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Cool Profits Heat up Outsourcing Debate

The decision whether to internally handle mutual funds' back-office administrative tasks, such as fund accounting, transfer agency and communications with shareholders, or hand these tasks over to outside service providers is far from new. The debate continues, however, heatedly in this prolonged market downturn, over whether outsourcing or "insourcing" of routine yet important services provides more efficiencies and cost benefits continues.

Desperately Seeking Returns

With asset levels and fee revenue significantly down, and fund advisors desperately seeking to reign in operating costs, fund firms are again evaluating the wisdom of their choices and calculating which approach provides the biggest bang for the buck.

According to a January 2003 report from the TowerGroup of Needham, Mass., service costs account for one-quarter to one-third of a mutual fund's total expenses and, consequently, directly impact fund returns. "Firms have to look at their core competencies and what their expectations are for managing their businesses," said Gavin Little-Gill, senior analyst with TowerGroup.

Beyond the usual outsourced functions, fund firms are carefully considering which additional functions and services that they've traditionally handled themselves may best be strategically outsourced. Where new markets are created, such as with hedge funds, offshore funds, 529 college savings plans and managed account programs, fund sponsors are carefully considering whether they could or should provide the servicing internally through affiliated companies or opt for external servicing from the get-go.

Outsourcing is often a solution adopted by those fast-growing fund firms that become victims of their own success at attracting assets. Many times fund firms will start off handling the administration of a new program themselves, said Jim McCoy, director of sales and marketing for the managed account program at PFPC of Wilmington, Del., the servicing unit of PNC Financial Services Group of Pittsburgh. "But as they get enough assets on the books, it becomes obvious that it's difficult to achieve scale," he said. "Clients often want a variable cost structure that will align with their variable revenue."

"It's a scalability issue," said Michael Delfino, president and CEO of ING Managed Account Group in New York, which earlier this month hired The Bank of New York (BONY) to manage the 30,000 accounts and $7 billion in assets under its managed accounts program.

"When we viewed the past two years' growth rate, we saw that we had more than tripled the number of accounts. But our principal business is not really managing a back-office operation," Delfino added. So ING struck the outsourcing deal with BONY under which 50 ING employees would be transitioned to the bank as employees.

"This seriously gives the managed account [sales] group the ability to focus on the core business," Delfino said.

It often comes down to the client's desired focus, noted Andrew Bell, SVP with BONY. "Do they want to be bothered with Y2K fixes, decimalization changes, Euro conversions? Do they want to deal with all of the technology and operational issues - or manage assets?" he said.

Looking Deep Within

Fund company executives are also analyzing whether even such core services as the distribution of fund shares, might benefit from an alliance with an outsource partner.

In some cases, fund sponsors have decided to reach beyond the usual outsourcing service contracts and are now hiring many of the same outside organizations to handle rather mundane but important investment portfolio-related tasks, technology development and day-to-day operations.

One early pioneer was the famed fixed-income shop Pacific Investment Management Company (PIMCO), which in May of 2000 decided to hand over the reigns of its mutual fund operations in Newport Beach, Calif, including a staff of 300 employees, to State Street Corp. of Boston. After a 10-year administrative outsourcing relationship with State Street, PIMCO executives decided to further relinquish control of certain tasks such as pre-trade research and trade settlement, to focus solely on managing assets, putting State Street in the driver's seat at its West Coast operating facility.

A similar agreement was inked between State Street and J. & W. Seligman of New York this past Spring. In May 2002, after a 14-year outsource relationship, Seligman additionally turned over its trade support and settlement, portfolio recordkeeping and custodian communications for settlements to State Street, but strategically chose to retain control of all client service and communications. Previously, State Street had provided fund accounting, fund administration and custody for Seligman's domestic and offshore funds with $16 billion in assets.

Right now, Seligman is being migrated to a new technology platform and its operation is being moved to Princeton, N.J., where a staff of 40 technology professionals now reside, noted Tom McCrossan State Street EVP. There's been a lot of talk about outsourcing, driven by the deterioration of asset bases, rising costs and opportunities to shed expenses, he said.