For the past four years, and usually around this time of year, funds managers and other professional forecasters have been warning Australian super funds to prepare for single-digit returns. One year, quite possibly this one, they will be right.
The performance of the Australian share market is still the singlemost- important influence on total fund returns notwithstanding a general dip in allocations as super funds adopt a greater diversity of lowly correlated investments. And this is also notwithstanding some years, such as last year, when the biggest decision investment committees had to make was whether or not to hedge their US dollar exposures.
Inevitably total fund returns will come back much closer to their strategic targets of 4-5 per cent above inflation, whether it’s this year or next. In such an environment, it has also been predicted for several years, super funds will be more keen to eke out smallish cost savings or added value across their portfolios. In this regard, at least, the forecasters have been proved correct. Big funds are putting more emphasis on the overall efficiency of their investments. They have reduced the cost of beta dramatically, they have improved the management of their cashflows and foreign exchange, they have looked at ways to minimise tax and now they are looking at combining portfolios to further reduce transaction costs such as brokerage and market impact.
In all these endeavours, custodians have a crucial role to play. However, they do not have the market to themselves. Investment banks, in particular, are encroaching on the investor services companies’ turf through the expansion of securities lending and transition management services. Some investment banks are offering ‘free’ custody of equities for long/short managers in return for prime brokerage. Similarly, some managers and multi-managers are offering emulation and master manager services. The lines between service providers are becoming blurred.
The most significant development in the marketplace concerns the potentially dramatic reduction in the cost of implementing a fund’s investment strategy through the combination of its discretely managed portfolios. First tested in Australia from 2003 by Russell Investment Group for its locally domiciled international shares fund, the full service is generally referred to as ‘master manager’. Russell simply replicated the buy/sell decisions of the managers for this fund but implemented those decisions more efficiently. In the two-year test period, cost savings averaged 28bps.
MLC was the first to market an emulation fund, in 2005, in a venture with Vanguard Investments. Vanguard last year introduced its own master manager service, called centralised portfolio management (CPM), with Victorian Funds Management Corporation as a key client.
As Russell said when revealing the test results for the emulation service, a master manager service can be provided by different types of institutions, not just a multi-manager like itself, including investment banks, index managers and custodians.
So far, NAB Custodian Services has been making the running following a client roadshow last October. NAB is offering three services: emulation, master manager and ‘propagation’, with most savings accruing from a combination of master manager and propagation.
Propagation is a term used by systems provider DST International for a module in its HiPortfolio funds management system. The module allows trades in one portfolio to be automatically put into other portfolios. This has a variety of uses, one of which is to minimise capital gains tax (CGT).
Traditionally, CGT has been calculated at the portfolio level, even though the tax is applicable at the fund level as the legal entity which owns the shares. If the custodian ‘propagates’ all the portfolios, it significantly widens the choice of tax parcels or lots to be matched for greatest tax efficiency.
Propagation of portfolios has been available through Hi-Portfolio for about 14 years, originally developed for Perpetual Trustees for more efficient management of multiple funds across different asset classes. It has also been used by insurance companies whose funds are subject to different regulatory requirements.
NAB quotes figures from specialist agency broker and trading technology firm Investment Technology Group (ITG) for the cost savings from the master manager service (see separate report), based on trading data from 47 funds managers. Trading cost savings, including market impact, were estimated by ITG at 66bps. With tax savings and the re-investment of the freed-up cash, total savings can be more than 100bps, according to Patrick Liddy, director of marketing and strategy for NAB Custody.
NAB has been talking to a range of funds managers, on behalf of its client super funds, and is hopeful of trialling its first full master manager service for either one or two big funds from this quarter.
While it is difficult to point to any theoretical flaws in the argument for using a master manager, the most commonly asked question is whether disclocating the relationship between manager and broker will adversely impact performance longer term. NAB’s Liddy says that of the managers he has spoken to so far, 90 per cent said they would participate in a master manager program if the clients so directed.
Liddy raises the interesting suggestion that if the master manager concept takes hold, then the ASX may no longer represent the major source of liquidity. “If there are a lot of new dark pools of off-market liquidity, then maybe the ASX will no longer be the prime determinant of price,” he says. “There are a lot of vested interests involved in this trend. Our role is to do the most cost-efficient job for the client, which is, ultimately, super fund members.”
Interestingly, before re-joining NAB in 2006, Liddy headed up marketing for transition management and some other services at UBS investment bank in Sydney for about two years. In this capacity he proposed that UBS move into the master manager arena but the proposal was rejected.
Across at JPMorgan, David Braga, head of product for the securities services division, says that there is a great deal of interest from both super funds and managers in improving the after-tax reporting and efficiency of their portfolios. “We’re finding that people are getting much more active with respect to tax. There are a lot of developments there. Products like propagation are helping to make sure that tax is being managed right across the fund.”
He says that JP Morgan, which also uses HiPortfolio, has a similar concept to the master manager service which it is discussing with one of its larger clients. “We think there are potential benefits there, but perhaps these have been overstated,” he says. “If the main goal is best execution, you can already go to one of the existing off-market facilitators.” Braga points out that tax reporting is also important in helping clients to manage funds on an appropriate tax basis. “You have to make sure that it comes through in all the other services, such as unit pricing. It’s clear the market is moving to be more active in the management of tax.”
