The London asset management market


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The London asset management market

  1. 1. The impact of new technology on institutions The London asset management market Shahin Shojai Director of Strategic Research, Capco Paul Reyniers Partner, Capco Zachary Berger Research Associate, Capco1 Abstract should find new sources of return and improve their opera- This paper provides an appraisal of how London has become tions so that they extract every last possible basis point. the world’s largest market for asset management and evalu- ates whether it possesses the attributes necessary to sustain The findings of our study indicate that, contrary to what many success in the future. had believed, the increased number of U.S. asset management firms in London has been very beneficial. Through the U.S. We find that most of the growth in the London market has firms, London-based institutions have gained knowledge of come from the institutional asset management business. The the latest asset management skills and styles. As a result, they institutional market will continue to be an integral part of Lon- are well positioned to dominate the four key growth areas: don’s asset base, although the high-net-worth market should specialist management, European credit markets, alternative also be viewed as a major source of funds. Other growth mar- investments, and high-net-worth individuals. kets include high-yield bonds and alternative investments. To continue to attract investments, London-based institutions need to recognize that power has shifted from the sell-side to the buy-side. This power shift is increasing competition and thus lowering fees. To remain competitive, London-based insti- tutions should consider outsourcing non-core functions to allow them to focus solely on the management of assets. They 1 The authors wish to thank the following for their invaluable contributions to this paper: Christian Yates; Senior VP at Julius Baer Asset Management, Eric Werner, 93 CEO of AIG Global Investors; and Stephen Cotterell and Richard Jan Mostyn of Capco. All the other omissions and commissions remain the sole responsibility of the authors.
  2. 2. The London asset management market Introduction one-third of the global daily FX volume, were traded in Lon- London’s position as the major European financial center has don. London’s share of the global FX market had become come under attack a number of times in the last few years. three times as large as that of New York. In fact, by 1999, there Intense competition from continental European cities, especial- were more dollars traded in London than in the whole of the ly Paris and Frankfurt, had convinced many that London would U.S. In that same year, over US$1.5 trillion of new bonds were find it hard to maintain its dominant position. Numerous Euro- issued in London. pean publications predicted that the U.K. financial services industry would meet a fate similar to that of the country’s car 1999 was a landmark year for another reason. In 1999 London industry - it would be surpassed by European competitors. surpassed New York as the world’s largest center for institu- tional equity fund management, with over US$2.4 trillion Both Paris and Frankfurt have offered strong support to for- under management (Table 2). eign banks wishing to relocate their European headquarters. London has not suffered from intense competition; it has The relocation to Frankfurt of the European headquarters of thrived on it. The question is, can this trend continue into the several Japanese banks seemed to provide further evidence future? The objective of this study is to determine whether that London could no longer maintain its position as a leading London can maintain its dominant position within the world of global financial center. finance. Because London dominates so many financial sec- tors, we have decided to focus on just one, the asset manage- Despite such intense competition, however, London has held ment industry. its dominant position among the world’s major financial cen- ters. According to the latest figures issued by the British Invis- This paper identifies the factors that have been responsible for ibles (Table 1), London is still the largest market in the world London’s domination of the institutional asset management for cross-border bank lending, foreign equities turnover, for- business. It also investigates what the major players in this eign exchange dealing, over-the-counter derivatives turnover, market need to do to sustain their current global standing. marine and aviation insurance premium income, and interna- tional bonds. By 1999, over US$630 billion of currencies, or Our analysis begins with a five-year review of London’s fund % Share UK US Japan France Germany Others (represented by London) Cross-border bank lending (march 2000) 19 9 11 6 9 46 Foreign equities turnover (1999) 58 32 - - 5 5 Foreign exchange dealing (April 1998) 32 18 8 4 5 33 Derivatives turnover - exchange-traded (1999) 8 46 5 8 16 17 - over-the-counter (April 1998) 36 19 9 10 7 19 Insurance premium income (1997, net) - marine 20 13 13 6 10 38 - aviation 29 25 4 16 3 23 International bonds - primary market (1999) 60 - - - - - - secondary market (1999) 70 - - - - - Table 1: International financial markets Source: International financial markets in the UK (October 2000), British Invisibles 94 - The Journal of financial transformation
