Asset managers: new requirements in light of the financial crisis

While the unprecedented crisis of late 2008 revealed clear flaws in the banking system, the more robust asset management sector was also affected considerably. Assets under management (AUM) did shrink and there were individual cases of malpractice damaging investor confidence. The consequences of the crisis for the sector are likely to be felt at a profound level and for a long time. Changes in regulations, investor preferences and within the industry itself will provide a range of opportunities and challenges that no asset management firm can afford to ignore. Asset managers need to adapt to these changes that will put different demands on IT platform functionalities.

by Partner François Génaux and Director Dariush Yazdani, PricewaterhouseCoopers (PwC), Luxembourg

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Investors have great cause for grievance in the wake of the credit crisis, as many suffered sharp losses from banking products that were poorly understood by buyers and sellers. Investors will therefore expect more evidence of enhanced management of risk, in its broadest sense. Institutional investors will increase their due diligence efforts and retail investors will require suitable investments reflecting their risk profile. Particular attention will be paid to counterparty and liquidity risk. Ensuring that assets are segregated on the balance sheet of the counterpart will be critical and asset managers should be aware of the sensitivities.

At the same time, investors have suffered from limited liquidity in some of their investments. This will make them think twice about which asset classes and which asset managers to select. The ability to explain how risk is managed and controlled, including liquidity risk and how their assets are held, is now as important to sceptical investors as information about specific risk measures relating to asset classes and portfolio construction.

RETURN TO OPPORTUNISTIC INVESTMENTS

While investors may remain suspicious of markets – particularly equity markets – for some time to come, allocations to equity investments are likely to increase as investors seek to rebalance their portfolios after a period of declining values in their equity allocations.

Low interest rates are also fuelling this trend, with institutional investors looking for and rewarding high alpha performance. Going forward, asset managers are likely to see investors (especially institutional) making a strong distinction between those delivering alpha performance and dumping those who are not able to generate true alpha for certain products like exchange traded funds (ETFs), for example.

The financial crisis has also been a rude awakening for retail investors, who have now turned ultra-conservative with a higher focus on asset preservation than on growth and a move towards simple and understandable products. This has resulted in a high inflow of capital to protected and guaranteed products (Figure 1).

This trend is set to remain for the future, not only due to the fear of another crisis but also the ageing European population, which will push asset consumption rather than asset accumulation to centre stage.

PRESSURE TO REDUCE COSTS

The financial crisis has led many asset managers to operate in survival mode and to examine ways of reducing costs in the short term to maintain profitability or contain losses. However, the pressure on reducing costs goes beyond the financial crisis. Proposals for stronger regulation, transparency and reporting requirements for the industry will impact the cost base.

The mounting pressure on fees being driven by investments in low margin products, such as ETFs on the one hand and entrance of low fee asset managers on the other, will also put additional pressure on margins in the long term. This trend can already be seen in the US where investors tend to put their capital in funds with lower than average expense ratios (Figure 2). Asset managers will have to adapt to these pressures and assess exactly what sustainable cost management means for them

TRANSPARENCY AND REPORTING NEEDS

In the wake of the crisis, liquidity and performance challenges have led to investors demanding greater transparency and improved reporting. In order to satisfy these needs and retain institutional investors, asset managers will need to offer deeper insight in their investment process, valuation methodology and holdings, as well as deliver a sophisticated and real-time reporting.

On the retail side ‘easy-to-understand’ products and reporting will be key to attracting investor capital. The introduction of more and more hedge fund-like UCITS vehicles (Figure 3) demonstrates the move towards sophisticated vehicles with greater transparency and investor acceptance.

DISTRIBUTION CHALLENGES

The shift in investor demand (especially retail) is also posing new challenges for distribution of asset management products. Distributors see themselves faced with the challenge of giving good advice rather than focusing on ‘pushing’ products offering high retrocession fees. This demand forces distributors to have a more thorough understanding of the products, which could lead to distributors preferring in-house over third-party products where extensive know-how and training offerings lie within the group.

Hence the evolution towards a stronger open architecture model within the asset management industry in Europe seems to have fallen back a multiple of years. Third-party providers, who strive to be successful in such an environment, will need to offer comprehensive sales support to distributors including product trainings, information and help hotlines, timely and easy to understand reporting, marketing and sales documents. JPMorgan, for example, has established the JPMorgan Academy, aimed at educating financial advisers to achieve a better understanding of investment products, free of charge.