He believes that the initiative by multi-manager Warakirri Asset Management, which introduced after-tax benchmarks for its funds last year – and also worked with ITG – will become more prevalent. However, there is as yet no standard for after-tax performance reporting. Scott MacDonald, managing director of RBC Dexia Investor Services in Australia, says that each custodian has clients who want the reporting a different way. “There’s no one model yet. But it’s early days. There will have to be a standard at some stage,” he says.
RBC Dexia, which specialises in funds management outsourcing rather than servicing super funds, has had as its number one priority over the past year or so the bedding down of its new retail unit registry operation, which the firm sees as a big differentiator from other administrators.
RBC Dexia introduced its global registry platform, Shareholder Accounting & Registration Platform (SARA), as part of the take-out of the Goldman Sachs JB Were (GSJBW) backoffice from late 2006. The Dexia-built system was acquired through the formation of the global joint venture between RBC and Dexia a year earlier. Aberdeen Asset Management has subsequently been added to this and MacDonald says that deals are in train for more managers to come on line soon. “It’s been successfully implemented and now the only issue for us is managing the growth,” he says. “It’s a question of how many we can transition, which is a nice problem to have.”
The RBC Dexia registry centre, in Melbourne, is the first in Australia to adopt the new SWIFTnet system, which provides for greater straight through processing opportunities. MacDonald says the Australianisation of the SARA system is a good example of the benefits of the global joint venture for clients and also a good way of demonstrating the companies’ commitment to investor services in general and Australia in particular. “The joint venture was not about randomly increasing scale. It was about adding a greater footprint, new capabilities and new technologies,” he says.
Because they are generally part of large banks, custodians in Australia as elsewhere have for years been plagued by M&A activity. Only last year, Bank of New York merged with Mellon to create the world’s largest custodian. Two of the four domestic banks, Commonwealth and Westpac, have exited the field altogether. Often times, the M&A activity has been about divestment of non-core businesses on the one hand or greater scale allowing for cost reductions on the other.
State Street, which launched its Australian office in 1986 and, with it, master custody for this region, has caused its share of M&A activity over the years. As the largest client of Westpac it encouraged that bank to close its competing master custody business in the 1990s and then exited master custody for super funds itself, for a period, in a deal with Commonwealth several years later. State Street re-entered master custody for super funds last year. Westpac, meanwhile, finally exited domestic custody too, selling its book to HSBC in 2006.
Someone who watches the big global moves more closely than most is Jacques-Philippe Marson, the president and chief executive of BNP Securities Services in Paris. He wrote a paper entitled ‘Vision 2036’ in which he imagines a situation with only three major global custodians left 30 years from now. He also considers that such a scenario could even result in BNP Paribas having its head office in Shanghai.
Marson asserted during a visit to Sydney in December that the wealth of nations in the future would come from natural resources and manpower, so India, China and potentially Brazil would be increasingly important. However he said that no-one could ignore Australia, not because of its natural resources, but because of the size of its savings market.
Australia and New Zealand represent the fourth-largest of the 30 BNP Paribas Securities Services locations around the world, with Sydney used as a regional headquarters. “We’re expanding in Asia,” Marson said. “We’re considering Hong Kong, Korea, India and China. We have a ‘client window’ in Singapore. We believe that the closer you are (to clients) the better. We have a decentralised model.” He suggested that Australia needed to create a new regulatory and tax environment to make it easier to do business in a global world.
As an aside, Marson made a personal prediction that the Dow Jones index (currently about 12,800) would go to 20,000 by 2015 because “the whole world is saving”. David Travers, managing director of investor services at State Street Australia, says his firm’s services have evolved with the needs of the market. Large super funds today have requirements which are often just as sophisticated and demanding as those of its funds manager clients, he says.
Having last year transitioned the super fund Non-Government Schools Super, and insurance fund NSW Workcover, alongside manager Credit Suisse Asset Management (CSAM), State Street is currently emphasising middle-office outsourcing as the next wave for managers. “We’re rolling out our middleoffice functionality,” Travers says. “With CSAM as a new client we have a timetable and we plan to expand the global functionality of our services in the region.”
While the lines between back, middle and front office services are blurry, they can be broadly divided into: asset servicing (back), asset gathering (middle) and asset managing (front), with pre-trade activity in the front and post-trade in the back. Pure backoffice activities include trustee services, safekeeping and settlement, corporate actions and proxy voting. Moving towards the middle are: transfer agency, fund accounting and portfolio reporting. In the middle are: performance measurement, compliance, currency flow analysis, risk management and online reporting. Moving towards the front are: securities lending, foreign exchange, cash management and transition management. In the front office are various fund distribution and platform interface services.