  3. 3. The London asset management market Ranking by institutional Total equity holdings Country ($bln) 1994 1999 UK as % of total n° of UK as % of total n° of City 1 London UK 2,461 UK as % of total UK as % of total 2 New York US 2,363 EU (15) assets EU (15) assets EU (15) funds EU (15) funds Total number Total number (Euro billion) (Euro billion) 3 Tokyo Japan 2,058 Total assets Total assets 4 Boston US 1,871 of funds of funds 5 San Fransisco US 726 6 Los Angeles US 569 7 Paris France 458 8 Philidelphia US 419 9 Zurich1 Switzerland 414 UK 91.81 1,559 8.35 14.17 253.93 1,780 8.17 8.16 10 Denver US 340 EU 1,100.00 11,000 3,109.61 21,823 11 Amsterdam Netherlands 327 12 Chicago US 316 Table 3: UK’s share of European mutual fund market 13 Frankfurt Germany 310 Source: FEFSI 14 Toronto Canada 289 15 Edingburgh/Glasgow UK 253 16 Houston US 242 observe that while the size of funds under management in 17 Hartford2 US 199 18 Milan Italy 196 Europe increased by 282% [from e1.1 trillion (approximately 19 Minneapolis US 186 US$1 trillion) to e3.1 trillion], the U.K. market only grew by 20 Geneva Switzerland 185 114% (from e92 billion to e254 billion.)3. As a result, the U.K.’s 1 includes Basel, Winterhur share of the European mutual fund market fell from 8.3% to 2 includes greater Connecticut 8.1%. The main growth countries have been France, Italy, and Table 2: Top international target cities 1999 Luxembourg. Source: British Invisibles In contrast to the mutual fund market, the UK’s share of the and institutional asset management industries, focusing pri- European institutional market has actually increased – from marily on how the latter market has developed during this 35% (US$1.9 trillion) in 1994 to 42% (US$4.9 trillion) in 1999. period. In section 3, we analyze how the major trends in the London, where 95% of the U.K.’s assets are domiciled, fueled asset management market will impact London and assess how this tremendous growth. well prepared London is to face future challenges. In the same section we make prescriptive recommendations about what In fact, in terms of assets under management, London grew by London should do to prosper in the future. 261% during this period, as compared to 215% for the whole of Europe. The five-year review We begin our analysis of London’s asset management market Having determined that the London and U.K. growth has come by segregating the institutional business from mutual funds. principally from the institutional market, we were interested in The objective of this exercise is to assess whether London’s identifying the origin of the majority of these funds. growing importance as an international center for asset man- agement has been due chiefly to the institutional market, as Foreign customers fuel growth many have suggested2. According to the British Invisibles, a significant portion of the growth in the U.K. institutional asset management market Table 3, which compares the total U.K. mutual fund market comes from managing assets on behalf of overseas clients. with the rest of Europe, shows that between 1994 and 1999, Based on these estimates, 22% of the £2.6 trillion (approxi- the proportion of funds managed out of the U.K. fell. We mately US$3.19 trillion) of assets managed in the U.K. in 2000 2 Since information about the mutual fund market in London is unavailable, we are 3 U.K. asset managers are frequently appointed to manage portfolios domiciled out- obliged to use U.K. figures for our analysis of the mutual fund market. side the United Kingdom. As a result, U.K. asset managers have benefited from the 95 growth in the European pension and investment fund industry. The relationship that the U.K. asset manager has with these portfolios is institutional, even though the funds may be distributed to the retail market in Europe.
  4. 4. The London asset management market The data provided in Table 5 illustrate that the influence of 1994 1999 overseas or foreign-owned asset management firms increased dramatically between 1994 and 1999. In 1994, over- management ($bln) management ($bln) management firms management firms Number of asset Number of asset seas funds (18%) and U.K. firms acquired by foreign institu- Assets under Assets under tions (6%) managed only 24% of funds. By 1999, this figure had approached 47%. The most significant factor in this growth was the acquisition of U.K. firms by overseas asset management companies, mainly U.S.-based. London 68 1,800 70 4,691 UK 70 1,881 74 4,921 * London-based firms were not the only targets of overseas Europe 250 5,441 250 11,731 firms. Some U.K. companies acquired U.K. firms. The six major London/Europe (%) 27.20 33 28.00 40 domestic acquisitions between 1994 and 1999 created com- UK/Europe (%) 28 34.57 29.6 41.95 * bined groups that control in excess of 14% of all assets under * Incl. Scotland management in London. Table 4: London’s share of the European asset management market Though the power of these U.K. giants increased dramatically, Source: Institutional Investor it is actually foreign-owned powerhouses that have grown most. In the next section we look at why this ‘foreign legion’ were managed on behalf of overseas institutional clients. has been so successful in London. We undertook a similar analysis focusing solely on the London Growth and performance market. We segregated our data based on the nationality of Before assessing individual performance, we had to determine the holding company, which is not necessarily the same as why foreign-owned firms, both divisions of overseas firms and where the funds originated. The companies we analyzed had acquired London-based asset management companies, more than US$1 billion under management and operated out increased their ownership of U.K. institutional assets. To do of London. Table 5 provides the results of our study of the this, we analyzed a database of the institutions that managed ownership structures of the major asset management firms. the top 40 performing funds in the S&P five-year London- 1994 1999 management ($bln) management ($bln) % of assets under % of assets under Number of firms Number of firms management management Asset under Asset under in London in London London AMs acquired by overseas firms 3 116.47 6 12 1 142.64 24 London AMs acquired by UK firms n/a n/a n/a 6 662.60 14 Overseas AMs operating in London 15 321.76 18 19 1,095.55 23 Table 5: Analysis of the London asset management market Source: Institutional Investor 96 - The Journal of financial transformation
