.
- Acceptable risks to be mitigated: This level combines risks with a major/extreme severity and a low probability, as well as those with a minor severity and a high probability. For instance, oversight risk resulting in poor performance for clients can be mitigated by a reinforced governance mechanism.
- Unacceptable risks to avoid: This level represents the most serious risks with both a major/extreme severity and a high probability. The first reaction should be avoidance. For example, as the eco-offshoring moves up the value chain, more valuable intellectual property will be transferred to another country. Admittedly, if it is not possible to avoid, prevention can help to lower the frequency. In this case, ensuring high employee engagement and promising a continuing career growth development would build an internalized talent pool and thus reduce unwanted competition.
As fund industry enters an ever-changing era, traditional offshoring model must be replaced by a new tailored and agile model to move up the whole investment value chain from traditional fund administration and transaction processing services to more complex and bespoke business processes. Meanwhile, technological advances can also benefit the eco-offshoring model by leveraging various components of the investment lifecycle. At last, all ambitious aims are attained with risks, different levels of risk must be managed properly to yield the best results economically and ecologically.
 AMF – Key figures for asset management in 2018 – Investment management company assets under management
 Source: A survey conducted by KPMG and Hong Kong’s Private Wealth Management Association in 2019
 Calculation based on statistics of AMF
 Source: Fund Selector Asia, 10 Oct 2019