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Thursday, May 24, 2007

Study: Fund Outsourcing to Ramp Up in the Next Two Years

News summary by MFWire's editors

A new study by PricewaterhouseCoopers has found that approximately one in three (31 percent) investment management firms said they plan to increase their outsourcing arrangements with third-party providers over the next two years. Forty percent of investment management finance executives said their primary reason to expand outsourcing is that it will enable the firm to focus on core competencies.

As the investment management industry uses more complex financial instruments and faces increasing pressure to improve performance, cut costs and comply with regulatory requirements, more firms are turning to third-party service providers for administrative, back- and middle-office functions. Approximately one in three (31 percent) investment management firms said they plan to increase their outsourcing arrangements with third-party providers over the next two years, according to a survey of more than 150 finance executives from mutual funds, hedge funds and other asset management firms, who attended PricewaterhouseCoopers Investment Management Industry forums in Boston and New York over the past week.

Six in ten executives surveyed (62%) said they would maintain their current third-party service arrangements, while only 7 percent said they intend to bring certain previously outsourced operations back in-house.

Forty percent of Investment Management finance executives said their primary reason to expand outsourcing is so that the firm can focus on core competencies. One in three (31%) outsource as a way to improve the quality of functions their finance teams don't have adequate time or resources to handle on their own. Only 29 percent outsource primarily as a way to cut costs.

Outsourcing is one of ten top issues the investment management industry must grapple with in the year ahead, which are driving increased focus on internal controls, including oversight of third-party service arrangements, according to PricewaterhouseCoopers. The firm has issued a report entitled, "Looking Ahead: Strengthening the Structural Foundation of the U.S. Investment Management Industry," which calls on the industry to strengthen internal controls in response to increasing challenges.

"Outsourcing to third parties is about delegation, not abdication of accountability and responsibilities," said Barry Benjamin, U.S. Investment Management practice leader. "The investment management industry is enjoying a robust period of growth, but it is imperative that investment management firms continue to invest in their structural foundation, infrastructure and internal controls so they are strong enough to meet the challenges posed by the regulatory and legal environment, increased competitive pressure and more diverse product mix."

When PwC asked investment management industry finance executives what were the most significant challenges their organizations will face in the coming year, the three top answers were, in order of importance: Regulatory uncertainty, regulatory pressure to increase transparency, followed by performance pressure. This supports PwC's experience. Based on its work with leading mutual funds, alternative investments and industry service providers, PricewaterhouseCoopers has identified the following as the top 10 issues currently confronting the investment management industry:

1. Outsourcing: Delegation, not Abdication. Faced with sophisticated new products, regulatory and investor demands and a talent shortage, investment managers will expand their use of third-party service providers for operations and other activities. The growth is likely to be especially significant among firms offering alternative investments, many of which had performed most back-office functions in-house. Investment managers need to remember that delegation is not abdication, and must ensure that service providers are properly performing the delegated functions.

2. The Performance Squeeze. Although the industry as a whole achieved solid results in 2006, individual actively managed mutual funds and alternative investments are under constant pressure to outperform their benchmarks. While investors buy into these funds for a number of reasons, including diversification and risk management, benchmark-beating performance remains the bottom line for many. Funds generating after-tax results that consistently trail their benchmarks could face redemption demands.

3. A Retirement Windfall for Mutual Funds? Last year's Pension Protection Act makes it easier for employers to automatically enroll workers in 401(k) plans. Mutual fund companies could be the Act's biggest beneficiaries, seeing a new infusion of retirement savings. However, they must position themselves with investors, plan sponsors and financial advisors and also develop processes to meet the new law's requirements.

4. Who "Owns" the Investor? Until now, many mutual fund companies often had no idea who their shareholders were; that information was closely held by the financial intermediaries who sold the funds. However, SEC Rule 22c-2, intended to help identify market timing and rapid trading in mutual funds, goes into effect this year and requires that funds have information-sharing pacts with their intermediaries. One possible outcome: Mutual funds may gain a treasure trove of data they can mine to market directly to customers.