  5. 5. The London asset management market based fund performance rankings. agers, who have accumulated a depth of expertise in the man- agement of global fixed income portfolios, U.S. houses have We chose to use the five-year mutual fund performance fig- typically taken a bottom-up approach to allocating assets ures for two reasons. First, because according to most scien- across these types of instruments. As a result, as the corpo- tific studies, investors select mutual funds based on their five- rate debt market grows in importance across Europe, so does 4 year performance [Carhart et al. (2000) , Carpenter and the demand for the specific expertise of U.S. institutions. Lynch (1999)5]. And second, because information about the performance of institutional funds, which are typically cus- The U.K. houses benefited greatly from their expertise in glob- tom-tailored, is not easily accessible. We believe that the per- al fixed investments for many years. The European govern- formance of an institution’s mutual fund manager is a good ment bond markets, where most of their attention was barometer of the quality of its asset managers. focused, were very large and fragmented. Two factors have changed this environment. The first has been the replacement Using the S&P five-year mutual fund performance rankings of national bond markets with the Euro. U.K. houses can no for the year 1999, we found that only 17 companies in our longer use their expertise in global fixed income markets to database were among the 40 best-performing funds in Lon- differentiate themselves from their foreign competitors. (This don. Of these, nine were foreign acquisitions, three were over- proposition is not only valid in the post-Euro period. It is also seas firms, three were domestic acquisitions, and two were valid in the convergence period that preceded the January U.K. companies. Since this data was compiled, Fleming, one of 1999 launch of the single currency.) The second factor is the only two U.K. funds in both our database and the top 40 list, reduction in government bond issues. Both European govern- has been acquired. Schroders remains the only London-based ments and the U.S. have reduced their issuance of sovereign fund to be in the top 40 list. In other words, as of 2000, 76% debt, either because of smaller government deficits or large of the best performing asset management firms in London surpluses6. were either foreign-owned or divisions of overseas firms. Today, fixed income houses are required to find returns else- No matter where the funds or the organizations that manage where. They have consequently flocked to the corporate debt them originate, the influx of so many foreign-owned firms has markets, including asset-backed and high-yield securities. enabled London to become the largest center for institutional Investing in these types of instruments, however, requires a equity holdings in the world. But can London take advantage completely different set of skills than those possessed by of its current world standing to widen the gap with its com- most of the U.K. houses. Institutions that invest in these types petitors? This question is addressed in the next section. of instruments need familiarity with credit risk, an attribute possessed by the U.S. institutions that have been investing in The performance of foreign firms in London the very large U.S. corporate7 and high-yield bond and asset- Despite the difficulties involved in determining, with any accu- backed securities markets for years. These institutions have racy, why foreign firms have performed so strongly in London, been able to use the expertise accumulated from many years some factors may provide explanations for their superior per- in the U.S. to create differentiation within the new European formance. The four most widely cited factors are: environment. The growing importance of credit The increasing number of specialist mandates Within the fixed income markets, familiarity with credit risk As plan sponsors become more proficient and demanding, has been cited as a key factor in differentiating U.S. houses they are beginning to recognize the benefits of using special- from their European counterparts. Unlike U.K. asset man- ist managers. These managers became popular in the U.S. 4 Carhart, M., J. Carpenter., A. Lynch., D. Musto., 2000, ‘Mutual Fund Survivorship,’ 6 According to the European Commission, Euro-zone governments have reduced Working Paper, University of Pennsylvania. their gross debt, as a proportion of GDP, from 74.7% in 1996 to 70.5% in 2000. 97 5 Carpenter, J.N. and A. W. Lynch, 1999, ‘Survivorship Bias and Attrition Effects in The share of the total debt domestic bond issuance by the Euro-zone governments Measures of Performance Persistence,’ Journal of Financial Economics, 54, pp. 337- fell from 57% in 1996 to 53% in 1999. 374. 7 As of the end of 1999, US$4551.5 billion of corporate bonds were outstanding in the U.S.
