SEI’s Holly Miller (pictured) and Ross Ellis explain the core tenets of establishing a successful middle office…
A survey published by Deutsche Bank in September 2014, entitled From Alternatives to Mainstream Part Two, found that the US alternative mutual fund industry has experienced 38 per cent annualized growth since 2008. The survey predicts that it has the potential to become 6 per cent of the USD15tn US mutual fund industry by 2019; total assets exceeded USD300bn in May 2014.
There are many factors driving convergence between traditional and alternative fund managers; key among them is investor demand for regulated, transparent products that can generate uncorrelated returns to the rest of their portfolios. What this means is that all asset managers need to have robust systems in place to handle the myriad complexities of different liquidity profiles, different reports and levels of transparency and so on to meet investor and regulatory expectations.
Therefore, having an institutional-quality middle office that is both flexible and future-proof is becoming a ‘must have’. According to Holly Miller, Managing Director of Middle Office Services at SEI’s Investment Manager Services division, there are four elements to establishing a successful middle office:
- Experienced expert people
- Best-of-breed technology/systems (including upgrades, new requirements)
- Well-designed system integration and data movement
- Workflow around the systems, including governance
Because of the convergence effect, the trade settlement and reconciliation environment has become a lot more homogenous than it was twenty years when traditional and alternative asset managers were distinctly different beasts.
“Now you’ve got alternative managers launching ’40 Act or UCITS alternative mutual funds. There’s a blending of activity taking place. We see managers now who are straddling both side of the meridian: part of their business is in the western hemisphere (i.e. traditional funds) and part of it is in the eastern hemisphere (i.e. alternative funds),” says Miller.
With so much data to handle, getting the right machinery in place, the right moving parts as it were, is fundamental and in short, no easy exercise.
At the heart of this issue is how to get the system infrastructure set up in such a way that the appropriate data reaches the right people to perform the relevant front-, middle- or back office functions for the strategy/vehicle in question in the most optimal and timely manner possible. “The job of the middle office is to provide information to support investment decision-making,” says Miller, “so it needs to be fast, auditable and accurate.”
For many managers, given the cost pressure they are under, attempting to create or revamp everything internally is not necessarily the best, or even a viable, option.
“Whether they are setting up for the first time or they are coming from the traditional side where they’ve always had a middle office, the bottom line is all these managers are searching for a way to become leaner and meaner,” says Miller, who points out that regulation is now playing a key role in how managers view their business operations.
“Now they have to think about things like: Am I keeping a copy of my trade confirmation? They never before had the sort of regulatory books and records obligation that they have today. Managers have also started to take on more separate account mandates which require side-by-side trading policies, and that is driving up operational costs. A single SMA running alongside the flagship strategy fundamentally causes a manager’s operational costs to increase, even double. You’re doing twice as much work: two trades to settle, two portfolios to reconcile, two portfolios on which you need to do reporting and accounting. These functions cannot be pooled.”
Managers need to transform and be fleet of foot to shift with changing market and investor demands. They cannot do so if their systems are not properly aligned to support future expansion or industry evolution.
Which is why outsourcing the middle office functionality is becoming so appealing. Why would managers distract themselves with the ongoing costs of running multiple best-of-breed systems and employing additional staff? Not to mention aligning themselves to a set of systems and expert staff that may or may not be best-of-breed down the road. It’s just not logical to all but the very largest managers to take this course of action. Ross Ellis, Vice President and Managing Director of the Knowledge Partnership in the Investment Manager Services division at SEI, uses Zipcar by way of analogy:
“If I live in the city I don’t need a car every day. But maybe one day I have to go to a wedding in the country and I want to drive a convertible sports car to take advantage of the weather and show off to my friends. I will hire it for the weekend and then I return it. Likewise if I want to go to special ceremonial function for my parents – in that case maybe I don’t want something so flashy but rather something more conservative that doesn’t steal the attention. In many ways the same holds true for operations.
“An investment manager doesn’t need a Global Investment Performance Standards (GIPS®) expert 24/7, nor a bank debt person or a performance analytics person 24/7. Rather, by outsourcing, the manager can effectively use a percentage of the person we have on staff year-round who is the GIPS expert, the bank debt expert and so on. It’s a better use of a manager’s resources.”
#1 – Experienced people and pooled expertise
Logically, following on from the Zipcar analogy, one of the key requirements of any successful middle office operation is having the right people in place.
A hedge fund operations team might have lots of experience in handling global equities but not necessarily more esoteric instruments such as bank loans. They might get so far in conversation with the front office but there comes a point when they need to know things beyond their level of expertise; to access a deeper pool of knowledge to draw upon.
“Clients can tap in to our team at a low level or high level or anywhere in between based on their specific needs. It means they get to use our expertise for the particular slice of time when they need it,” explains Miller.
This might sound all too obvious but if managers take a step back and see the bigger picture, the implications are potentially far reaching: if they have full confidence that their middle office can handle all asset classes and instruments it gives them the imprimatur to think far more strategically. Where might they expand an existing strategy? What additional hedging techniques could they employ? What would the reporting burden be if they were to launch a regulated ’40 Act fund or alternative UCITS fund?
“The middle office supports a manager’s investment team, arming them with the necessary data, and insight, to enhance decision making as well as the compliance, sales and distribution arm of investment firms,” adds Miller. “But it’s not limited to just internal uses – the middle office enables better servicing of regulators and investors and helps maintain good relationships with other intermediaries, such as counterparties, prime brokers and custodians.”
There’s no doubt that getting best-of-breed systems in place is the very least managers need to do if they intend to build out their own middle-office capabilities. No compromise can be made here given the extent of regulatory requirements and reporting that managers now face, both in the US and across Europe. Indeed, there are even short selling reports that managers who trade in Hong Kong must file on a daily basis with the Securities & Futures Commission.
