ASSET SERVICING: A plethora of data

It's all about data. And for asset servicing firms, not only is the volume of data growing, but the complexity of that data is increasing too.

As institutional investors scour the globe for new and improved investments, they continue to land in alternative areas such as hedge funds, derivatives and private equity. While these investments might provide better returns than, say, stocks and bonds, they come loaded with more complex valuation schemes and complicated accounting requirements as well as more difficult trading and reporting trails.

"Our clients — both pension funds and investment managers — are trying to find new and different ways to invest, and typically they're investing in products that don't have a lot of transparency," said Serge Boccassini, head of global product development at Northern Trust Corp., Chicago. "People are investing in all kinds of derivatives — OTC (over-the-counter) and exchange-traded derivatives — and everybody's investing in hedge funds and private equity. People are also looking at real estate again."

As a result, asset servicers have been working feverishly to figure out how to get critical data from these types of investments to their clients. Most of them are enlisting prime brokers, clearing and settlement firms, as well as software developers and, in the case of private equity, general partners, to solve the problem.

Bo Abesamis, senior vice president at investment consultant Callan Associates Inc., San Francisco, said the firms are not equally competent at dealing with alternative investments and the added layer of information inefficiencies that accompany them.

"Custodian banks are adapting to reality not only to capture business opportunities but to bridge the intellectual gap," Mr. Abesamis explained. "They're in different stages of the game as far as a service solution goes. The major players are way ahead of regional or smaller custodian institutions in this arena in terms of a deliverable service offering or just sheer capability."

During the past few years, asset servicing firms have largely focused on bringing their products into the Internet age, providing clients with online access to their accounts, as well as outside information such as daily news stories and third-party investment reports. Those efforts also included giving clients the opportunity to slice and dice their account information quickly and easily in a multitude of ways.

Until now, however, the data these firms have been handling has been straightforward information on prices, positions and values of investments like stocks and bonds that are largely transparent, where trading and trade settlement are relatively quick and easy.

That game is changing and changing fast, creating challenges and opportunities for asset servicing firms.

Patrick E. Curtin, executive vice president and head of U.S. investor services at Bank of New York, New York, said investments like credit default swaps and other esoteric derivatives "are not easy things to value and price."

Mr. Abesamis said the problem goes beyond valuation and pricing to fundamental risk management.

"If I want to learn my exposure to the technology sector and if I have investments in private equity or a hedge fund that has a technology holding, if I'm not able to bring that (investment value) up to the total fund level and add it to the tech investments that are transparent, I don't really have a sense of what my total exposure to technology is," he explained by way of example.

"If you cannot see underneath (the investments) or there is no transparency, then risk management is not perfect," he said. "It's not just about being able to account for the investment. At the end of the day what plan sponsors are seeking is better risk management."

At Northern Trust, Mr. Boccassini said the issue largely comes down to transparency.

"The challenge is how do you get these types of securities to be more transparent and (trading) more straight through — to get the performance, but ensure that cost of doing so doesn't strip away the investment benefits

Mr. Curtin explained it as solving the transparency problem in a way that can be scaled to cover many clients, each with different needs.

"It's not like it's one client or one type of security," he said. "It's multiple clients with slightly varying needs. We have a great opportunity to get that right."

To get that right, Bank of New York and other asset servicing firms are largely banking on their core technology, on which they've spent millions of dollars both individually and collectively over the last several years.

"It's a combination of adding increasing sophistication and functionality to some of our existing platforms, as well as building some proprietary functionality to support either individual investment types, individual client types or individual market segments," explained Diane Eshleman, executive vice president and head of the trust company at JPMorgan Worldwide Securities Services, a unit of JPMorgan Chase & Co., New York.

Paul d'Ouville, senior vice president in charge of investment risk and analytical services at Northern Trust, said solving the data problem without stripping out the investment benefits for clients requires an investment in expertise. Once that is in place, leveraging it across clients is cost effective, Mr. d'Ouville said.

"The way to make some of it scalable is through expertise," he said. "We've got a division in our operations group that's focused exclusively on special asset processing."

"Once (information) is on our central processing platform, it flows through to our accounting platform, our online platform, to risk and analytics," he continued. "Once it's on there, everything else is very scalable."

Ms. Eshleman at JPMorgan concurred that people are as important — if not more important — than technology.

"What sometimes gets ignored is the people element," Ms. Eshleman said. "It doesn't matter how sexy your technology is if you don't have the right people: smart, experienced people who understand the marketplace and can anticipate what the technology can do and what it can't do."