  6. 6. The London asset management market after ERISA (Employee Retirement Income Security Act) was trading decisions. They also include consistent and stringent passed in 1974 to protect pension funds from mismanage- performance monitoring and a transparent investment ment, and they have come a long way since the early days process. Many of these techniques are uncommon in Europe. when they focused on broad asset classes such as equities Market transparency has also promoted the growth of third- and bonds. Specialist managers provide investors with partic- party advisors, including specialized consultants and portfolio ular expertise in a given market or investment style. These monitoring agencies. This environment has promoted the days, they are specialists in growth, value, small-cap, mid-cap, growth of a cadre of specialized managers that are strongly large-cap styles, specific emerging markets, etc. differentiated from more general asset managers. According to figures released by UBS Phillips & Drew, more Safety in numbers than 41% of funds used specialist managers in 1999, as com- Another important factor that could explain the growing dom- pared to 27% in 1997. This figure rises to 70% for schemes inance of the U.K. market by foreign institutions is that they that have in excess of £1 billion (approximately US$1.5 billion). are typically much larger than their domestic counterparts. Even so, 78% of U.K. pension managers still allocate part of According to our analysis, the average size of assets managed their asset allocation to balanced funds. by U.S. firms in the U.K., including those domestic houses that were acquired, is US$160 billion, as compared to US$61 billion The growing demand for these specialist funds in the U.K. can for independent local institutions8. According to some be attributed to the lackluster performance of active balanced observers, the problems experienced by Baring Asset Man- funds in recent years. Specialist funds, though more expen- agement and Dunedin Fund Managers caused a large number sive, have had a very strong record in the U.K. in recent years of U.K. pension schemes to transfer their funds from some of and most managers believe that the U.K. market will become the smaller asset management firms to the much larger ones as keen on these instruments as the U.S. market is. The because they were perceived to be safer. The fact that the growth in these types of allocation styles is also believed to overseas institutions typically had many more assets under have contributed to the growing importance of the foreign management also worked to their advantage. legion in the U.K. The foreigners buy the best U.K. institutions Another reason behind the growth of the specialist market Many believe that the success of the foreign institutions in could be that the U.K. is substantially less concentrated than London is largely due to their ability to buy the best talent. In other major European countries. Because the manufacturing fact, they claim, these institutions come to London because and distribution of asset management services are predomi- they want to buy the kind of expertise that they can’t find at nantly segregated, U.K. institutions, unlike their European home. This argument is based on the notion that if the foreign counterparts, who operate within a universal-banking model, legion possessed better skills than those available in London, cannot rely on captive investors. Consequently, they have had then London would not continue to grow in importance with- to actively seek new business from external sources. in the global asset management market. This competitive environment has prompted several respons- Whatever the reason for the success of the foreign legion, es. One of the most important is transparency. Many portfolio London continues to remain the number one center for asset management tools and techniques that aid transparency are management globally. How can London maintain its current in common usage in the U.K. asset management market. world ranking? The next section will look into where the future These include performance attribution, benchmarking, and sources of growth lie and examine whether London is posi- the separation of strategic asset allocation decisions from tioned to take advantage of them. 8 Globally, U.S. institutions manage substantially larger portfolios of assets than 98 - The Journal of financial transformation their U.K, counterparts. However, for the purpose of this study, we have only accounted for those assets that are managed in the U.K.
  7. 7. The London asset management market Dominating the market of the future Securities lending/borrowing Portfolio management Cash management Margin/credit It is always harder to stay at the top than it is to get there. This Order F/X Execution is the historical dilemma that London faces today. What must management London do to maintain its leading position? Confirmation/affirmation & allocation We strongly believe that a major power shift is taking place in Settlement/clearance Candidate for the industry, facilitated largely by revolutionary technologies. & custody outsourcing The Internet has reduced barriers to entry, increased con- Investment/fund accounting sumer choice and made information more commoditized. Consequently, the buy-side community has become both Performance Financial management accounting more powerful and more comfortable with technology. Investors threaten to take their business elsewhere if they Figure 1: Functions that need to be supported for each portfolio model don’t get best-in-class service. They may even consider taking legal action against those failing to meet their needs. As a result, those asset managers that succeed in the long run will scalable and more efficient operations becomes more imper- be those that recognize the growing power of the buy-side ative. Over time, the costs incurred in keeping up with the lat- and take steps to better meet its needs. est technological advances, combined with the growing inter- nationalization of markets, will become too large for many To be the best in their class, asset managers must focus as asset managers to shoulder alone. Based on current industry much on how they manage their operations as they do on estimates, over 60% of the staff of an asset management firm their assets. We believe that the following recommendations, are involved within the back-office and systems departments. when implemented, will help London to continue as the We believe that the huge investments required to update and world’s leading center for asset management. manage back-office operations will force many asset manage- ment firms to consider outsourcing. Functions with the poten- Improving operations tial for outsourcing are highlighted in Figure 1. Operational efficiency is just as important to asset manage- ment firms as it is to the broker/dealer community. Members As the number of firms that outsource operations increases, of both types