mutual fund wave. Seventy-five years ago, the institution, then at the corner of State and Exchange streets in downtown Boston, was mainly known for making loans to maritime businesses.
But when a little-known company called Massachusetts Investors Trust asked the bank to be the custodian for the first-ever mutual fund, it agreed.
That mutual fund has grown into Massachusetts Financial Services, a giant with $114 billion of assets under management. State Street, meanwhile, is in the final stages of phasing out its commercial banking business, and has narrowed its focus to providing an array of services for institutional investors. Catering to the custody needs of mutual fund companies is the single biggest part of its business.
As the fund industry has grown into a $6 trillion colossus, State Street has increasingly staked its fortunes on the custody business, and to a lesser extent, those of asset management and financial markets.
In the early 1980s, State Street sold or closed all but half a dozen of its retail branches. Later in the decade, it sold its credit card business and a data processing business serving thrifts.
In May, the company sold the remainder of its commercial banking business to Citizens Financial Group, Providence, R.I. State Street pared back in part because those businesses were cyclical and because it was too small in them to be a dominant player.
And in part it got out because the business of serving institutional investors was more attractive, promising tremendous growth.
State Street is the biggest full-service provider for 1940 Act mutual funds and funds outside the United States, according to Securities Data Publishing. It handles everything from accounting to pricing and administration for 2,200 U.S. mutual funds and 1,566 investment trusts abroad that have $1.279 trillion of fund assets under custody.
In all, State Street itself has $5.3 trillion of assets under custody, including pension plans, endowments, and insurance company assets.
It also provides performance analysis and other services that help fund managers and fund companies be successful. Despite its dominant position, the company says it will not grow complacent because its clients will not allow it to.
"The Merrills, the Scudders, the Federateds are not complacent people," said David A. Spina, president and chief operating officer of State Street. "They certainly keep the bar high on what their information needs are."
Art Cherry, president and chief executive of Federated Service Co., the back-office arm of Federated Investors, said State Street's technology was a strong point. "They continue to invest a lot in people and systems," he said.
State Street spends lots of money to keep its clients happy. Technology costs, everything from buying computers to keeping data centers up and running to paying programmers and telecommunications engineers, accounted for a fifth of the company's operating expenses, or $413 million, last year.
That technology gives State Street the ability to meet the challenges presented by ever more sophisticated financial markets, allowing it, for example, to price derivatives quickly at the end of the day.
The custody business has undergone a major consolidation in recent years. There are now a handful of big players who focus on mutual funds, all of them based in the United States, such as PFPC Inc., Chase Manhattan Corp., and SEI Investments.
Custody specifically refers to keeping stock certificates and other assets for mutual fund companies, pension plans and other clients. But the term is also used to describe what happens after a trade is executed: settling trades, moving money, safekeeping the securities, collecting interest and dividends, monitoring stock splits and bond calls, accounting, determining daily valuations, and providing analysis on why the investments performed as they did. It also includes fund administration and compliance checks for tax and regulatory purposes.
Custody is the largest part of State Street's business, and is part of a larger function, services for institutional investors, that accounts for more than 70% of the company's revenues. The mutual fund industry is State Street's biggest client area.
The consolidation was largely caused by pricing pressures that allowed companies with the most scale to dominate. But the growth of the asset management business around the world means there are still plenty of opportunities for custody companies including State Street.
"They are living off the most rapidly growing business in financial services, which is supporting asset management," said Bob Tetenbaum, executive vice president, First Manhattan Consulting Group.
Mr. Spina said that several trends were fueling the growth of mutual funds and retirement plans, including longer lifespans, the shortcomings of pay-as-you-go retirement plans around the world, and the increase in cross-border investing.
"All that fuels demand for our services," he said. "We think there is enormous growth potential not only in the U.S. but abroad."
But State Street and its competitors should not expect a cakewalk. They face an array of challenges, said Mr. Tetenbaum.
For example, the investment industry around the globe is moving to a shorter and shorter settlement cycle, and custodians must be able to keep up with the change. A downturn in market valuation would reduce assets under custody and thus revenues.
And the adoption of the euro threatens to hurt profitability in State Street's foreign exchange business by reducing the number of exchange transactions.
State Street's competitive advantages in the custody business are one reason the company has shed other parts of its franchise.
"We did that on the theory that to succeed in commercial banking you have to have a distinctive competence," Mr. Spina said.
Mr. Spina said that the company's growth abroad was an extension of its business catering to U.S.-based fund companies.
"To serve our U.S. customer base well, we must provide global services because the large mutual fund companies in the United States are registering funds in different locations around the world," Mr. Spina said. "Our products must work as well in Munich as in Muncie."
State Street has been building its global custody and global investment management business for a decade and now has 2,500 employees outside the United States. The company expects business to start to become significant in Europe within five years and in Asia within 10 years, as pension reforms take hold and the choices available to individual investors multiply.
That foreign business, in particular pension business, is a vital piece of the puzzle for the custodians who want to succeed because profits margins outside the United States are bigger than they are domestically.
"Profitability of the business is based on demand for non-U.S. custody, since U.S. custody profits are small in the basic core business," Mr. Tetenbaum said. "The international custody area is a profit-making enterprise for all these guys."
And the most profitable businesses of all are ancillary ones such as information reporting, risk management and compliance reporting, and foreign exchange.
Information reporting involves telling clients things such as what sorts of assets they hold, where they hold them, and how they break down by industry and by type of security.
Risk-management and compliance reporting allows retirement plan sponsors and mutual fund directors to ensure that the asset managers they are associated with follow the agreed-upon investment guidelines. Foreign exchange simply involves translating currencies when cross-border trades are made.
Having the total package is the key to success, Mr. Spina said.
"The real key is the ability to provide solutions for large, sophisticated institutional investors," he said.