| Convergence gathers momentum |
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| The development of the credit crisis and the creation of hubs by administrators would see capabilities which require client proximity or which represent value-added services remain in Ireland, says Brian Clavin, co-author of the report Convergence and Divergence: new forces shaping the investment universe. |
The latest research report produced by KPMG International and the independent think-tank CREATE, Convergence and divergence: new forces shaping the investment universe, highlights a new wave of convergence and divergence within the investment management world.
Looking at nature, scope, scale and impacts of convergence between investment strategies as clients switched from relative returns to absolute returns in the aftermath of the 2000-3 bear market, the report notes that worldwide, 40 per cent of fund managers have diversified into long-only funds and 30 per cent into alternatives in the last three years.
The study has relied on information from three global surveys, covering fund managers, pension funds and independent administrators in 28 national jurisdictions. The surveys were followed-up by structured interviews with senior executives in over 100 organisations from the three groups of survey participants, making this one of the most broadly based research studies on the subject of convergence in global fund management. | | Brian Clavin |
The alternative investment industry has witnessed explosive growth in the last number of years; growth which is highlighted by recent figures issued by the Irish Funds Industry Association (IFIA) which estimate current alternative investment fund assets serviced out of Ireland at $700 billion, representing a 250 per cent increase since March 2003. Such growth has sparked transformational shifts in the investment universe. Skill is now everything with market-driven returns becoming a commodity.
As a result, active long-only managers are getting closer to the alternatives sector, which is itself witnessing the convergence of hedge funds, private equity, real estate, infrastructure and structured products. This convergence has lead to the emergence of a whole new class of products which sit somewhere between hedge funds and active long-only, a process which has itself been encouraged by regulatory changes such as the UCITS III regime. This has lead some in the industry to speculate that ‘sophistication’ is about to go mass-market, particularly in light of the Financial Regulator’s approval for Irish domiciled UCITS III funds to short stocks outright, rather than having to use derivatives to express negative positions.
The report shows that as hedge fund managers and private equity firms have fuelled competition by promising absolute returns that are not correlated to conditions in the financial markets, long only managers have responded by offering products that mimic the returns offered by their new competitors.
As a result, their respective returns are converging, as are their back office infrastructures. The ensuing competition is driving out mediocrity, squeezing the margins and institutionalising the alternatives.
However, such convergence is far from uniform, according to two groups who participated in the study’s three global surveys: 310 fund managers, pension funds with $28 trillion of funds under management; and 48 administrators with $38 trillion of funds under administration.
Within each sector, managers have fallen into one of three groups which can be characterised as: purists, who have stuck to their core capability; pragmatists, who have diversified; and procrastinators, who have considered change without actions.
While pragmatists are doing new things by changing the boundaries of their sector, the purists appear to be doing old things better. Thus, convergence and divergence are reshaping today’s investment universe, helping to generate all-round benefits.
For investors, this process has delivered better returns and access to all-weather portfolios. For fund managers, it has delivered improved profitability and enhanced ability to attract, retain and deploy top talent.
However, the report argues that the pace of convergence will slow down, especially in the long only sector, as the current credit crunch creates a flight to quality and simplicity. For alternatives to retain their dizzy growth of the recent past, they will have to do two things: deliver absolute uncorrelated returns and deliver a new generation of customised structured finance products with capital protection and full transparency.
Such investors want to see a good housekeeping seal of approval via more standardised products, more stress testing, more transparent pricing of illiquid assets, more independent audits and more independent administration.
But what does this all mean from an Irish perspective?
Although there are some very successful investment fund managers in Ireland, fund administration, particularly in the alternative investment space, represents the country’s real claim to fame.
As interest in absolute returns has grown, so too has demand for administration of alternatives by an independent third party, surpassing the long-only funds when it comes to growth in total assets under external administration. This represents a real opportunity for Ireland over other long-only focused jurisdictions, as well as significant structural challenges.
Diversification by long-only managers means that administration is no longer a commoditised business. As a centre of choice for the administration of many offshore funds, the skill sets and know-how could be said to already exist to a certain extent within the Irish fund administration industry to take advantage of this convergence between long-only and alternative investments. Additionally the report predicts the role of third party administrators to grow in middle office activities like asset valuation, performance attribution, performance monitoring, risk and compliance. The underlying assumption is that the recent sub prime crisis will make end-investors ever more concerned about the basics of their investments: operational risks will be just as important as investment risks.
Recent consolidation within the administration sector locally is predicted to continue in order to accommodate large scale investment in upgrading the old infrastructure of systems and skills alike. With the boundaries between asset classes becoming increasingly blurred, managers will seek a single platform which can support long-only and each variation of alternative investment products. With such a huge technology spend being required, further institutionalisation of alternatives is likely to enhance the role of large multi-service administrators, leaving the niche players to serve the start-ups and independent boutiques.
Similarly, the creation of hubs by administrators outside of Dublin and indeed Ireland would be expected to increase and develop further, tapping into pools of labour and underpinning a ‘horses for courses’ approach whereby capabilities which require client proximity or which represent value-added services remain at the centre and low level, commoditised services outsourced to locations such as India and the Far East.
The study concludes that the combination of convergence and the prospect of a bear market will help to accelerate the pace of industry-wide M&As in pursuit of talent and market position. Within the investment management sphere, the pace will be set by large players among long-only managers, investment banks, hedge fund managers and private equity firms, seeking to strengthen their positions inside and outside their core areas of expertise.
This consolidation will be mirrored within the administration space with investment banks continuing to venture into this field, such as the recent acquisition of the BISYS Group Inc by Citi, leading to the emergence of all-service power houses with global reach. Whilst this expected consolidation will reduce the number of administrators, there is likely to be a clear bifurcation between these all-service behemoths and smaller specialists.
With so many new forces coming into play, the remarks of one participant in the study are particularly apt for all the players in the investment fund universe. It is one thing talking about a new model for a new age. Quite another delivering it. |
Brian Clavin is an audit partner at KPMG’s Financial Services Group. To view the full report, Convergence and divergence: new forces shaping the investment universe, visit www.kpmg.ie.
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