of organizations are working hard to prepare for organizations that provide these services will be able to ben- T+1 and ultimately STP (straight through processing). But efit from significant economies of scale. Over time, the costs members of the asset management community are lagging of outsourcing will diminish. While scientific data are not avail- behind their broker/dealer counterparts in implementing the able on the magnitude of cost savings from outsourcing, necessary changes. recent studies have found that outsourcing has saved compa- nies 26% in operational costs and 21% in headcount. According to a recent study of asset management companies, only 38% of U.K. managers, compared to 69% of U.S. man- The importance of a centralized institutional dealing desk agers, believed that their operations could cope with a move A key component of an asset management firm’s front-office to T+1. Furthermore, 40% of managers who do not currently operation is the centralized dealing desk, which most London outsource their operations expect to do so by 2004. based institutions already have. These institutional dealers receive orders from the portfolio managers and execute them STP is not the only reason why asset managers need to through the available channels, including brokers, market improve the efficiency of their operations. As the size and makers, and the many alternative-trading systems. variety of assets under management increase, the need for 99
  8. 8. The London asset management market There are a number of reasons why these dealing desks have which will flow untouched through the system to settlement been established. Clearly, it is necessary to have skilled pro- by the custodian. fessionals to carry out trading for the fund managers, espe- cially as the role of the broker diminishes and the market frag- The role of institutional dealers within their organizations is ments. The key function of the centralized dealers is to expected to grow in importance during the next few years. achieve ‘best execution’ on client trades, but they also have a Asset managers who demonstrated exceptional performance number of other responsibilities as part of their functions. during the last speculative bubble will find it hard to replicate Among them: those achievements. Combined with the growing intensity of competition within this environment, asset managers will be Compliance controls such as fair allocation and timely exe- forced to fight for each basis point of return in order to out- cution. perform their peers. One way in which they can do this is by Preventing dealing conflicts. reducing transaction costs, which include commissions and Controlling blocked stocks and closed periods. market impact. Institutional dealers have been trained to do Maintaining standard commission rates and charges. just that. Consequently, those institutional dealers who can Monitoring targets. read the market well and time their orders will find themselves Providing a continuous dealing service. in very high demand in the near future. Market intelligence for the portfolio managers. Responsibility for ‘soft commissions’. Back-office Back-office Back office Back-office Back-office The fund management firms carefully monitor the use of bro- BSP kers, who now generate huge commissions. Each manager will have an approved broker list comprising brokers that are con- European fixed Global fixed European Global Back office income income equities equities sidered reliable and give good service. Such issues as research/ideas, execution abilities, and settlement efficiency will be among several factors under consideration in making Shared institutional distribution arm up the list and setting commission targets. Figure 2: Separation of the asset management engine from institutional distribution The portfolio manager’s dealers will have the freedom to deal and back-office operations where ‘best execution’ can be achieved, though of course this will usually include a dialogue with the manager on how the order is to be handled. Limits, speed of execution, and pre- Improving distribution ferred brokers are among many factors likely to be discussed. Outsourcing does not have to be limited to the middle- or back-office of an asset management company. We believe that The institutional dealing desk is the start of the STP process and even the asset management process can be segregated from is an area where many mechanization efforts are now being the distribution arm (Figure 2). Although many mutual funds made. Direct links to markets, deal order management systems are sold through third-party distributors, especially in the U.S., for paperless trading, and FIX connections to brokers/market institutional asset managers tend to prefer their own internal makers are just a few of the initiatives currently underway. proprietary distribution channels. In fact, in the course of our research, we found just one example of an institutional asset The centralized dealing desk is a key element in the move to manager using a non-proprietary sales channel, although cer- the single entry of orders by the portfolio manager; orders tain sub-advisors do take advantage of these types of rela- 9 Fund managers often outsource the management of specific funds. They appoint change or reduce the number of sub-advisors to lower fees and pocket the differ- 100 ‘sub-advisors’ to effectively co-manage the mutual fund under their own umbrella. ence. Obviously, this technique is used in order to have specialist managers overseeing the portfolio in areas where they have greater knowledge. Apparently, this practice has grown in popularity since 1995, when multi-manager schemes became com- mon. In the U.S., there is a loophole where the SEC allows parent managers to
  9. 9. The London asset management market tionship9. BNP Paribas and Fischer Francis Trees & Watts During this innovation phase, new markets, investors, and (FFT&W) have established the only arrangement where the asset classes need to be considered. In the next section, we customer relationship management is separated from the will provide an overview of the factors that have fueled the asset management engine. BNP Paribas has agreed to out- unprecedented growth of the London asset management source the management of some of its fixed-income portfolios market and suggest where we see the greatest source of to FFT&W and in response, FFT&W has outsourced its CRM to future growth for the London market’s major players. BNP Paribas. New sources of funds We believe this is the best way forward for many institutional This section looks at where the growth in the asset manage- asset management firms. The costs of managing a group of ment has come from in recent years and at where we see the capable asset managers, combined with the operations and sources of funds coming from in the future. sales distribution that is needed to support these types of activities, can be crippling for many entrepreneurial asset Investment managers