Firms that strengthen and rationalize their operational activities will surmount the many cost pressures facing the fund industry.
Aside from operating in a challenging return environment, the buy-side is facing a number of cost pressures. These have been caused by a multitude of factors, including rising regulatory and operational spending, in addition to investors taking a harder line on fees. If the industry is to weather these difficulties, it will need to strengthen and rationalize some of its operational activities.
The Covid-19 crisis exposed a number of fragilities at traditional and alternative asset managers as returns temporarily plummeted. Since the worst of the volatility, the market has partially recovered with performance improving and redemption activity decelerating. Hedge funds, for example, registered their best monthly returns in more than 10 years in May as markets gradually reopened.
Although this recovery is positive, the performance of active fund managers and hedge funds has come under criticism since the financial crisis. For example, S&P Global found that 80% of active equity fund managers failed to beat their benchmarks over a 10 to 15-year time horizon. The first quarter of 2020 has not been any different. S&P Global data shows that while fund returns declined by 22.7%, the benchmarks were down 22.4%. Similarly, hedge fund alpha has also dissipated since the 2008 crisis, with risk adjusted returns averaging -0.8% over the last ten years.
Costs continue to spiral
With falling returns, investors have taken their business elsewhere. Some hedge funds are ceding ground to private equity and private credit, but nearly all active strategies have seen clients redeploy capital into passive products. Despite only managing $2.3 trillion in 2009, index trackers have since accumulated $11.4 trillion (at November 2019) as capital exits active strategies in favor of lower-cost passives. While a number of investors are happy to retain the services of active managers, others are pushing for fee deductions to compensate them for the recent performance shortfalls.
In addition, the funds industry is also confronting a number of rising costs. Post-financial crisis regulations in the US – including Dodd-Frank registration rules for private managers – have eaten up precious resources. Following Covid-19, it is very likely that investment into business continuity plans (BCPs) will have to rise. Automation and the adoption of scalable technology in their operations will be one way in which fund managers - irrespective of strategy – can help keep their costs at bay. It will also enable them to facilitate connectivity channels across their front, middle and back offices.
Buy-side firms need to have seamless connectivity and automation between their front, middle and back offices in order to grow. However, not all managers have digitalized their internal processes, with a great deal of investment firms still relying on paper- based processes and human intermediation, while simultaneously using antiquated software programs such as Microsoft Excel. With data held across multiple spreadsheets in unstructured formats, it can be hard to achieve data consistency, leading to further costs, errors and risks. If data flows across the front, middle and back office are inconsistent, firms will struggle to expand and scale-up their businesses.
To overcome this, investment firms need to ensure they have a robust front to back office workflow, consolidated view of their data sources and optimized operations. This can be achieved by leveraging industry-leading software to generate a golden source of data across all of their different business workstreams. This allows middle and back offices to validate and enrich security information inputted by portfolio managers in real time. Such solutions will net asset and hedge fund managers firm-wide efficiencies and let them rationalize their operational processes during this difficult period.