Managers move to sharpen focus on alpha

Managers move to sharpen focus on alpha By outsourcing their investment operations, managers are able to concentrate on generating strong returns Pressure to generate alpha is today more intense than ever. At the same time, new products and regulatory requirements are making considerable operational demands on asset managers. So, in order to focus on strategy, increasingly managers are opting to outsource their investment operations. Many managers believe that outsourcing operations will allow them to concentrate resources on generating investment returns. Also, the right outsource provider will provide benefits of scale that most managers could not achieve in-house. Many asset managers view service providers as partners for growth. As managers attract more assets, they would rather outsource investment operations and capacity than grow them in-house. Small and midsized managers especially are Partner for growth: Richard Hughes says that as managers reassess their strategies they see infrastructure support becoming essential taking such an approach. This contrasts with the pioneering outsourcing deals of the early 2000s, which many large managers primarily viewed as a means of reducing costs. As segments of the asset management community reassess their strategic goals, many are concluding that finding a partner to provide infrastructure and support for growth is essential, says Richard Hughes, head of business development for investment operations outsourcing, Northern Trust. Rapid expansion likely Although 2006 has seen few new deals to date, observers expect the market to continue to expand rapidly. Two thirds of respondents to a December 2005 CityIQ survey believed that outsourcing was here to stay. We appear to be in a period of evaluation, page 2 Automatic systems increase efficiency and reduce risk Most hedge funds still process orders by fax, with information re-typed at either end but electronic document management systems offer them a way to cut costs and reduce the opportunity for human error. page 2 Northern Trust takes quarter of UK onshore custody market A partnership with Royal Bank of Scotland, has helped Northern Trust to rapidly gain a 23% share of the UK onshore unit trust and OEIC custody market. It is now a leading service provider in this sector. page 4 Also inside Evolution in Asia...... 4 Northern Trust outlines plan to expand in the region. Asian securities....... 5 Regulators look at allowing stock lending and borrowing. Issue 4 Tracking innovation in asset administration

Analysis 2 Global Fund Focus Issue 4 In the hedge fund industry, performance was usually all that mattered. Yet, as it matures, factors such as transparency and operational risk are becoming important not least because of the demands of institutional investors. A May 2006 Northern Trust research paper, The Forced Institutionalisation of the Hedge Fund Industry, shows how institutional investors are pressing the practices of long-only funds on hedge funds. One key area of operational risk highlighted in this way is created by hedge funds traditional reliance on manual processing of orders and trade flows. As a result, hedge fund managers are likely to increase automation in their back and middle offices over the next few years. In the early stages, electronic document management (see box, right) is a relatively easy improvement to set up, and a valuable complement to the ultimate automation solution of straightthrough processing (see box). Promise of end to paper trail Electronic document management reduces hedge funds reliance on paperwork increasing efficiency and reducing operational risk Terry Drewett, a London-based vice president of process management at Northern Trust. Taking the funds of hedge funds business as an example, there is great scope for operational improvements. In this sub-sector of the hedge fund industry, the subscriptions and redemptions order flow tends to be high value, yet the volume is compara- Reducing risk and saving money The hedge fund industry has always been highly paper-based. Yet automating processes through an electronic document management solution both reduces operational risk and saves a great deal of time that is otherwise spent on manual processing, with consequent impacts on costs, says Managers move to sharpen focus on alpha page 1 where asset managers are assessing what type of operating model best fits their long-term goals. The outcome will ultimately shape their views on outsourcing investment operations. It is clear that the motivation for outsourcing is evolving. The original deals followed the end of the 1990s bull market, when large asset managers needed to adapt to less buoyant markets. These early deals were entirely led by cost, and often had somewhat unrealistic goals. Boutiques take the lead Mid-sized asset managers and boutiques are likely to lead the next phase of outsourcing. To prepare for performance-led growth, they need to have the necessary operations infrastructure the right systems and people in place. Operations outsourcing allows them to avoid new expenditure and benefit from service provider s economies of scale. Ongoing cost-cutting is a Richard Hughes Strategic alignment between client and supplier is a clear differentiating factor secondary motivation. The start-up boutiques currently proliferating at a