MOUNTING REGULATION

The spectacular failures of global entities and fraud cases over the last couple of years have stirred world leaders to act to reform financial markets and increase regulatory scrutiny. But even before the crisis, regulators were working on increasing investor protection, transparency and reporting.

While this should have increased investor confidence, so far it has essentially only increased the administrative burden of asset managers and distributors. These changes and burdens could even force them to change their business models. Hence the growing regulatory scrutiny also entails the threat of asset managers moving out of the EU to avoid such burdens on their business.

UCITS IV DIRECTIVE

For UCITS funds, the new legislative framework of UCITS IV will impact all European UCITS management companies, allowing them to operate more centrally. Under UCITS IV, CESR recommends an assessment of all risks and their materiality within the overall risk profile of the UCITS. Liquidity and operational risks are explicitly designated to be material. VaR calculation methods will also be reviewed and CESR is set to issue guidance before July 2010. UCITS IV will also allow for cross-border master-feeder structures where one or more feeder funds can pool their assets into a single master fund, which would mean pooling buckets of assets rather than products for asset managers.

Also under the directive, the asset manager will have to provide a Key Investor Information (KII) fact sheet, which will replace the simplified prospectus. This document targeting retail investors will explain the product and its risks in a non-technical language limited to two A4 pages with frequent updates. This means asset managers will have to adapt their procedures and systems to developing the new document in the future.

ALTERNATIVE INVESTMENT FUND MANAGERS DIRECTIVE

Under political pressure, regulators will target investment firms directly, predominantly those in the alternatives space. Many mainstream financial institutions may find that connections with ‘light-touch’ financial centres will no longer be commercially viable. The EU has already taken steps to impose regulation on alternative investment funds and managers, and this may be replicated elsewhere.

On 29 April 2009, the EU Commission published the draft Alternative Investment Fund Managers (AIFM) directive with the declared goal of creating a cohesive framework for high-risk activities in the financial markets. Under AIFM, alternative investment funds will be required to disclose details of the principal markets and investments in which they trade (including, on an aggregated basis, details of their principal exposures and concentrations) and details of their leverage through quarterly reporting to their regulators. While the AIFM directive is still being heavily debated, the alternative investment fund industry is set to be more strongly regulated one way or the other, forcing the players to adapt their processes to the new rules.

Figure 1. Breakdown of AUM of new funds launched at the end of each year of launch (UCITS and non-UCITS). Source: Lipper IM.
Figure 2. Comparison of net new cash in stock funds to the average expense ratio percentage 1999–2008. Source: ICI Fact book.
Figure 3. Number of hedge funds-like UCITS compared to the whole UCITS market.
Source: Lipper IM and EFAMA

REGULATING THE DERIVATIVES MARKET

The value of outstanding over-the-counter (OTC) derivatives equals many times total global GDP (Figure 4), giving rise to concerns that the unravelling of some of these contracts could tip the fragile financial sector over the edge.

Recognising this potential danger, the US proposed a new regulation in May 2009 to force all ‘standardised’ OTC derivatives to be cleared through central clearing houses, in order to reduce the risk of investors being exposed to a single counterparty. These types of derivatives would also have to be traded on regulated exchanges via electronic systems. Firms that use derivatives may find that the sands shift beneath their feet while regulators around the world grapple with this issue.

TAXATION ISSUES

Taxes in the US, much of Europe and the UK will have to rise to repair their fiscal deficits. Asset managers, in line with the entire financial services sector, will be expected to contribute significantly to these efforts. They can also expect a more rigorous enforcement of tax rules, swifter closure of loopholes and a generally more adversarial environment including a stringent review of transfer pricing rules. There will be renewed focus on privacy laws and tax evasion, mainly relating to individuals. Only a few asset managers will be unaffected by this; either because of increased compliance requirements or changes in client preferences as a result of these developments.

New US regulations set to be passed in the coming months have the same goal as the European Union Savings Directive in Europe: to identify the ultimate beneficial owners of the fund, their nationality and tax residency. These regulations will demand additional reporting and changes in withholding tax for asset managers who will have to adapt their IT systems accordingly.

