Calastone Connect Forum London: Blockchain, cost reduction and the rise of passive funds______

Jon Willis, Chief Commercial Officer

Calastone held its Connect Forum in London on May 16. Specialists from across the funds world spent the morning talking about technology evolution and how the industry should approach it.

Remaining relevant in the funds world: working with new technology intelligently

The active asset management industry is dealing with a number of issues on several fronts. I listened to a number of attendees at the Calastone Connect Forum, and they recognised that now is the time to begin implementing change and exploring technological innovations, so as not to be forced into reverse. The next few years will be critical for the funds world.  Active managers have struggled to make returns for clients, the audience was told. Long-term low interest rates have impeded profits, but so have other factors like global regulation and the forced expansion of non-revenue generating business divisions like operations, risk management and compliance.

In other words, managers have seen operating costs go up, but revenues plateau or decline. Investors have compelled managers to lower their fees, while regulators such as the Financial Conduct Authority (FCA) have issued reprimands rebuking firms for deploying uncompetitive costing structures.

Passive eats into the active cake

Explaining the rise of passive funds or index tracker products is not difficult. Pursuing an investment strategy that makes its returns simply by following a chosen index is far cheaper than selecting an active manager. Riding high off an eight-year equity bull run, passive funds have delivered good returns to investors at fractional costs. As such, experts at the Calastone Connect Forum anticipate that passive products will continue to eat into the customer base of active managers.

A study by Funds Europe, commissioned by Calastone and officially published in June, found 57% of respondents believed passive funds would take over from actively managed products as the core investment product for mass retail. Around 45% told the survey this shift would occur in two to five years.  However I saw recognition that active managers will remain popular among sophisticated investors.

There was also a view that a balanced portfolio incorporating active and passive strategies simultaneously is essential for risk diversification. An audience poll at the Connect Forum found that while 52% of respondents felt the key buying criteria for a fund had to be returns versus costs, 36% felt it was important to maintain a balanced portfolio.

The expansion of passive products has occurred against the backdrop of a positive growth market, and I’ll be interested to know how the asset class will perform during less accommodating circumstances. “Some commentators suggest that as we have encountered an extended bull market post the Global Financial Crisis, it will be interesting to know how ETFs will deal with a falling market and whether there will be any liquidity issues and the ability to exit ETF positions,” said Mike Tumilty, director of operations at Standard Life Investments.

Irrespective, the active management world is facing near-term competition from passive products. Certain fund management organisations have looked to consolidation to gain scale and therefore protection, with some speakers acknowledging the market was increasingly saturated.

Panellists said asset managers are simply trying to scale down their overheads to varying success. Reducing costs at active providers is challenging, mainly because employee compensation is high, they added. I was interested to hear that an increasingly popular approach at asset managers is to revise their fund pricing structures and fees from a fixed cost charge to one based on performance. In other words, fees will rise in line with performance. “This is an equitable solution to tackling the problem,” said Jervis Smith, head of investor services at Citi in Luxembourg.

Delivering innovation and controlling costs

The audience was warned that active managers need to reduce their costs, otherwise they risk losing even more share to passive products or emergent disruptors. Cost control can be managed through innovation, and operations is one area where new technology can make huge changes. The funds world is partially automated, but many processes remain manual, and this is a cost centre for managers and investors.

There are areas that the funds industry could use technology to limit costs. Data processing and reporting can be highly manual, for example, but some experts at the Connect Forum believed the growth of artificial intelligence (AI) or machine learning will change this. This was evidenced at the Connect Forum where 42% of the audience felt machine learning or AI would have the biggest impact on the industry.  AI can be deployed to speed-up the decision-making process and identify behavioural patterns, meaning that operational functions at fund managers which are repetitive will be the principal targets for AI.

Blockchain is probably the best known example of a new innovation, which could bring cost benefits to financial institutions. In fact, 21% of the audience at the Calastone Connect Forum predicted Blockchain would have the most lasting impact on the funds industry.

But be selective

“The technology is not mature but it is maturing. Many of the Blockchain architectures that were available in 2016 are no longer around in what has been a case of Blockchains and Notchains,” said a panel member. With this in mind, fund managers need to take a thoughtful and well-planned approach to integrating any new technology.

A criticism by many of the panellists I listened to of the burgeoning fintech market is that some products simply do not solve actual problems faced by the financial services industry. “A number of firms come to us and pitch, and they highlight that their product will solve a particular problem at our business. I often have to point out the particular issue they are trying to fix is not a problem for us and that they should consult with us first” said Paul Baybutt, senior product manager at HSBC.

There is clearly a lot of talent in the fintech world, but providers are going to go through a Darwinian selection process, the audience was told. Fund managers will need to give serious consideration to innovative technology, but they must be attentive that the decision to migrate systems or change processes can be risky, especially if they select a solution that eventually folds or fails.  Nonetheless, if they get the outcome right, panellists said the cost savings and operational efficiencies could be immense.


Note: Since this article was written, we have announced that we have successfully completed the first phase of our Distributed Market Infrastructure (blockchain) innovation programme. You can learn more about our progress on the project here

The digital fund distribution revolution: opportunity through change


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