Investment Research Outsourcing for Asset Managers: Best Practices at the Top of the Value Chain
Normal rules often break down in extreme circumstances. In science, many of the ordinary laws of physics go awry when scientists look at extremely small particles. Similarly, investment management firms, as well as consultants who are guiding the process, may need to modify their approach when evaluating outsourcing strategies for niche, high-end functions close to – or even within – the front office. One crucial front-office function is investment research, and investment research outsourcing (IRO) is a small but rapidly growing industry near the very top of the financial services food chain. The term covers a broad spectrum of functions used by asset managers to support the investment decision process. The key word here is ‘support’ – every investment manager rightly considers the unique insights that go into an investment decision to be their core competence. IRO does not seek to outsource this insight. Instead, it allows investment managers to apply their insight across an even wider range of investment opportunities by freeing them from supporting tasks that might otherwise clog up their day. In other words, IRO helps senior investment managers save on the most valuable resource of all – time. In this report, Amba Research Co-Founder and MD Anand Aithal looks at Investment Research Outsourcing trends and outlines several ‘best practices’ for asset managers considering the use of third-party vendors such as Amba Research
Factors driving IRO adoption
IRO first emerged about five years ago, driven initially by investment banks. The asset management industry only began to adopt IRO during the past 18 months. The motivations for outsourcing were different too. The investment banks were driven to outsource by a desire to cut research costs during a time of reduced industry profitability whereas the asset management industry has embraced IRO in part because of the current scarcity of skilled labor in areas such as quantitative financial research.
The other big driver of IRO has been the structural change in the way investment research ideas are delivered to asset managers. Historically, asset managers perceived that they could get a lot of basic research ‘for free’ from brokerage firms. Broker research acted as a centralized resource that all asset managers could use as a starting point for their own more detailed research due diligence. However, the amount of ‘free’ research being produced by brokerages has fallen in the past five years due to shrinking commissions and regulatory changes that have reduced the cross-subsidization of research costs from other investment banking activities.
Part of this research ‘deficit’ has been met by the emergence of small independent research firms. But asset managers have also responded by growing their in-house investment teams, creating the overall industry labor shortage.
Guidelines for success
Outsourcing investment research differs considerably from the outsourcing of back-office technology functions. Among the tasks at the top of the investment research outsourcing spectrum are financial modeling, background information screening, background due-diligence and background quantitative analysis. Unlike back-office functions, these tasks require the outsourcer to exercise judgment and undertake heterogeneous non-automated tasks. Just as important, execution of any of these require the outsourcer’s personnel to have direct and frequent interaction with the client’s front-office personnel including senior analysts and heads of research. The research teams at investment management firms typically include some of the most highly trained and demanding professionals in the world. To ensure that these groups are served properly and that investment research outsourcing mandates are implemented as smoothly as possible, we believe that certain guidelines should be followed
1. Undertake a realistic evaluation of the vendor’s HR skills
Functions close to the front office require individual judgment rather than automated rules and often require the outsourcing unit to dedicate named individuals to provide long-term customer service rather than anonymous pools of personnel. It is crucial therefore that the vendor have substantial experience in hiring, training and managing financially literate individuals.
2. Define the task accurately
IRO means different things to different vendors and purchasers. A vendor who is skilled at one form of IRO may not be skilled at another. At one end of the spectrum are low-end rules-based actions such as inputting historical data. Then there are more technology-driven tasks associated with the integration of databases and the migration of legacy technology platforms. Third are services in areas that are related to IRO, but which may actually require different skills (for example, the provision of editorial support services for authors of investment research reports). Vendors specializing in any of these services will not be well-prepared to present staff who can engage with heads of research.
3. Ensure that the vendor has domain expertise
The key cost of outsourcing is the management time spent training the vendor – getting this wrong can overwhelm any financial savings, and negate the ‘time to market’ argument for outsourcing. The closer one gets to the front office the more critical this time cost becomes. Many firms will claim to have domain expertise in financial services, but these claims need to be tested and refined. An expertise in mortgage processing is not the same as expertise in corporate finance, which in turn is not the same as expertise in investment research. If a vendor claims to have a management team with relevant expertise, the purchaser should ask to see their résumés. Is the management team involved in day-to-day operations? What level of seniority did they have in their prior firms? Have they managed large numbers of investment professionals before? Even if they worked for an investment research firm before, was their experience in a relevant department?