5. Growing Talent Drought. The proliferation of investment products has sponged up talent in everything from portfolio management to back-office service to compliance. With no signs of a slackening in the demand for new products, investment managers will have to pursue talent wherever they can find it and potentially expand outsourcing to carry out operating functions.

6. Maintaining Investor Confidence. The investment management industry is being challenged by the increasing complexity resulting from proprietary trading activities at financial firms, shared revenue arrangements and the presence of side-by-side investment management activities. Investment managers need to proactively identify potential conflicts and manage them through rigorous processes that maintain investor confidence.

7. Convergence or Collision? The lines between registered investment funds and alternative investments will continue to blur. Some mutual fund companies are launching hedge funds or employing hedge fund-like strategies designed to generate absolute returns. Hedge funds and other alternative investment managers are "institutionalizing" to manage their growth and address the transparency and reporting needs of pension funds and other large institutional investors. Investment managers need to comply with regulatory restrictions and avoid possible conflicts of interest, such as those that can arise if the same manager oversees both a mutual fund and a hedge fund.

8. Taxing Times for Investment Managers. The increased use of complex investment strategies and financial instruments and regulatory uncertainty present near-term tax challenges for investment managers. The Financial Accounting Standards Board's FIN 48 (Accounting for Uncertainty in Income Taxes), which takes effect this year, requires more rigorous reporting of potential tax liabilities and could reduce net asset values per share. Mutual fund companies will need to bulk up their tax accounting and reporting resources and implement ongoing programs to assess potential tax liabilities.

9. Through the Looking Glass: Greater Transparency for Funds. The SEC is serious about making mutual funds more transparent to investors, and so momentum is finally building for the use of interactive data in performance reporting. Recent developments - including the planned conversion of the SEC's forms-based EDGAR system into an interactive database - will jump-start the use of interactive data tagging (or XBRL) technology by mutual funds, making information more accessible and user-friendly.

10. Regulatory Uncertainty. The federal regulatory pendulum has swung back and forth in recent years, and it is unclear what direction regulators will take in such varied areas as mutual fund 12b-1 fees, derivative products and oversight of alternative investments. Investment managers need to be flexible to respond to any changes without compromising either performance or profitability.

"During this time of change and uncertainty, it is crucial for the investment management industry to maintain investor confidence," said Benjamin. "By managing potential conflicts, properly overseeing service providers and addressing the risks of complex investment instruments, the industry can meet its operational challenges while preserving investors' trust. Deeds, not words, will ensure investors' continued faith in the U.S. investment management industry."

"Looking Ahead: Strengthening the Structural Foundation of the U.S. Investment Management Industry" lays out the challenges and highest pressure issues facing the industry. The report also addresses in greater detail five areas of internal control for mutual funds to strengthen their structural foundation, identifies the ramifications for the industry and suggests best practices to address industry challenges.

The survey of over 150 investment management industry executives was conducted at three investment management industry forums held over the past week in New York and Boston, including the PricewaterhouseCoopers Finance Executive's Forum, held May 17 in New York, and the PricewaterhouseCoopers Investment Management Industry Forum Series, held in Boston on May 23 and New York on May 24. Respondents represented both registered investment companies and alternative investment firms.

About the PricewaterhouseCoopers Investment Management Industry Group

PricewaterhouseCoopers' Investment Management Industry Group provides auditing, accounting, business advisory and tax services to many of the world's largest mutual funds, common trust funds, limited partnerships, hedge funds, pension funds, annuities, trusts and industry service providers.

About PricewaterhouseCoopers

PricewaterhouseCoopers (www.pwc.com) provides industry-focused assurance, tax and advisory services to build public trust and enhance value for its clients and their stakeholders. More than 140,000 people in 149 countries across our network share their thinking, experience and solutions to develop fresh perspectives and practical advice.

"PricewaterhouseCoopers" refers to the network of member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity.  

Edited by: Erin Kello

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