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The Buy-Side Rethinks Outsourcing

Traditional and alternative asset management firms have faced a challenging year so far. 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.

Navigating the unknown

After incurring swinging losses during the peak of the Covid-19 volatility, equity fund outflows – fuelled by the ongoing equity market gyrations – show no sign of decelerating just yet. According to Morningstar research, US equity funds have so far suffered outflows totalling $147 billion in 2020 in what is expected to be the worst year on record.1 Similarly, international equity funds have not been spared either fielding redemption requests totalling $63 billion in the seven months leading up to July 2020, trumping the previous record of $53 billion in 2008.2 The industry’s cause was not helped by data from S&P Dow Jones3 showing 67% of actively managed US mutual funds investing in domestic equities were beaten by their benchmarks.

Hedge funds, however, are in a much stronger position now. After suffering eye-watering losses of $333 billion in Q1, the industry is presently enjoying a spectacular reversal of fortunes. Hedge Fund Research’s (HFR) HFRI Fund Weighted Composite Index was up 2.7% in August, bringing its five month return to 15.4%, the index’s best showing since the five month period concluding in February 2000.4 Off the back of this exceptional performance, total hedge fund assets increased by $220 billion – a new quarterly record – to reach $3.17 trillion.5 Outflows also stabilised during Q2 dropping to $12.2 billion – or 0.3% of total industry capital – having hit $33 billion in Q1, adds HFR.6

The mood is also bullish in certain private capital circles. While private equity exits have all but ground to a halt and many valuations are being written down because of COVID-19, the industry is sitting on vast amounts of dry powder. In the case of private equity, that number stands at around $2.5 trillion7 whereas private debt has amassed more than $812 billion in unused cash.8 The dry powder will likely be deployed to procure cheap assets with strong, long-term fundamentals. This would suggest the long-term return prospects for private capital managers looks incredibly strong.

The industry is not without its 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.9 A 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 totalling €33.4 billion in the three months leading up to July 2020.10 Having slumped to €780 billion following the March/April panic sell-off, ETFs have since regrouped and are presently managing €903 billion, with Morningstar confident that the asset class will break the €1 trillion barrier later in the year.11

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

The industry is going through a difficult patch – but it could regain momentum by implementing changes to its traditional business model 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 the recent COVID-19 crisis. With investment managers working remotely, a number of organisations 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. City Wire USA (August 14, 2020) Equity funds hit with record outflows in July, Morningstar finds
  2. City Wire USA (August 14, 2020) Equity funds hit with record outflows in July, Morningstar finds
  3. Financial Times (September 22, 2020) Active managers fail to beat the market again
  4. Hedge Fund Research (September 8, 2020) Hedge funds navigate virus, politics in August to extend historic five month surge
  5. Hedge Fund Research (July 20,2020) Hedge fund assets surge on 2Q recovery
  6. Hedge Fund Research (July 20,2020) Hedge fund assets surge on 2Q recovery
  7. Bain & Company (April 9, 2020) The impact of Covid-19 on private equity
  8. Preqin (February 4, 2020) Private debt keeps maturing through a stuttering 2019
  9. Financial Times (January 8, 2020)Index funds break through $10 trillion in assets mark amid active exodus
  10. Morningstar (July 13, 2020) ETFs back in favour after market crash
  11. Morningstar (July 13, 2020) ETFs back in favour after market crash

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