4. Ask about the training regime
India and other countries have plenty of statisticians and chartered accountants who have graduated from top schools, but few are employable in financial services unless somebody invests in training them in capital markets theory. Will the vendor be relying on the purchaser to provide training? If not, what is the vendor’s training program and who is their faculty? Is the training in-house or hired from subcontractors?
5. Evaluate the vendor’s ability to scale while maintaining quality
Vendors with thin management teams might still be able to produce acceptable output during trials. However, the teams responsible for working on trials may not be the teams doing the ongoing client work. In order to guard against such bait-and-switch tactics, purchasers should ascertain precisely who in the vendor will be responsible for ongoing quality control, and if those people will be working exclusively for that client.
6. Check for compliance standards, protection of client intellectual property
The research groups at investment management firms must ensure that the work they do meets regulatory standards. These standards are particularly stringent in the U.S. and Europe. Clients must confirm that the vendor understands the nuances of investment industry compliance requirements. In addition, they should ask how the vendor ensures that a purchaser’s intellectual property is not recycled and used elsewhere.
7. Properly evaluate the difference between outsourcing and using a captive
When considering whether to in-source or use third-party providers, the considerations will be similar to those with other forms of outsourcing. Superficially, many firms might find a captive more appealing because of the ease of technology integration and a perception that front-office corporate culture can be more easily maintained. There are also potential downsides to a captive strategy, which tend to be magnified because of the niche nature of IRO. Many asset managers will not have sufficient scale to set up their own IRO captive, and will not want the considerable expense and hassle of finding on the ground management, supervision, training and HR support teams.
8. Avoid these common mistakes
Even if a research group at an investment management firm has agreed in principle to look at outsourcing, they often do not have the ability to source these services without at least some help from consultants. However, the consulting groups often make two common mistakes. First, many consultants use standardized RFPs that often do not cover the above issues in sufficient detail. It is vital to involve front office line managers in specifying the RFP questions. Secondly, it is often thought that investment management firms can simply piggy back an investment research outsourcing captive onto the back of an IT captive. This is helpful from an IT integration perspective. However, the HR model used in IT outsourcing may be very different from the HR model most useful to IRO: IT outsourcers are set up to recruit, train and motivate a very different type of labor pool.
Conclusion
IRO has been used successfully across a wide range of capital market domains, including equities, fixed income, risk management, and derivatives. We have seen examples of IRO in the main financial centers around the world. However, because the investment research outsourcing industry is still very new, there is still much confusion in the market about what IRO is and how it can help investment managers. The IRO firm will not be able to supplant the years of accumulated in-house investment insight, but rather may provide skilled personnel to execute certain tasks, which require a high level of skill and ability to fit into the front-office culture. Thus, we believe that the outsourcer’s ability to hire, train, manage and retain talented financially-literate individuals is the single most important determinant of success in IRO.
About the Author
Anand Aithal was previously a Managing Director at Goldman Sachs and has 20 years of global research experience. He undertook a variety of research-related roles at Goldman Sachs, including being Asia strategist, head of a research joint venture in India and head of US and European convertible securities research. Anand began his career in 1989 in Goldman Sachs’ Investment Banking department. He is a contributing author to the Handbook of Equity Derivatives (John Wiley & Sons, 2000). Anand holds an MA in Economics from Cambridge University.
