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Down and Outsourcing

Asset managers turn to third-party vendors to help cut costs and manage risk.

Asset management firms exist, among other reasons, to watch over other people’s money. But these days they increasingly have reason to watch their own. Redemptions, withdrawals and market depreciation have caused a sharp drop in assets under management — and profits from fees based on those assets.

"Expenses are at 2008 levels, but revenues are more like 2001 to 2003," the last great bear market, observes Chandresh Iyer, New York–based head of global custody and investment administration services at Citigroup.

Confronted with tighter margins and looking for ways to cut costs, an increasing number of money management firms are outsourcing such back- and middle-office operations as investment accounting, performance measurement, reconciliation, compliance reporting — all the daily tasks apart from making investment decisions and executing trades. Custodian banks and other vendors can provide these services less expensively because their technology, infrastructure and personnel costs are divided among multiple clients.

Demand for outsourcing services is surging, notes Lawrence Scott, president of the global industries unit of Ness Technologies, a Hackensack, New Jersey–based provider of information technology and investment management services. Ness provides services to firms managing a total of $500 billion in outsourced assets, a 20 percent increase from one year ago.

Citi’s Iyer estimates that the amount of assets for which third-party vendors will provide back- and middle-office services will increase by $1 trillion in 2008, compared with $500 billion in 2007. That’s welcome news for custodian banks, which also have seen their profits squeezed by declining assets and stand to offset some of those losses with increased revenue from fees for clearing and settling trades and other outsourcing functions, and interest collected on cash balances.

Year-to-date through November 30, Bank of New York Mellon Corp. picked up ten more clients, with a total of $77.4 billion in assets, for whom it will provide back- and middle-office services, according to John Savage, the firm’s Chicago-based national sales manager of financial institutions and tax-exempt sales. BNY Mellon now provides outsourcing services to 51 clients, with $1.8 trillion in assets.

One of the new clients is O’Shaughnessy Asset Management, with $7 billion. The Stamford, Connecticut–based firm broke away from Bear, Stearns & Co. last spring, shortly before the government-backed takeover of Bear Stearns Cos. by JPMorgan Chase & Co., and opted to outsource its back-office operations so that it could take advantage of the expertise that custodians offer. "We knew just enough to be dangerous," says Christopher Loveless, president and COO. He adds that by saving money through outsourcing, his firm avoided laying off staff members as the economy deteriorated.

The need for cost-cutting and the possibility of layoffs represent a dramatic change in an industry that came of age in the 1980s and enjoyed astounding growth for years. Money managers’ revenues — and profits — took off as baby boomers poured money into defined contribution plans and individual retirement accounts and U.S. stocks rode a historic two-decade bull market.

Then, in 2007, the collapse of the U.S. subprime mortgage market triggered a credit crisis and global recession, leading jittery investors to pull billions of dollars out of mutual funds and pour the money into low-fee money market funds or even federally insured bank savings accounts.

In addition to lower costs, third-party vendors offer other advantages. "With the market dislocation the investment management industry is being reshaped," Citi’s Iyer says. "Now firms are looking at outsourcing as a way to manage risk." For example, a custodian can provide risk analytics and other data analysis to help assess counterparty risk, he notes.

Outsourcing also provides asset management firms with a partner so they can enter new markets quickly or launch products more cost effectively, says Jeffrey Conway, head of investment operations outsourcing at Boston’s State Street Corp., which oversees $6 trillion in outsourced assets.

"Managers want an operational partner to help them go global or share expertise on what is working in the market and how to do it," Conway explains.