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The geopolitics of asset management

Sep 03, 2014
by Dr. Michel Verlaine and Roberts Reimanis

The geopolitics of asset management
COST STRUCTURE: Comparison of total production and distribution costs for equity funds by member state based on current average fund sizes.

Opportunities for the Baltics

Most people, and even many finance professionals, think of the asset management industry as consisting of only investment managers and advisors. In reality, however, there are additional, so-called service providers that exercise different functions that make up the industry.
One typically distinguishes the following five categories of the industry: the investment advisor; accounting and administration; the distributor; the transfer agent; the depositary bank.
Apart from the depository bank, these services can actually be integrated into one legal unit, called the Management Company (ManCo). However, different business models exist, where those functions are outsourced to external service providers.

Service providers
It is important to highlight that an investment fund is, in principle, a different legal unit from the ManCo and other service providers. This implies that those units can be registered in separate countries. As an example, think about it as an investment fund registered in Luxembourg and the ManCo, or other external service providers, registered in another EU member state.

For governmental decision makers it is important to realize that the asset management industry is an industry like any other, with its value chains and different business models. Public decision-makers in Latvia that aim to develop the financial sector, other than banking, have to understand the way this industry is structured and how and where private entities decide to locate their operations.

The industry has exhibited tremendous growth over the last 25 years, with this growth expected to continue. This makes it interesting for small and open economies, like Latvia, to attract part of the business.
U.S. researchers Greenwood and Scharfstein point out that the U.S. asset management industry has grown from 1 percent of GDP to approximately 5 percent of GDP since 1980.
This means additional jobs in the service providing units.

The Latvian authorities have not been dynamic enough in developing a strategy to develop a well-regulated and efficient financial center, including asset management services.
In this respect, it is important to highlight that the asset management industry in the European Union has faced a notable transformation due to the introduction of Undertakings for the Collective Investment in Transferable Securities (UCITS) IV Directive. Amongst other provisions, the UCITS IV Directive introduced the so-called Management Company Passport. This means that a Management Company registered in one member state can offer services in another member state.
This is supposed to increase competition in the European internal market, which should lead to lower industry costs. This could also serve as a catalyst to increase investment into Latvia.

Control costs
The cost components of an investment fund consist of the following sub-categories, which are similar to the functions exercised by the service providers: regulatory compliance of the fund; audit; accounting; custody (depositary bank); transfer agency and asset management.
By asset management we mean the tactical and strategic decisions of the fund managers and their execution through buy and sell orders. Note that this part barely covers one fourth of the total cost of a fund in most EU member states.
The big cost components here consist of regulatory compliance and, notably, accounting.

Accounting and external audit are mandatory requirements for all UCITS funds operating in the EU. These are key functions as they help determine and verify the Net Asset Value (NAV) of the fund, where NAV denotes the value of the fund. Each day the NAV has to be evaluated, as this is the price basis for investors in buying and selling their shares - technically called redeeming shares.

If the fund is liquid and invested in shares quoted on a stock exchange, it is quite straightforward to calculate the value of the fund. If the fund invests in less liquid assets or in so-called complex financial products, it is more difficult to value the fund. Valuation experts then need to be hired, driving up costs. Qualified analysts can be up to 2.5 times more costly than standard accountants and auditors. This implies that accounting and auditing costs depend on the type of strategy the fund chooses.

One of the main costs in audit and accounting is labor, which varies widely across Europe. This implies that, under UCITS IV, we should see accounting services move to lower cost states, as long as the required skills are available.
Investment funds are also subject to regulatory requirements in each member state. Though the requirements are in line with the EU Directives, there exists some leeway in the implementation. Thus, the costs of complying tend to differ from state to state. For example, regulatory compliance costs over the previous decade in Germany amounted to approximately 70,000 euros, while regulatory compliance costs in Luxembourg and Ireland were considerably lower at around 5,000 to 12,000 euros. These differences are explained through more favorable regulatory requirements in Luxembourg and Ireland.

Even though the difference in compliance costs is rather negligible compared to a fund’s assets under management, this amount is not negligible in the total production cost. For the average European equity fund, regulatory compliance costs account for around 10 basis points in a total of 60 basis point cost.

Getting started
In that sense, another cost - authorization cost - is worth analyzing. A fund cannot start investment activities until the home member state has authorized the fund to carry out activities. The costs of such authorization vary. For example, authorization of a single fund in Italy costs 1,400 euros, while in Luxembourg it is 2,650 euros annually. In countries where this cost is based upon fund size, it could add a substantial annual fee. Latvia should impose any fees at the low end of the range.

Another issue is time needed for authorization. Funds won’t want to locate operations in countries that require long start-up times. While in Belgium the time for fund authorization approval takes 1 to 2 weeks, in Poland the process can last 5 to 6 months.

All those cost elements are important for funds in deciding their business models and where to base operations. From a policy perspective for a government that wants to promote the financial services industry, they are important to watch.
An additional consideration is that fund costs are a factor of fund value, with costs decreasing, as a percentage of assets under management, as fund size increases. For instance, for small equity funds that have 5-10 million euros under management (AUM), the accounting cost may amount to 40-50 basis points, whereas for larger funds, say from 150-200 million euros, the accounting services carry a fee of around 10 basis points.

This opens the door for Latvia and its neighbors to develop a niche target market. Given the local labor costs and the relatively good English language skills, the Baltic States could work to develop a financial services industry that provides services for the fund industry, specifically in the smaller and rather sophisticated fund sector. This would require an evaluation and development of the education system focused on producing a pool of skilled individuals to work in the industry, along with ensuring the necessary infrastructure is in place.
Moreover, Latvia with its Russian language skills has the potential to develop well-regulated financial services for the CIS market as well.

The upcoming Latvian Presidency of the EU will offer interesting opportunities for authorities to put these issues on the European Agenda and work on a common strategy to develop other financial centers.

Dr. Michel Verlaine is managing director of SLF “Specialists in Law and Finance.” Roberts Reimanis is a graduate of Riga Graduate School of Law. For more info: www.slf.eu.com.

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