About Amba Research
Amba Research is the leading provider of investment research support services to the global capital markets industry. The company was founded in 2003 by former senior research directors at leading global investment banks. Amba works with over 70 clients, including investment banks and asset managers in all the world’s major financial centers. Amba offers a wide range (over 100 types) of investment research support services covering equity, fixed income, and quantitative research & analytics Amba is staffed with 500+ high-caliber finance professionals across offices in Bangalore (India), Colombo (Sri Lanka), San José (Costa Rica), New York, London, and Singapore For more information on Amba Research, please visit http://www.ambaresearch.com/
Normal rules often break down in extreme circumstances. In science, many of the ordinary laws of physics go awry when scientists look at extremely small particles. Similarly, investment management firms, as well as consultants who are guiding the process, may need to modify their approach when evaluating outsourcing strategies for niche, high-end functions close to – or even within – the front office. One crucial front-office function is investment research, and investment research outsourcing (IRO) is a small but rapidly growing industry near the very top of the financial services food chain. The term covers a broad spectrum of functions used by asset managers to support the investment decision process. The key word here is ‘support’ – every investment manager rightly considers the unique insights that go into an investment decision to be their core competence. IRO does not seek to outsource this insight. Instead, it allows investment managers to apply their insight across an even wider range of investment opportunities by freeing them from supporting tasks that might otherwise clog up their day. In other words, IRO helps senior investment managers save on the most valuable resource of all – time. In this report, Amba Research Co-Founder and MD Anand Aithal looks at Investment Research Outsourcing trends and outlines several ‘best practices’ for asset managers considering the use of third-party vendors such as Amba Research
Factors driving IRO adoption
IRO first emerged about five years ago, driven initially by investment banks. The asset management industry only began to adopt IRO during the past 18 months. The motivations for outsourcing were different too. The investment banks were driven to outsource by a desire to cut research costs during a time of reduced industry profitability whereas the asset management industry has embraced IRO in part because of the current scarcity of skilled labor in areas such as quantitative financial research.
The other big driver of IRO has been the structural change in the way investment research ideas are delivered to asset managers. Historically, asset managers perceived that they could get a lot of basic research ‘for free’ from brokerage firms. Broker research acted as a centralized resource that all asset managers could use as a starting point for their own more detailed research due diligence. However, the amount of ‘free’ research being produced by brokerages has fallen in the past five years due to shrinking commissions and regulatory changes that have reduced the cross-subsidization of research costs from other investment banking activities.
Part of this research ‘deficit’ has been met by the emergence of small independent research firms. But asset managers have also responded by growing their in-house investment teams, creating the overall industry labor shortage.
Guidelines for success
Outsourcing investment research differs considerably from the outsourcing of back-office technology functions. Among the tasks at the top of the investment research outsourcing spectrum are financial modeling, background information screening, background due-diligence and background quantitative analysis. Unlike back-office functions, these tasks require the outsourcer to exercise judgment and undertake heterogeneous non-automated tasks. Just as important, execution of any of these require the outsourcer’s personnel to have direct and frequent interaction with the client’s front-office personnel including senior analysts and heads of research. The research teams at investment management firms typically include some of the most highly trained and demanding professionals in the world. To ensure that these groups are served properly and that investment research outsourcing mandates are implemented as smoothly as possible, we believe that certain guidelines should be followed
1. Undertake a realistic evaluation of the vendor’s HR skills
Functions close to the front office require individual judgment rather than automated rules and often require the outsourcing unit to dedicate named individuals to provide long-term customer service rather than anonymous pools of personnel. It is crucial therefore that the vendor have substantial experience in hiring, training and managing financially literate individuals.
2. Define the task accurately
IRO means different things to different vendors and purchasers. A vendor who is skilled at one form of IRO may not be skilled at another. At one end of the spectrum are low-end rules-based actions such as inputting historical data. Then there are more technology-driven tasks associated with the integration of databases and the migration of legacy technology platforms. Third are services in areas that are related to IRO, but which may actually require different skills (for example, the provision of editorial support services for authors of investment research reports). Vendors specializing in any of these services will not be well-prepared to present staff who can engage with heads of research.
3. Ensure that the vendor has domain expertise
The key cost of outsourcing is the management time spent training the vendor – getting this wrong can overwhelm any financial savings, and negate the ‘time to market’ argument for outsourcing. The closer one gets to the front office the more critical this time cost becomes. Many firms will claim to have domain expertise in financial services, but these claims need to be tested and refined. An expertise in mortgage processing is not the same as expertise in corporate finance, which in turn is not the same as expertise in investment research. If a vendor claims to have a management team with relevant expertise, the purchaser should ask to see their résumés. Is the management team involved in day-to-day operations? What level of seniority did they have in their prior firms? Have they managed large numbers of investment professionals before? Even if they worked for an investment research firm before, was their experience in a relevant department?
