“Absolute size, by itself, is no indicator of success and achievement, let alone of managerial competence. Being the right size is.” – Peter Drucker, author and management consultant.
What is the right size for an investment fund’s internal staff? What are the drivers behind the size of a fund’s front-office operations, responsible for day-to-day investment activities? How big should back-office functions – responsible for governance, operation and support – be in relation to the front office?
To answer such questions, and gain insights into the investment operations of large global funds, CEM Benchmarking undertook a study in 2016 of 26 such organisations with total assets in excess of $2.7 trillion. CEM looked at the full-time equivalent (FTE) headcounts of both front- and back-office staff. The study’s findings confirmed that staffing levels are a poor predictor of total fund cost once external management expenses are included. Further, while our clients often express a belief that the back office should have staffing levels similar to the front office (roughly a 1 to 1 ratio), the findings showed this rule of thumb is, at the very least, overly simplistic and in many cases not useful at all.
For front-office operations, the number of FTE primarily depends on:
Asset size – the more assets funds have, the more front-office FTE they have
Asset mix – the more illiquid assets funds have, the more front-office FTE they have
Implementation style – the more internal management funds have, the more front-office FTE they have.
Within this framework, strong relationships can be seen, and close to 90 per cent of the variation in front-office FTE is explainable through a combination of these factors.
To illustrate the utility of the model, compare the FTE intensity of external active public equity to that of internal private equity. For internal private equity, one FTE would be expected to oversee about $0.2 billion in assets as opposed to about $2.5 billion for external active equity, a 12-fold difference (and this is before considering differences in economies of scale between asset classes, which can be profound). However, the cost of internal private equity is lower than for external active shares, showing that having fewer staff members does not translate into cost savings.
Front office predicts back office, with some caveats
The survey did show a robust relationship between the size of the back office and the front office. However, the ratio was close to 2.5 to 1, rather than the often-cited 1 to 1. This single figure hides important findings:
There is a base level of back-office FTE required, regardless of the size of a fund’s assets under management
This base level varies dramatically based on fund complexity and the number of functions a fund chooses to do in house. For funds of lower complexity, the base level is about 20 FTE. For complex funds with most back-office functions performed in house, this number grows to 240 FTE
Once this base level has been realised, about 1.2 back-office FTE is required for each additional front-office FTE, regardless of fund complexity and in absence of any changes to the investment program.
Funds with complex investment programs generally exhibited much higher FTE counts than would be expected based solely on their amount of assets. This increased FTE is a poor indicator of cost-effectiveness because:
The largest cost for most investment funds is external manager fees, with the cost of internal FTEs being relatively immaterial
Performing back-office activities in-house is often more cost-effective than outsourcing.
These more complex funds exhibited elevated headcounts across all back-office functions; however, the increase in information technology support was responsible for more than half of the increase. Based on the data (see charts below), it appears there may be a tipping point at which organisations feel it becomes cost-effective to in-source many back-office functions.
The more complex organisations cited several reasons for insourcing back-office functions, including:
Ability to run more robust and customised risk monitoring
Running complex derivatives programs involving a large number of over-the-counter derivatives.
Economies of scale vary by asset class
Another area of interest was economies of scale in the front office. While these were evident, they varied greatly by asset class:
Strong economies of scale were present in the management of indexed public assets, whether they were managed internally or externally
Weaker economies of scale for actively managed public assets, particularly internally managed active fixed income, for which economies were not significant
No economies of scale in the management of real estate or private equity, regardless of whether these assets were managed internally or externally.
Ultimately, asset size, asset mix and implementation style drive front-office FTE. Back-office FTE is driven by front-office FTE, but with important distinctions for larger, more complex funds, which have much higher staffing levels, relative to asset base, than smaller funds. That these higher staffing levels do not result in higher overall costs reflects the fact external management fees remain the biggest cost driver for most funds.
The findings of this study are of interest to funds that want to:
Plan for growth – how your FTE will grow as your assets under management increase
Prepare for change – determining how many FTE you will need to move into new asset classes or change implementation styles
Understand differences – why some organisations have more or less FTE than others.
Michael Reid is vice-president, relationship management, at CEM Benchmarking. Alexander Beath is a CEM senior research analyst.