should start looking at client relation- managers. It is not surprising to discover that most capable ship management in a completely different way. The concept managers establish a mutual fund boutique because the cost of ‘build them and they will come’ no longer works within of running an institutional business is prohibitive10. today’s highly competitive environment. Consequently, asset managers must undertake the same type of market analysis By separating the asset management engine from the cus- that their manufacturing counterparts have been using for tomer services business, customers will have access to a bet- decades. As well as improving their client relationship man- ter selection of managers and expertise. As a result, they can agement, traditional asset managers also need to look at new get the kind of service they require from their asset managers sources of funding to fuel their future growth, at the same with the added flexibility of being able to choose the best time recognizing that each source has different needs. managers for different asset classes. This capability will become more valuable as the variety of investment vehicles Figure 3 illustrates the percentage changes in the contribu- increase over time. tions made by different sources of funds towards the growth of the U.K. asset management industry. It shows that the most In the same way, separating asset selection and allocation significant increase has come from U.K.-based private funds. processes from the asset management infrastructure, includ- ing the distribution arm and the management of the busi- % ness11, will be beneficial. It will free asset managers from issues 1 0.5 related to the management of the business and allow them to 0 UK focus on what they do best - manage assets. No longer inhib- -0.5 O/S Unit trusts Investment Insurance Pensions trusts ited by the need to make huge investments in operational infrastructures, many new aggressive managers will enter the market and help transform the industrial landscape. These new entrants will usher in the next phase of innovation within the asset management industry, preceded only by Figure 3: Contribution of UK and overseas funds towards the growth of the Markowitz’s portfolio optimization theorem. UK asset management industry (1994-1999) Source: British Invisibles 10 In order to achieve this objective, however, consultants, such as William Mercer and 11 We believe that even the role of the CIO (Chief Investment officer) and the CEO Watson Wyatt, need to become more comfortable with recommending the selection should be separated and that the latter should have business management, rather 101 of smaller asset managers by plan sponsors. than investment management, skills. In a large number of institutions at present, the two roles are either combined or the CEO was previously the CIO. The asset management industry needs to recognize that theirs is a business just like any other.
  10. 10. The London asset management market These assets have increased from £34 billion (approximately could be attributed to the U.S. pension market, global pension US$48 billion) in 1994 to £291 billion in 1999. Based on Gemi- assets would be close to US$38 trillion by 2010. If the U.K. con- ni estimates, the assets of the world private wealth industry tinues to grow its international pension business at the pres- could increase from US$25 trillion in 1999 to US$44.9 trillion ent rate, it could be managing 3% of global pension assets by by 200412, one-third of this total held offshore. At present Lon- 2010. This would require the U.K. to increase its share of glob- don has 15% of the offshore private wealth market, estimated al pension assets by 50% per year, however, and at present to be US$ 8 trillion, and is ranked second only to Switzerland, pension assets increase by only 25% per annum. with 33%. But not all pension assets are managed through institutional Other constituents that have experienced significant investment mandates. In fact, a large number of pension funds in the U.S. growth are overseas pensions and investment trusts, with the for- invest in institutional mutual funds. According to the latest mer representing over 8% of the total funds managed out of the figures released by the Securities Industry Association, U.S. U.K. in 1999. Furthermore, Figure 3 shows that both unit and pension assets that have been invested in mutual funds have investment trusts are losing their importance in the U.K. market. increased from US$207 billion to US$2426 billion and to 19% of all pension assets. If this trend continues, there would be These findings corroborate those presented in Section 2 above, more pension assets invested in mutual funds than through where we found that foreign institutions have increased their institutional mandates by 2010. share of the U.K. institutional pension markets. Ten years is a very short time in the pension management mar- The question that many London-based asset managers should ket so it is important for U.K. houses to respond to this trend. ask themselves, therefore, is whether their focus on the insti- tutional market makes sense from a long-term perspective. The argument against focusing too much on institutional mandates becomes substantially stronger when one consid- Estimates provided by Intersec suggest that U.K. institutions are actually reading the market well. In addition, Intersec 30 % of Total commitments believes global pension assets, excluding U.S., will continue to 25 grow at a very healthy rate13. In fact, if the same growth rate 20 15 % 14000 100.00 10 90.00 12000 5 80.00 10000 70.00 60.00 0 8000 Banks Corporate (non-pension) Public pension Family/individuals Endowment/foundation Intermediary Foreign/other NEC Private pension Insurance 50.00 6000 40.00 4000 30.00 20.00 2000 10.00 0 0.00 1995 2000 2005 2010 Defined contribution Defined benefit DC/total Buyouts & mezzanine DB/total Venture capital Figure 4: Growth of global pension assets (ex US) ($bln) Figure 5: Demand for U.S. private equity by investor type Source: Intersec Source: Venture Economics 12 This figure will need to be revised downwards in order to take account of the 14 For further information about personalized mutual funds please refer to Shojai, S., recent corrections in the world’s major stock market indices. and R. Preece, 2001, ‘The Future of the U.S. Asset Management Industry,’ 13 Similar to most European countries, emerging markets will be forced to privatize Journal of Financial Transformation, Vol. 1, pp. 77-84. their pension schemes. Improving national GDP’s within these emerging markets 15 Asset management firms will need to integrate their front- and back-offices in will increase demand for investments in pension schemes. As a result, demand for order to provide reliable real-time portfolio performance and attribution professional asset managers to manage these growing pension assets will also information to their institutional clients. increase in years to come.