4. Ask about the training regime
India and other countries have plenty of statisticians and chartered accountants who have graduated from top schools, but few are employable in financial services unless somebody invests in training them in capital markets theory. Will the vendor be relying on the purchaser to provide training? If not, what is the vendor’s training program and who is their faculty? Is the training in-house or hired from subcontractors?
5. Evaluate the vendor’s ability to scale while maintaining quality
Vendors with thin management teams might still be able to produce acceptable output during trials. However, the teams responsible for working on trials may not be the teams doing the ongoing client work. In order to guard against such bait-and-switch tactics, purchasers should ascertain precisely who in the vendor will be responsible for ongoing quality control, and if those people will be working exclusively for that client.
6. Check for compliance standards, protection of client intellectual property
The research groups at investment management firms must ensure that the work they do meets regulatory standards. These standards are particularly stringent in the U.S. and Europe. Clients must confirm that the vendor understands the nuances of investment industry compliance requirements. In addition, they should ask how the vendor ensures that a purchaser’s intellectual property is not recycled and used elsewhere.
7. Properly evaluate the difference between outsourcing and using a captive
When considering whether to in-source or use third-party providers, the considerations will be similar to those with other forms of outsourcing. Superficially, many firms might find a captive more appealing because of the ease of technology integration and a perception that front-office corporate culture can be more easily maintained. There are also potential downsides to a captive strategy, which tend to be magnified because of the niche nature of IRO. Many asset managers will not have sufficient scale to set up their own IRO captive, and will not want the considerable expense and hassle of finding on the ground management, supervision, training and HR support teams.
8. Avoid these common mistakes
Even if a research group at an investment management firm has agreed in principle to look at outsourcing, they often do not have the ability to source these services without at least some help from consultants. However, the consulting groups often make two common mistakes. First, many consultants use standardized RFPs that often do not cover the above issues in sufficient detail. It is vital to involve front office line managers in specifying the RFP questions. Secondly, it is often thought that investment management firms can simply piggy back an investment research outsourcing captive onto the back of an IT captive. This is helpful from an IT integration perspective. However, the HR model used in IT outsourcing may be very different from the HR model most useful to IRO: IT outsourcers are set up to recruit, train and motivate a very different type of labor pool.
Conclusion
IRO has been used successfully across a wide range of capital market domains, including equities, fixed income, risk management, and derivatives. We have seen examples of IRO in the main financial centers around the world. However, because the investment research outsourcing industry is still very new, there is still much confusion in the market about what IRO is and how it can help investment managers. The IRO firm will not be able to supplant the years of accumulated in-house investment insight, but rather may provide skilled personnel to execute certain tasks, which require a high level of skill and ability to fit into the front-office culture. Thus, we believe that the outsourcer’s ability to hire, train, manage and retain talented financially-literate individuals is the single most important determinant of success in IRO.
About the Author
Anand Aithal was previously a Managing Director at Goldman Sachs and has 20 years of global research experience. He undertook a variety of research-related roles at Goldman Sachs, including being Asia strategist, head of a research joint venture in India and head of US and European convertible securities research. Anand began his career in 1989 in Goldman Sachs’ Investment Banking department. He is a contributing author to the Handbook of Equity Derivatives (John Wiley & Sons, 2000). Anand holds an MA in Economics from Cambridge University.
About Amba Research
Amba Research is the leading provider of investment research support services to the global capital markets industry. The company was founded in 2003 by former senior research directors at leading global investment banks. Amba works with over 70 clients, including investment banks and asset managers in all the world’s major financial centers. Amba offers a wide range (over 100 types) of investment research support services covering equity, fixed income, and quantitative research & analytics Amba is staffed with 500+ high-caliber finance professionals across offices in Bangalore (India), Colombo (Sri Lanka), San José (Costa Rica), New York, London, and Singapore For more information on Amba Research, please visit http://www.ambaresearch.com/