Analysis 3 Global Fund Focus Issue 4 tively low. As a consequence, there seemed to be little need to automate workflows, and instructions have generally been issued to third-party service providers by fax. But manual processing and faxbased communications create the potential for human error and bring other operational risks, as well as creating unnecessary cost. Subscription and redemption orders have to be manually handled, scanned Stages of automation Electronic document management systems remove paper from the office especially when it comes to fund subscription and redemption documentation. They complement straightthrough processing (STP), which automates securities trade processing. STP is defined as automated handling of transactions without resort to manual intervention or message repair, except for reasons of policy, across the entire value chain. Flat files with documents in.csv format allow recipients to extract information to automate processes. and re-keyed. Extensive legal documents, such as prospectuses, can stretch to 70 pages or more, and these regularly need to be couriered offshore to fund administrators, when only five pages might need additional data input. Electronic document management Many examples of the potential savings of electronic document management exist in other industries, where it has been widely adopted. In some cases, Terry Drewett Electronic data management saves a great deal of time that is otherwise spent on manual processing so it cuts costs time taken for document processing has been reduced by up to 40%. According to Imagetag, a paper-to-digital document management company, paper handling accounts for 20%-45% of an organisation s labour costs. For funds of hedge funds, converting paper files into electronic files would have multiple benefits. For a start, electronic flat files (which transfer data in a format that is easily machine-readable) could be sent from the fund of funds company to recipients, such as their custodians. This would enable them to extract the information needed to start an automated workflow process without re-keying information. Additionally, with the approval of the appropriate regulators, it would be possible to post electronic subscription documents on a secure website, where the relevant parties could download them at their convenience. In this way, only the five or so pages that needed to be completed would have to be sent physically to the offshore administrator. Benefits of off-site storage Finally, there are benefits from a business continuity perspective. All electronic documents would automatically be stored at a secure off-site location. In the event of a fire or other event affecting the offices of a hedge fund, the documents would not be damaged and could be easily retrieved, even if the organisation had to move offices. As the hedge fund industry increasingly seeks to improve its administrative processes, electronic document management has a major role to play. Furthermore, it will lower the barriers to eventual introduction of straight-through processing which will transform the efficiency of the hedge fund industry. rapid rate often see operations as peripheral to their businesses. They are generally established by investment professionals who know they will prosper or falter according to investment performance, and they may seek to outsource operations from day one. Mid-sized asset managers have a similar approach. They recognise that, as assets and volumes grow, their technology and infrastructure needs to track this growth. Some have concluded that it is far better to outsource operations than spend scarce time and capital building infrastructure. Seeking cost benefits As for the large managers, cost remains the key motivation. Many have grown through acquisition and have multiple trading and fund accounting systems. Outsourcing allows them to move to one set of systems without capital expenditure. However, they want strategic rationalisation rather than the earlier wholesale realignment of cost bases. Regardless of size or motivation, there is a dawning realisation that managers and service providers need to work together if they are to realise the benefits of outsourcing. Strategic alignment between client and supplier is a clear differentiating factor, says Hughes. Northern Trust s philosophy is that, as we construct an outsourcing solution, we consider a variety of factors to ensure that the fit is right for both parties. Aligning investment strategies around systems, connectivity, people and culture are critical factors for success.