  11. 11. The London asset management market ers the growing demand for online personalized mutual rather than the 300% growth that we experienced between 14 funds . Personalized funds give the investor a choice in decid- 1994 and 1999. Achieving superior returns from traditional ing both how to manage assets and who should manage them. asset classes has become much more difficult. As a result, These personalized funds allow individual investors to receive asset managers will need to look elsewhere for returns. the sort of personal treatment traditionally reserved for the large institution. Interestingly, they are also cheaper than Within the European context, the best alternatives seem to be even the more generic mutual funds. within the corporate bond market, an area in which the U.S. institutions have many years of expertise, and in alternative Over time, many of the large pension funds will question the investments. By incorporating these new asset classes within fees they have been paying institutional asset managers for their more traditional portfolios, asset managers will be able receiving the type of personalized treatment that is now avail- to improve returns and achieve greater levels of diversifica- able to every individual at a fraction of the cost. Asset man- tion. These new asset classes will allow portfolio managers to agement firms will have to reduce their prices and improve create optimal portfolios. their services if they hope to remain competitive with these new online personalized fund providers. Even though the benefits of these new asset classes are well documented, they remain underweight within the portfolios of Furthermore, as the financial services industry continues to most London-based asset managers. According to a recent integrate the Internet within its operations, there will be grow- study by the British Venture Capital Association, U.K. institu- ing demand on the part of large institutions to have real-time tions have allocated just 0.9% of their assets to alternative access to information about the portfolios that are managed investments, as compared to 7% in the U.S. Studies by Indo- on their behalf15. As a result, the cost of establishing the infra- cam /Watson Wyatt find, however, that U.K. pension funds structure required to meet this growing need will force more invest a greater proportion of their assets in alternative asset managers to consider outsourcing the management of investments. U.K. institutions were found to invest 2.62% of their back- and middle-offices. their assets in these types of vehicles, as compared to 2% for U.S. pension funds. Although it is difficult to determine the We therefore believe that for London to remain the dominant accuracy of this study, we have decided to use the findings of market for asset management, its major players should focus the Indocam/Watson Wyatt study for the purposes of compa- more on institutional mutual funds (a market currently under- rability. developed in the UK) providing real-time asset allocation and performance information to their clients. They should also It is clear that demand for alternative investments is increas- outsource non-strategic operations and concentrate on ing on both sides of the Atlantic and that if London wishes to attracting more funds from high net-worth individuals. maintain its leadership position, it needs to strengthen its services in these areas. New asset classes To attract and retain clients, successful asset managers need Corporate debt market/high-yield debt instruments to do more than just improve their client relationship man- For many years, the success of the sovereign bond markets had agement. They need to continue to perform better than their impeded the growth of the corporate bond markets in Europe. peers. The recent market downturns in the U.S. and Europe This trend ended with the arrival of the Euro and the fall in the have made that task significantly more difficult. By returning borrowing requirements of European governments. Institu- to their long-run equilibrium, the major stock markets are tions now find that they need to familiarize themselves with expected to experience real annual growth of around 1%-2%, the corporate debt markets, including asset-backed and high- 103
  12. 12. The London asset management market yield instruments, to generate the sort of returns they need to In order to prepare for the growing demand for these types of compete with equity fund managers. In response to this grow- investments, London-based asset managers have the usual ing demand, many new issues have entered the market. two options - build or buy. Many U.K. institutions have decided to build their own in-house venture arms, a rather surprising Between 1995 and 2000, total corporate bond issuance development since, despite growing demand, the price of increased from e298 billion (approximately US$268 billion) to most independent venture capital firms fails to reflect their e704.5 billion. Similarly, high-yield bond and asset backed future potential. It is surprising to us, for example, that Apax securities markets have also experienced growth in excess of Partners and 3i are still independent. 