RETAIL DISTRIBUTION REVIEW PROPOSAL

Regulators consider that inducements are one of the main sources of conflicts of interests in the context of portfolio management and merit specific regulation. The UK Retail Distribution Review (RDR) proposal aims to tackle this issue by simply prohibiting the payment of any retrocession or trailer fees by a product provider to advisors/distributors. In this respect the RDR is set to change the distribution and sales of funds and investment products in the UK. In order to operate successfully within such an environment, asset managers will need to collaborate with advisors/distributors by ensuring they receive the required relevant information (rather than a vast amount of unsystematic information) and reporting at the right time.

Those asset managers who are able to invest in key areas such as compliance, risk management and reporting infrastructure to cope with changes in investor preferences and new regulation will derive a direct benefit. Financial intermediaries and other third-party distributors, especially banks, will have to restore trust and demonstrate their value added. Significantly, higher levels of professional and technical qualifications, as well as an adapted IT infrastructure, would be necessary to operate successfully in such an environment.


Figure 4. Outstanding notional amounts of derivatives.
Source: BIS.

DEMANDS ON IT PLATFORMS

While the above-described trends have highlighted clear requirements for the evolution of IT systems and infrastructures, we would like to elaborate on some specific aspects affecting asset managers. Evidence of enhanced management of risk and its transparent communication to investors will be key determinants in the future. The ability of asset managers to satisfy these market requirements will decide over success or failure.

A precondition for an effective management and transparent reporting of risks is the access to and the consolidation of risk-relevant data. In today’s fund markets this data is collected by a number of legally independent entities, each of them providing a special contribution to the fund product. Data is collected and stored in a number of technically more or less sophisticated IT tools including specialised packaged systems, in-house developments, data warehouses and Excel sheets.

The effective management of risks re¬quires an efficient upstream transfer of data from distribution entities, transfer agents and fund administrators to the asset managers. The main criteria are as follows:

• Systems should enable the asset manager to have quick access to all investor data with the appropriate level of detail in order to be in a position to have a timely communication with the right recipient. This will require transfer agents and distributors to closely observe and report on the investment behaviour. Through the provision of dashboards consolidating qualitative and quantitative investment data, transfer agents can support asset managers in the anticipation of investor demands and claims in case of crisis.
• Centralisation of all data within one single platform to efficiently analyse any data relevant to the asset manager.
• Ability to compute/analyse/report the level of risk taken by the asset manager and to disseminate this information in a consistent and precise manner in different reporting factsheets and marketing materials. The implementation of UCITS IV will require informing investors about the ‘essential elements’ of the product. These elements will have to be consolidated in the ‘KII’, enabling the investor to easily make comparisons between different offerings. The creation of a ‘KII’, which will become a standard marketing tool, will have to address investor desire for increased risk transparency and frequent updates.
• A complete and accurate securities master file, enabling detailed analysis and creating results with a high degree of precision allowing sound management decisions in crisis situations. This should include accurate data such as geographic areas of investment, industry sectors, issuers, underlying assets, location of deposits, valuation principles, etc.
• Improved middle office system, enabling the clear identification and necessary analysis of counterparty risks.

Neither the integration of systems nor the development of effective reporting tools are new concepts: the quest is as old as the IT-supported fund production itself. But it has never been thought through in an industry environment, which was characterised by sufficient liquidity, growth and focus on sophistication of products and services. We expect that increased focus on risk, liquidity squeezes, transparency and reactivity will lead to significantly higher cost pressures where these old concepts will become more fashionable than ever before.

The interconnectivity, meaning that the systems communicate with each other, straight-through-processing (STP), or the seamless, electronic transfer of information to all parties involved utilising standardised information flows, technologies, and infrastructures, accuracy and flexibility of the various systems and tools: all these should be the key features of the IT infrastructure made available to asset managers in order to allow them to cope with upcoming challenges. However, this is not an easy fix. It will require some time, starting from a blank sheet of paper and rethinking the ideal interactions and functionalities of the different systems to achieve an efficient and flexible infrastructure.



François Génaux is partner at PricewaterhouseCoopers (PwC) in Luxembourg, leading the Financial Services Consulting Practice. He holds a masters degree in Finance and Economy from Louis Pasteur University of Strasbourg, France, and an MBA from Warwick University in the UK.

Dariush Yazdani leads the Financial Services Research Unit at PwC Luxembourg with more than 14 years of experience in the financial services industry. He has led and contributed to various research and thought leadership studies for external clients and in support of other PwC Units. He holds an MBA from the University of Chicago GSB.