News 4 Global Fund Focus Issue 4 Rapid growth in share of onshore custody market Partnership with The Royal Bank of Scotland drives market share to 23% Through its partnership with The Royal Bank of Scotland (RBS) Trustee and Depositary Services, Northern Trust has rapidly expanded in the UK unit trust and open-ended investment company (OEIC) retail market. It is now a leading asset servicing provider in this space. Northern Trust s UK business was kick-started in 2000 when, after considerable due diligence, RBS selected it to provide custody services for its clients. Together, they have developed an integrated, best-of-breed solution, offering clients an independent trustee/depositary product, coupled with an equally independent custody service. Northern Trust offers UK clients a compelling alternative Today, Northern Trust has 23% of the UK unit trust and OEIC market under custody by number of funds, and provides fund accounting to 14% of this market. We believe this solution is unique, says Jeremy Hester, senior vice president, business development, Northern Trust Global Fund Services. It is a compelling alternative in a market that has traditionally considered a one-stop-shop the only viable service proposition. Outstanding quality of service Northern Trust seeks to differentiate itself through quality of client service and offers a highly focused relationship management approach, delivered in a pragmatic and innovative style. It spends $300m a year on ensuring its clientdriven technology consistently delivers effective and consistent reporting and information solutions for clients. Northern Trust Singapore has informed the local investment management community about its plans to enhance the range of services offered to funds in rapidly growing Asian markets. Services to evolve Wilson Leech, head of Northern Trust Global Fund Services, outlined the bank s interest in evolving from providing services to Asian funds domiciled outside Asia to offering full services for local funds in local time zones. Northern Trust outlines plans for Asia Singapore forum told of plans to expand in region Speaking at the bank s second investment managers forum, held on 18 May, at Swissotel, The Stamford in Singapore, he also highlighted the robust growth Singapore forum: 48 delegates from 18 investment firms in Asia s mutual and hedge fund industries and Northern Trust s response. Over the past 10 years, the bank has expanded its Asian presence to five locations covering Singapore, Hong Kong, Tokyo, Beijing and Bangalore. Kathy Dugan, senior vice president, product management, spoke about the new OTC derivatives pricing service and outlined plans for custody processing and collateral management. Tom Benzmiller, senior vice president, managing director Northern Trust Hong Kong, reported on the trends in the manager of managers programme in Asia, and Mary Beth McCrory, senior vice president, worldwide operations and technology, reported on Northern Trust s enhanced pricing capabilities. The forum attracted 48 delegates from 18 investment managers double the previous year s attendance. This newsletter is issued by The Northern Trust Company (TNTC) and Northern Trust Global Services Ltd (NTGS). TNTC and NTGS are authorised and regulated by the Financial Services Authority in the United Kingdom. Registered office: 50 Bank Street, London E14 5NT. TNTC is registered as a branch in the United Kingdom, branch number BR001960 and NTGS is registered in England 4795756. IRS Circular 230 Notice To the extent that this newsletter concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law. For more information about this notice, see http://www.northerntrust.com/circular230. This material is directed to market counterparties and intermediate investors and should not be relied upon by private investors.

News 5 Global Fund Focus Issue 4 Asian countries move to bring in securities lending Securities lending appears likely to increase in Asia over the medium term, as regulators look to enhance the efficiency of local capital markets. The authorities in China, India and Malaysia are all discussing broad plans to allow market participants to lend and borrow stock. The Philippines has advanced considerably towards introduction, while Taiwan is considering improving existing rules. Rules for best practice Following his March 2006 re-election as chairman of the Pan Asia Securities Lending Association (PASLA), Sunil Daswani, regional manager for securities lending (Asia), Northern Trust Channel Islands see big rise in assets Growth to be further boosted by legal moves Driven largely by alternatives property, private equity and hedge funds the Channel Islands fund industries are experiencing strong growth, just as they consider new fund initiatives. 50% growth in a year Jersey and Guernsey s fund assets grew almost 50% by value in the 12 months to the end of first quarter 2006. Jersey reported assets of 156bn; Contact Northern Trust Image: Sarah Williams For further information on any issues covered in this newsletter, please contact: Guernsey assets of 111bn. Both domiciles are proposing to enhance regulatory laws, with the emphasis on streamlining authorisation and Securities lending is useful for these countries because it lifts their weighting in stock index allocation models Global Investments, is helping ensure new rules reflect global best practice. Securities lending has advantages for these countries because it lifts their weighting in stock index allocation models, and increases foreign investment, he says. According to PASLA, the Asian region currently accounts for $250bn of securities lending annually approximately 25% of the global total. licensing of investment funds in order to allow them to be established more rapidly. Jersey and Guernsey s appeal lies in established service-provider infrastructures, innovative regulatory frameworks and their proximity to the UK and Europe. Hold the date 27 September Northern Trust European conference, Lord s Cricket Ground, London Penelope Biggs, global head of business development, C&IS: penelope_biggs@ ntrs.com, tel: +44 (0)20 7982 2200 Wilson Leech Head, Northern Trust Global Fund Services Outlook Keeping you up-to-date on The REITs Question The property market has been one of the UK s best performing asset classes in recent years. The long awaited real estate investment trust (REIT), the UK government s latest investment vehicle, is expected to support the development of an efficient property investment market accessible to retail investors. The draft rules for REITs, issued in December 2005, met a great deal of criticism from a UK investment industry worried that the structure would not achieve its desired objective. IMPROVED POST 2006 BUDGET In his April 2006 Budget, the Chancellor of the Exchequer, Gordon Brown, proposed a structure that allayed some of those fears, offering a flexible and more accommodating regime. Shares in most listed property companies gained ground as the industry reacted positively to the news and the expectation that many such companies would convert to REITs. The new property vehicles look set to become reality with their launch scheduled for 1 January 2007. Whilst REITs will offer considerable benefits to investors, there are still some questions around the technicalities of their structure that could impact on their success. Northern Trust is monitoring developments closely and we will keep you updated on this over the coming months.

