Failure to select a custodial partner, with capabilities aligned with the current and future objectives of the fund, can result in a significant drain on alpha through opportunity costs, improper oversight and excessive fees. The potential financial impact resulting from such operational and non-market risks can far exceed the more apparent fees generally associated with a custodial provider.
Risks to consider
In 2011 economic uncertainty remains, so it’s important to maintain strategic vigilance as plan sponsors continue to explore these alternatives. Custody banks are crucial partners in this vigilance, since they touch all aspects of plan administration—from investment management and administration to trade settlement and valuation, tax and regulatory reporting, and benefit payments. Effective use of a custody bank enhances fiduciary control and oversight, and provides an independent book of record, checks and balances on cash and securities movement, and enhances monitoring of investment activity to facilitate prudent decisions.
That range of capability is vital in helping investors manage the full spectrum of risks they face. Market risks, such as the fluctuations of stock prices, credit and liquidity issues are clear enough to investors; they affect alpha generation and require and often get close management.
But investors’ often fail to take into account non-market risks, such as operational, reputational and transactional execution risks and these can have an equally significant impact on alpha. Some of the most spectacular investment and trading losses over the last decade can be directly attributed to weak control environments and insufficient independent oversight. A truly holistic approach to investment management factors in both market and non-market risks to maximize return and reduce overall risk.
Repositioning for a two-speed world
The investment world today is marked by high growth in rapidly developing economies, and slow growth in developed ones. As institutional investors reposition for this “two-speed world” they generate a number of non-market risks through portfolio restructuring that must be taken into account. Specifically, restructuring requires transitions into risky or less liquid asset classes that can be costly if not managed and executed properly.
In addition, transaction costs can go up, since the execution of emerging markets equities is less transparent and can be more prone to less efficient execution. Similarly, foreign currency exchange (FX) transactions in emerging markets currencies is often poorly managed and certainly less transparent, which can lead to higher overall costs and lower net returns.
The reality is that new investment managers whose role it is to navigate the challenges of the two-speed world may introduce greater operational risk, as they manage the complexities of hedge funds, emerging markets and small-cap management. Moving to a more global (and potentially more complex) investment approach that includes these asset classes requires a sophisticated custodian with greater global capabilities, and often entails higher fees.
Increasing fees, while certainly important, may not be as impactful as the potentially material draining costs of a poor custodial relationship in which objectives and capabilities are mismatched.
Increasingly, the custodian is the foundation of plan administration, and the critical component of fiduciary control and oversight. As such, the custodial function must be revisited in the context of the fund’s future objectives and must not only be able to service the more traditional asset classes, but must also be well positioned to support growth into strategies such as derivatives, emerging markets, hedge funds and other alternatives. Failure in this capacity can translate to a weakened control environment, poor transaction controls, and a mismatch of objectives and capabilities which, in turn, can increase costs, reduce transparency and hinder investment strategies.
Choosing the right custody bank is important, since poor choices can lead to excess costs and can hinder transparency. Key areas to be assessed in making this custodial choice include the following:
- financial strength;
- functions and internal controls (core custody, settlement, fund accounting, income collection, tax reclaims, transaction processing, etc.);
- cash management and controls;
- the ability to service investment managers and other vendors; and
- reporting accuracy and capabilities, particularly on-line investment reporting.
There are also transactional risks to consider, such as inefficient FX; failed or delayed settlement; inaccurate asset valuation; cash overdrafts; and securities lending.
The potential for inefficient execution, with a corresponding erosion of alpha, can’t be overstated in the somewhat opaque and volatile world of FX trading. FX is an area that will become increasingly important with the growth of investment in the emerging markets. Custodians today continue to manage a significant portion of foreign exchange executed by plan sponsors; however, a lack of transparency in the FX market makes it difficult for an investor to perform proper oversight and monitoring. Understanding the custodian’s FX practices, as well as regular reviews of execution quality and costs, are necessary steps in avoiding undue risk and excessive costs in the FX markets.
Importance of governance
Ultimately, a successful investment strategy for the two-speed era requires that investors define good governance for their organization. That means establishing a process to evaluate both financial/market risks and non-financial risks. It also means understanding and continually evaluating service providers such as investment managers, transition managers and custody banks, since the risks that must be managed and the needs of the service providers continue to change.
This requires consistent and comprehensive measurement and monitoring processes that benchmark against industry best practices; drive greater transparency and understanding of costs and risks; and identify qualified external information sources. There is no substitute for a committed service partner who can meet your needs today as well as be able to execute on your three-to-five-year strategy.
These challenges are varied and not easily met without strategic rigor and the right support, but the price for failing to meet them is steep. As plan sponsors seek a global platform for their strategic asset allocations, they must embrace the complexity and rely on proven process to see them through an alpha-rich 2011 and beyond.
The role of the right custodial relationship—one that matches objectives and capabilities, provides vigilant plan governance and oversight, and touches every aspect of plan administration—can not be overstated.
Mark Fieldhouse and Freeman Wood are principals with Mercer’s investment consulting business.