50% year-on-year during the past five years16. We anticipate that these markets are just beginning to gain momentum and Hedge funds that within the next three to five years they will begin to As with private equity markets, it is difficult to ascertain the approach levels that are more in line with those in the U.S17. size of pension fund interests in hedge funds. According to Indocam/Watson Wyatt, U.K. institutions have zero allocations London-based institutions are especially well placed for the to hedge funds, a fact which seems rather surprising and growth in both the high-yield and asset-backed markets, which potentially incorrect. Figures obtained from Hedge Fund is still very much in its infancy in Europe with only US$74.361 bil- Research, Inc. suggest that, assuming the size of the hedge lion in asset/mortgage-backed securities issued in 2000. As fund market is US$350 billion, U.S. institutions have invested observed above, a major reason for the success of the U.S. insti- close to US$30 billion, or 1% of their assets, in hedge funds. tutions in London has been their familiarity with credit. Exper- tise in this field has now permeated most of the major institu- Assuming that the U.K. figures are even half those of the U.S., tions in London, and we believe that over time they will be able we find that the exposure of the major institutions within to leverage that expertise to place themselves in an advanta- these two markets is still extremely small relative to hedge geous position vis-à-vis their European counterparts. funds. We believe that this figure will grow dramatically with- in the next three to five years. Private equity/venture capital Lack of consistency in the descriptions used for private equi- London-based institutions can prepare for this growth either ty and venture capital makes it difficult to ascertain exactly by creating their own divisions or by acquiring many smaller what proportion of funds is invested in each. Consequently, we funds. Both moves will cause significant problems. The main have provided figures for the two combined. problem with incorporating a hedge fund within a traditional asset management operation is the huge difference in com- Based on the Indocam /Watson Wyatt study, U.K. institutions pensation structures. Hedge funds have much more attractive have invested close to US$4 billion in alternative investments, packages. Some of the large institutions that have established equal to 2.62% of their funds. U.K. institutions distributed an in-house hedge fund, including Alliance Capital, Merrill their holdings across private equity funds in the following Lynch Mercury, Gartmore, Deutsche, and HSBC, have found manner: e374 million in European and e1,850 million in Euro- the compensation issue to be the most challenging aspect. It pean and international buyout/mezzanine funds; e1,505 mil- is very difficult to justify two different compensation packages lion in European and e610 million in European and Interna- for people performing essentially the same tasks. London- tional venture capital funds. This figure is dwarfed by figures based institutions nevertheless need to have these services in released in the U.S. by Venture Economics, which show that place, ready for when demand picks up. total U.S. investments in venture capital and buyouts/mezza- nine funds approach US$38 billion. 16 As of December 2000, US$28 billion of high-yield bonds and US$74 billion of 104 - The Journal of financial transformation asset/mortgage-backed securities had been issued in Europe. 17 As of December 1999, over US$4 trillion of asset/mortgage-backed securities, US$4.5 trillion of corporate bonds, and US$500 billion of high-yield bonds were outstanding in the U.S.
  13. 13. The London asset management market Overall, London-based asset managers should prepare for the tive asset classes. These could range from the skills necessary anticipated increase in demand for alternative investments, to invest directly within these new asset classes to investment both from the U.K. and from abroad. According to Goldman in those professionals who are best able to manage them. Tra- Sachs and Frank Russell, U.S. pension funds expect to increase ditional asset management skills will no longer be able to gen- their exposure to alternative investments by 8% of total erate the type of returns demanded by today’s investors. The assets in 2003, a very dramatic increase. The findings from near future belongs to the credit markets and alternative the U.K. are not very different, with some institutions expect- investments. London is well-positioned for this paradigm shift ing to increase their allocation to 15%. and should use its current position to widen the gap with its nearest competitors, - New York and Boston in the U.S. and Conclusion Frankfurt in Europe. London has been and remains one of the most, if not the most, important global centers for asset management. There Thanks to the arrival of the foreign legion, London has gained is no doubt that the industrial landscape is undergoing the kinds of skills necessary to succeed in tomorrow’s envi- tremendous change and that London needs to prepare for ronment. If it hopes to remain the most important financial and adapt to this change. A major shift in power has taken center in the world for the next century, London should make place and the providers of asset management services must sure that its doors remain open to these interlopers. recognize it. They should be aware that in future they need to build services around customer needs at fees that are much lower than those they are accustomed to. Falling fees and the ever-increasing level of competition will mean that the suc- cessful organizations of tomorrow will be those flexible enough to meet client needs and yet efficient enough to pro- vide that service at a fraction of the cost they charge today. In order to be flexible, tomorrow’s institutions will need to sep- arate the asset management engine from all that surrounds it, the back-office/technological infrastructure and the distribu- tion arms. Asset managers must be free from all of these dis- tractions to focus on what they do best — manage assets. This flexibility is especially important within an environment in which asset managers must be able to provide different service levels for their three main client bases - retail, institu- tional, and high net-worth. Asset managers should recognize that each group has different needs and expectations, and that the current generic model is no longer adequate to meet the needs of proficient and demanding customers. The landscape has not only changed because of the power shift from the sell-side to the buy-side. Success in tomorrow’s environment also requires skills to manage new and alterna- 105