“There are some applications that will integrate across the board (front to back) but those one-stop-shop solutions typically involve significant compromise in functional capability. If one does to decide to buy a number of different best-of-breed systems for trade order management and execution, portfolio management, risk management, fund accounting etc., they need to get them implemented and integrated correctly, which is no small undertaking. Also, there’s the issue of dealing with ongoing upgrades and license fees,” says Miller. “That creates a self-perpetuating cycle of costs and upgrades.”
The regulatory backdrop is putting significant pressure on managers at a time when fee compression means that there’s less money in the coffers to address these operational infrastructure demands. Speaking recently on this issue, Jim Warren, Head of Solutions for SEI’s Investment Managers Service division, said that the current environment supports the trend toward outsourcing back- and middle-office functions to create better operational efficiency.
“It’s no longer a decision of ‘buy versus build’ for investment managers, it’s become ‘partner or perish’,” said Warren.
In theory, system integration should be straightforward. A trade gets placed in the order management system, moves on the execution management system, the trade appears in the accounting system, and finally winds its way through to the performance and risk systems. Nothing difficult there.
Where the real challenge arises, however, is how the various systems respond if somebody needs to cancel a trade. How does one amend the trade and what exactly was it that got amended? The broker code? The security? The price? The quantity?
“That pushes you inevitably into a rat’s nest of communication protocols. Does that trade cancellation go on a one-way trip or does it get sent back to the OMS? It seems so straightforward on the surface but the saying ‘the devil is in the detail’ could not be more relevant in this context,” says Miller.
Without the proper level of integration, one small change made at the security master level could result in a butterfly wing creating a hurricane where the manager discovers that the performance attribution report generated in the middle office that got sent out to Institution X was inaccurate, or the regulatory report filed to the SEC used an incorrect risk exposure figure.
System integration has to be such that any change made in one system is immediately applied and updated across all critical systems.
Best-of-breed systems coupled with expert system integration results in powerful capabilities. “Say you’ve got an investment manager who owns a position in Phillip Morris,” says Ellis. “One investment team within the firm may want to categorize that as tobacco and another team may want to categorize it as food. Investors, however, may have their own definitions that need to be considered for separate account pre-trade compliance. You need to have a system that is capable of splitting the same security in multiple ways so as not to affect other things within the fund.”
Miller expands on the point in relation to regulation by adding: “When it comes to filing with regulators, they have their own opinions on how financial instruments should be classified. CPO-PQR and Form PF each has its own definition of instrument types which is causing stress as managers are having to fit their own instrument classifications into these new regulatory definitions, especially when classifications differ between the two regulatory reports.
“You need to have the technology to handle this complexity, the people internally to understand what is required and the necessary governance of workflows to ensure that things are being done consistently.”
This is the final piece of the puzzle and overlaps with system integration. In any business, no matter how robust the systems, and how well integrated they are, the potential for human error is always there. To mitigate this, the right governance structure and workflow environment needs to be established.
For example, say one of the front-office traders purchases a bond and someone inputs the wrong call schedule. Without effective reviews of security master set-up and a proper workflow around confirm matching, that bad security master item will calculate incorrect accruals, cause trades to fail and create inaccurate performance/risk data as it travels through a host of different systems. When the middle office finally detects the error during the reconciliation process, that errant trade will have contaminated the entire infrastructure and that’s a real problem. The less frequently reconciliation occurs, the greater the damage.
“You need to determine whether the security master data is correct. If not, it can have the effect of setting off a nuclear chain reaction: and that could ultimately lead to an incorrect investor or regulatory report being sent out,” says Miller.
“Most elementary systems can figure out bad mistakes. If your call schedule is 2014 and it has been input as 2104 it’ll get flagged up. But if it’s 110 instead of 101 you might have missed three quarters of accruals or calculated incorrect yields,” adds Ellis. This is significant because it means the fund performance would potentially have been better than that reported during such a period.
Workflow governance is of particular import if a manager is running multiple versions of the same trading strategy (or indeed has plans to do so in the future) – i.e. for a regulated fund, for multiple managed accounts in parallel with the offshore fund, etc. The last thing senior management wants is for the front office to stray outside of investment guidelines or include the wrong stocks in an institutional SMA. Of course the odd mistake is sometimes unavoidable but in today’s unforgiving climate, a lack of internal governance protocols and processes can lead to significant reputation risk.
“This is again where experienced people come in to play. They are the ones that are going to know how to put the proper workflows in place around different systems,” says Miller, who continues: “If I’m running Advent Geneva versus SunGard InvestOne, for instance, both of these investment accounting engines need different workflows and controls to be properly maintained, though it is often difficult for novices to discern which controls are most effective and where they should be placed. But when you start bringing 20, 30 years’ experience to the table, you can look at it pretty quickly and determine where things could go wrong; just as a car mechanic can listen to a car engine and determine what the problem might be based on what he hears – he will instinctively know where to look when he lifts the hood.”
Conclusion
Institutional investors are the primary driving force behind this need for middle-office excellence. As well as seeking reassurance that the manager has a repeatable investment process that can deliver performance, they are also looking for hallmarks of institutional quality: an auditable track record, and increasingly a performance track record compliant with Global Investment Performance Standards (GIPS).
“In today’s environment, a hedge fund manager needs much higher levels of granularity and expertise from his middle-office team to better explain asset class correlations, whatever they may be. Institutions don’t just need to know what is happening within the specific strategies they invest in, they also want to understand how those strategies fit within their overall portfolio allocation,” concludes Ellis. “That requires more sophisticated reporting from the manager to the investor, which in turn requires better, faster and more information from the middle office.”
