Investment management is becoming a more complex business. The average geography, instrument reach and complexity of most funds has increased over the last couple of decades. And that has been accompanied by a regulatory tendency to extend the risk remit of administrators and custodians.
Many pension funds now overlay their schemes with longevity-related derivatives. The alternative fund sector has currently a leverage of 2.5-3.0 times both through straight debt and derivative instruments. The traditional long only sector has been attracted to exchange-traded funds, which are now a far cry from their original simple tracker structures. And hedging is as much a phenomenon of the long only sector as it is of its more adventurous brethren among the hedge fund community.
One by-product of Dodd Frank or EMIR will be to bring many OTC instruments into clearing; and thus into structures that mean they could be traded on markets. That will make them even more respectable; and thus more likely to figure in more portfolios.
Stock lending still prevails as a core feature of many fund classes, especially ETF’s where performance differentiation within any one class is a challenge. And, although custodians quite rightly express concern at prime broker re-hypothecation of fund assets, many funds still find it valid as they have few alternative funding sources in this age of conservative lending, deleveraging and risk averseness by the banks.
Yet, whilst funds have become more complex and structures more risky, fees have declined. Even the hedge fund market is seeing certain more maverick funds seeking to cut through the incredible 2 +20% structures of this sector, albeit by apparently looking for a still rich 0.5+10% fee on assets and profits respectively. And that is genuinely rich by comparison to the few basis points that the index trackers can command.
And consider the poor custodian or administrator. Published results by many majors in this sector indicate that they earn an average of around two basis points of assets under custody. That covers a variety of flows. There will be ad valorem fees ranging from notional in markets such as domestic US through to perhaps 25 basis points or so in some frontier markets. Transaction charges for funds are rarely a meaningful component of fees unless one handles certain active quants or high frequency trading funds. Stock loans, collateral management, cash management and other traditional sources cover the balance of fees. It was the great Marsh Carter, when he ran State Street, who said of custody: “one product with multiple revenue streams!”
As we move into this new diverse and more regulated age, the risks do compound. Administrators in Europe appear liable for cash management and are expected to mirror the cash management role of their funds. That is simple for long only, low volume trading funds but consider a leveraged, derivative overlaid, multicurrency, highly active fund. Administrators in the fund of fund space are becoming more and more embroiled, in many jurisdictions, in validating the operational due diligence undertaken by their managers in selection of funds for investment. Custodians are becoming accountable for sub-custodian risk. Stock lending is quite possibly going to be hit with increased capital ratios under the latest Basel rules. Re-hypothecation, in the “very light touch” regulated London market, will most likely be subject to limitations similar to those imposed by the SEC.
Yet fees continue to fall. One brave global custodian, in a recent interview, suggested that fees would have to rise to around fifteen basis points to justify the risks being assumed. That quantum appears to me to be exaggerated but it does highlight the reality that fees and risk are misaligned and an adjustment is needed.
There are two obvious ways forward. The key one is that custodians and fund administrators are going to have to learn to say no more often. The second is that fees may have to rise; or at least stabilise.
There are risks that few custodians will want to assume. These may be structural with the already fraught relationship between prime brokers and custodians being ripe for change, although gaining positive dialogues is getting more difficult. Prime service provision is becoming a core activity of the custodians themselves and they look more like predators than partners of the PB population. The risk of specific markets, where ownership rights are unclear, where the difference between beneficial or legal title is ill defined or where the banking system is fragile, have to be re-assessed and a “banned” list provided to the more adventurous of funds. And custodians, as well as administrators, need to be proactive, rather than reactive, to changes in leverage or instrument strategies across their funds.
Fees do need to stabilise. The average two basis points noted covers a range. But the old policy of looking for a bull market to bail out a poor fee proposition is untenable in today’s environment. Interestingly, some avid price predators in some markets appear recently to have hit the buffers in respect of their top management support.
Have we reached the bottom in terms of fees? It would be a brave person to state that is the case. But any sensible business analysis shows the current risk return ratio for custodians, especially for those covering global OECD based funds, seems pretty close to sub-optimal!
John Gubert
Chairman
Global Securities Services Executive Committee