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The Buy-Side Rethinks Outsourcing

Traditional and alternative asset management firms have faced a challenging 12 months. In addition to managing money in arguably the most difficult and unpredictable market conditions witnessed in over a generation, the industry is trying to fight off new competition in the guise of inexpensively priced passive funds while concurrently dealing with new regulations, many of which are adding to their business costs. Irrespective of the impact of these adversities on asset managers, the industry could still turn itself around. By implementing changes to their operating models and developing a sensible outsourcing strategy, active asset managers could once again reclaim the lost ground.

Recuperating and Regathering Momentum

After incurring swinging losses during the peak of the Covid-19 volatility, active managers staged a remarkable recovery but this has not prevented investors from withdrawing assets. According to Morningstar, $250 billion exited US active equity funds during 20201. The industry’s cause was not helped by data from S&P Dow Jones2 showing 67% of actively managed US mutual funds investing in domestic equities were roundly beaten by their benchmarks.

Hedge funds, however, are in a much stronger position now. After suffering eye-watering losses of $333 billion at the beginning of the COVID-19 crisis, the industry is presently enjoying a spectacular reversal of fortunes. Hedge Fund Research’s (HFR) HFRI Fund Weighted Composite Index was up 11.6% last year and this momentum is continuing into 20213. Off the back of this exceptional performance, total hedge fund assets increased by $290 billion in Q4 – the largest quarterly AuM growth in the industry’s history – to reach $3.6 trillion.4

The Industry is not Without it's Challenges

The investor market share controlled by traditional active managers (and to an extent hedge funds) is gradually being eroded away by lower cost passive funds, an asset class currently managing in excess of $10 trillion, a new record.5A lot of this money is being re-allocated from active managers owing to ongoing retail and institutional investor frustration with their performance and high fees. Exchange traded funds (ETFs) – having been hit by heavy redemptions during the initial COVID-19 volatility – are once again accumulating capital inflows with new allocations totaling $507.4 billion in the US alone last year.6

In addition to fee pressure – active (and alternative) asset managers are dealing with a number of regulations, many of which – including Dodd-Frank, the Alternative Investment Fund Managers Directive (AIFMD) and the Markets in Financial Instruments Directive II (MiFID II) were introduced following the 2008 financial crisis. Although a handful of regulatory provisions contained in the European Market Infrastructure Regulation (EMIR) and the Central Securities Depositories Regulation (CSDR) have been delayed because of COVID-19, others – most notably the Shareholder Rights Directive II (SRD II) – are now live. Again, these rules add to the incremental costs of doing business at fund managers at a time when their margins have been put under unprecedented strain.

Outsourcing as a Solution

Parts of the funds industry are going through a difficult patch – but they could regain momentum by implementing changes to their traditional business models through outsourcing. One of the primary benefits of outsourcing is that it can enable firms to acquire the benefits of scalability at a fraction of the cost of doing it themselves internally. Rather than hiring additional people to perform non-revenue generating operational functions, firms can leverage the deep pool of expertise at external vendors. Aside from the cost advantages this brings, the value-add of outsourcing was laid bare by COVID-19. With investment managers working remotely, a number of organizations faced operational challenges and disruption as a result. Conscious that outsourced providers weathered COVID-19 relatively seamlessly, managers – now under greater pressure from their end investors – are becoming increasingly open to the principle of outsourcing parts of their operational processes.

1 Institutional Investor (January 25, 2021) Active managers kept losing out to passive even after markets crashed
2 Financial Times (September 22, 2020) Active managers fail to beat the market again
3 Hedge Fund Research (January 8, 2021) HFRI extend surge to conclude 2020
4 Hedge Fund Research (January 19, 2021) Hedge fund capital surges to record level to start 2021
5 Financial Times (January 8, 2020) Index funds break through $10 trillion in assets mark
6 (January 4, 2021) Record ETF assets growth in 2021

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