Chris Field, head of sales and marketing for State Street, says there is definitely a trend for clients to ask for more services “up the food chain” in support of the front office of managers. The growth of hedge funds and increasing use of hedge fund-like strategies by traditional managers are placing further demands on investor services companies. Field says: “Hedge funds are definitely more complex as clients. Their performance reporting, for instance, usually involves performance fees with high water marks and so on. The trick is to automate the processes as much as possible. “We’re the largest hedge fund administrator globally and it’s a priority for us to look to see how we can service all aspects of that market sector. It’s a global initiative for State Street.”
The big super funds are not only watching developments in the master manager space, they are also working hard on improving the efficiency, which usually means reducing costs, of other aspects of their management of members’ money.
Foreign exchange and cash management have traditionally been services provided by custodians which have not drawn much client scrutiny. Increasingly, though, super funds are looking to have panels rather than single providers of foreign exchange services and to look for better ways to handle their cashflows.
JP Morgan’s David Braga says: “We’re looking at all the ways whereby super funds can get the maximum benefit from their scale. We’re looking at trading patterns, tax, crossing, lending for long/short portfolios… We’re finding ways to ring fence the benefits.” Ian Martin, the head of State Street’s Global Markets division for Australia, which runs the firm’s standalone foreign exchange operations (as distinct from State Street Global Advisors’ funds management activities or the investor services business), admits that for the company as a whole, currency, cash management and securities lending activities have tended to be a higher margin business than traditional custody.
He says, with currency, that clients can always manage the transactions themselves by directing them through third-party banks. If they choose to direct currency execution via their custodian they may have slightly higher spreads but will need less infrastructure. “With the introduction of transaction cost analysis in the 1990s, there’s a much higher level of transparency now. And various systematic approaches, such as benchmarking, have added to the transparency.”
More than 90 per cent of State Street Global Markets’ foreign exchange business is not directed through the firm’s custody clients. Global Markets is the arm which also provides transition management services, acting as an agent only, as the consultants such as Mercer Sentinel do. The investment banks which also offer transition management act as principals. “Neither approach has really taken over in a definitive way,” Martin says. NAB Custody introduced a foreign exchange panel in 2000, where five or six banks are asked to provide competitive bids on each transaction.
Vicki Martyn, NAB Custody’s head of product development, says that NAB, which is on the panel, only gets the business if its pricing is as good or better than the others. She says that the firm is currently developing a passive currency overlay service. The growth of private equity has presented administration challenges for both funds and their custodians. Some custodians, such as State Street, JP Morgan and BNP Paribas have brought – or are bringing – their offshore specialist systems to Australia. Others have been looking at local thirdparty specialist systems or have adapted existing systems.
Jean-Marc Pasquet, BNP Paribas Securities Services managing director and head of Asia Pacific, says there is no one solution for all the different types of alternatives. “We have an existing product for hedge funds,” he says. “But to automate the process is very difficult.” In private equity, BNP Paribas has developed a system in conjunction with its funds management sister company, which will be made available in Australia.
This collaborative effort, with an “internal” client, worked well for BNP with its performance measurement tool, which the company believes is the best of its type in the world. “It’s top of the list because it was developed from a client’s perspective,” Pasquet says. “That’s what we’re also doing in private equity.”
RBC Dexia’s Scott MacDonald, however, points out that close links with a funds management company may not always be in the best interests of other – external – clients. “Many fund management clients aren’t comfortable with the idea that an asset manager, who might be a competitor, has input into the pricing of their securities,” he says. MacDonald agrees that alternatives will always be difficult and that the best way to succeed in providing good administration services is for the custodian to have an intimate knowledge of the client. “Hopefully, we get brought into the loop well before they launch a product,” he says. “It’s a challenge for the whole industry.”
Hedge fund and private equity managers present another challenge because not only are they complex, particularly with regard to valuations and fees, but also they tend to be small firms. Pasquet says there is a minimum investment required by the custodian for each client partly because of the regulatory environment but also because each one requires some degree of customisation and a minimum of service. “The plain vanilla service has come down in price because of automation,” he says. “If we were in a motionless market, with no new products or regulations, the industry would be fantastically efficient, but it is our vocation to permanently deal with changes.”
Angelo Calvitto, head of sales and account management at ANZ Custodian Services, says that ANZ has spent a good part of the last 12 months looking to remove the last vestiges of fax-based instructions from clients. Typically the small-tomedium- sized managers are culprits without fully automated instructions. “We had a look at the risks of dealing with a piece of paper and how to remove that risk. It’s going back to the core of our business and inevitably leads to a discussion of price versus risk,” he says.
ANZ is rolling out the SSCNet system, which picks up files from clients or manager trading systems or middle office systems and sends through encrypted information over the SWIFT network.
ANZ last year notified some of the small custody clients that they needed to make other arrangements, reigniting the long-standing argument about whether custodians as a group are servicing boutiques or small super funds as well as they could. “[Service providers] have not focused on small managers. We feel we have supported small managers but there is a challenge with pricing,” Calvitto says. “They sometimes have a higher touch rate.”
He says the biggest challenge for custodians is to keep pace with technology, because of increasing numbers of new products and service requirements. “The market continues to be very competitive. Australia is of interest to all the global players,” he says. ANZ’s long-standing global custody partner, Northern Trust, last year won the large and prestigious Future Fund account, for which ANZ is providing domestic custody.