Analysis 6 Global Fund Focus Issue 4 Global Fund Focus is written and designed by The Clerkenwell Consultancy www.clerkenwellconsultancy.com Not only is UCITS III raising controls and risk management across the industry, but it has been giving managers the opportunity to review their portfolio strategies. According to Karen Hamilton, Northern Trust, Global Fund Services, we have seen clients not only converting/rationalising their existing product ranges but looking to move further into alternative investments such as derivatives and property. Importantly, the new legislation allows managers to market a greater variety of fund types, including a wider use of derivatives that support enhanced risk management or allow financial derivative instruments to be used to a limit of 100% of net asset value (NAV). It also removes barriers to crossborder marketing of funds. Final deadline looming The UCITS III fund legislation was enacted in 2003. Initially, take-up by managers was slow, but the pace has picked up considerably as the deadline imposed on existing UCITS funds by the Committee for European Securities Regulators (CESR) has either now passed or is fast approaching the final deadline for remaining UCITS I funds to convert is in February 2007. The UCITS management UCITS III takes off After long preparation, managers are now looking to take advantage of the opportunities of UCITS III directive clearly sets out the scope of activities and requirements for the management company/board. In this directive lies a requirement for increased capital and more extensive corporate governance arrangements procedures that must be documented in a business plan approved by the regulator. Codes of conduct are also a requirement. These cover restrictions on insider dealing, inducements, market abuse and exclusion of liability. Importantly, UCITS funds must demonstrate process and controls around the use of derivatives, and sophisticated UCITS funds must apply a value at risk (VAR)-based limit. Patrick Wilkinson, senior legal counsel, Northern Trust Ireland, comments, One of the most interesting aspects Karen Hamilton Asset servicers can provide considerable support to managers with UCITS III funds of the new UCITS III legislation has been the interest in investment strategies that historically have been the preserve of the alternative investment arena. The ability for managers to create products with an absolute return bias through the use, albeit to a limited extent, of short selling or sophisticated derivative instruments, like contracts for differences (CFDs), is indicative of an acceptance by regulators of the appetite for such strategies by retail investors. Strong support for funds Hamilton says asset servicers are able to provide considerable support to managers with UCITS III funds. They offer tailored reporting packages and essential capabilities, such as valueadded VAR risk management systems, risk analytics and systems that monitor and report on borrowing levels. They can also monitor investment restrictions and borrowing levels in line with the regulation. Hamilton goes on to mention that there is a danger that funds rely excessively on brokers prices. At Northern Trust, for example, existing independent pricing services are being enhanced to support the valuation process of the fund s NAV. Additionally, the bank is implementing a collateral management solution for OTC derivatives in the final quarter of the year. Northern Trust has management companies in Dublin and Luxembourg available to clients seeking to launch UCITS III funds. Ian Baillie, managing director, Northern Trust Luxembourg, says, Promoters of UCITS III funds have to make the choice between either building their own UCITS compliant management company or buying (outsourcing) the services. In making their decision, promoters must weigh up the costs, in both time and money, of establishing their own entity and sustaining it going forward, versus the immediacy of Northern Trust s turnkey management company solution. At Northern Trust, for example, not only have we made the necessary investments in people and technology to build a robust and scalable management company model, but we can also point to an enviable track record of achievement in delivering this service to our clients. northerntrust.com