Finding such people has become harder as the asset servicing business has become more complex and specialized, she said. As a result, JP Morgan has a built a training program to develop junior staff in asset servicing.

"We have found that the market is such that there just aren't enough experienced people, so we've got this incubator to build those capabilities," she said.

In some cases, like hedge funds, firms have acquired the necessary servicing skills. In fact, all the major custodians acquired hedge fund administrators over the last few years just as the proliferation of hedge funds began.

"In the case of hedge fund servicing and administration, that's where all of us (custodians) will leverage our technology," Mr. Curtin at Bank of New York said. "But the reason you've seen … Bank of New York buy that capability, as opposed to build it, is the intellectual capital is somewhat more important than the technology."

That appears to be a safe bet as more institutional investors are expanding their existing allocation to alternatives like hedge funds, or are carving out new allocations to them.

According to the Commonfund Institute, Wilton, Conn., 32% of endowments expect to increase their asset allocations to alternatives this year, decreasing their allocations to equity, cash and short-term investments.

Meanwhile, pension fund investment in multistrategy hedge funds is expected to grow 775% by the end of 2010, reaching $350 billion from $40 billion at the end of 2005, according to an analysis by Donald H. Putnam, managing partner of Grail Partners LLC, Boston (Pensions & Investments, Nov. 28). Mr. Putnam also estimated pension fund investment in hedge funds of funds will increase 33%, to $200 billion by the end of 2010, from $150 billion in 2005.

Pension funds also are increasing their use of derivatives such as credit default swaps. In 2004, pension funds accounted for 2% of all writers of credit default swaps, double the prior year, according to the British Bankers Association, London. Credit default swaps allow investors to buy or sell protection against default on a debt portfolio — such as high-yield bonds or asset-backed securities — through a counterparty.

CDS contracts, including notional amounts, are expected to reach $15 trillion this year, up from $12.4 trillion last Nov. 30, according to GFI Group Inc., New York, an OTC derivatives broker-dealer.

Asset servicers, for their part, are jumping into the fray.

In late 2004, JPMorgan began offering custody for hedge funds of funds, one of the first to do so. That means the bank holds fund-of-fund managers' shares in other hedge funds.

Jay Hooley, executive vice president and head of global investment servicing at State Street Corp., Boston, said his firm services 10% of the hedge fund market, with $120 billion in hedge fund assets under administration, up from $30 billion when it acquired hedge fund administrator International Fund Services in 2002.

"We've put a lot of investment into analytic systems, risk management systems — particularly in the fund of hedge fund space," he explained. "It's absolutely critical for pension plan sponsors to see underneath the fund of hedge funds to the individual hedge fund and understand the individual holdings from a risk management standpoint."

Even as asset servicers ramp up their hedge fund and fund-of-funds capabilities, hedge funds have improved their own reporting practices.

According to an annual analysis of hedge fund databases by Strategic Financial Solutions LLC, New York, more hedge funds are reporting performance and other information to the 12 major hedge fund databases. The number of hedge fund records at the end of 2005 was up about 64% to roughly 57,000 compared with a year earlier. By reporting more, hedge funds are making it easier for asset servicers to get things like valuation and pricing right.

But the investment expansion goes beyond hedge funds and funds of funds into other non-traditional asset classes, such as securitized auto loans.

"We've acquired a company that does third-party servicing and enables our clients to … get into some of these asset classes like auto loans that they otherwise wouldn't necessarily feel comfortable in … because of either understanding the underlying market or the complexity of servicing," Ms. Eshleman at JP Morgan said.

Mr. Curtin at Bank of New York said that in 2006, the demand for alternative investments will only increase, especially amid the higher interest rates engineered by the Federal Reserve over the last 18 months or so.

"The equity risk premium had disappeared because of lower interest rates," he explained. "Now we've entered an environment in which investors' risk tolerances will more greatly resemble their historic norms.

"That's why you'll see investors move to alternatives," he said.

Jack Klinck is a vice chairman of Mellon Financial Corp., Pittsburgh, and president of the company's Investment Manager Solutions, which provides asset servicing to investment management firms. Mr. Klinck said asset servicing companies are going to have to adapt to the changing nature of clients as well.

"The real broad issue is that players like Mellon and others are having to adapt their business model fairly substantially to be much more savvy and astute with financial institutions, whether they're hedge funds or banks or insurance companies. That's really where the growth is, not in defined benefit plans," Mr. Klinck said.

"The major custodian banks have to get very smart very quickly around financial institutions. All clients are fund managers, banks or broker/dealers. That's where the battle is going to play out."

And what a battle it will be.