A shift towards external expertise

Sub-advisory roundtable, June 2007, Milan, Italy.

Participants:

• Giovanni Bagiotti, head of wealth management, Mediolanum
• Tommaso Corcos, chief executive officer, Fideuram Investimenti
• Marcello Esposito, head of products and marketing, Xelion Bank
• Alex Fletcher, co-head of distribution, EMEA, region, Goldman Sachs Asset Management
• Xavier Sement, deputy head of research, BNP Paribas Fundquest
• Roman G. Trageiser, head of institutional business services, Allianz Global Investors
• Vincenzo Volpe, head of Italian business development, Goldman Sachs Asset Management
• Panel chairman: Yuri Bender, editor in chief, Professional Wealth Management

Yuri Bender: The aim today is to discuss developing issues around the sub-advisory market including the rationale for the development of the business, the influence of regulations, the difference in approach between global and local distributors, the use of boutiques versus large houses and the role of private bankers, advisers and Italian promotori finanziari in marketing the products.

Tommaso Corcos, at Fideuram Investimenti, can you expand on the kind of cultural change and battles that take place within a bank moving towards the use of sub-advisers from a purely internal platform, and what led to this kind of move within your ?65bn funds house?

Tommaso Corcos: We were already creating our own products, managed by different asset managers, who are the best in each class. But we realised that our customer base would also like a wider product offering, so we put more emphasis on this.

Basically, our change of strategy means we are moving in the same direction, but with a deeper and stronger emphasis. This has had an impact on our asset management company, which has moved towards new duties of selecting multi-managers and working with them in a partnership. We have changed our role from being a pure product factory to an advisory house that provides sophisticated solutions to our customers. These cannot necessarily be built inside our own skills and professional competence. But they can be reached through a strategic partnership like the ones we entered a couple of years ago with some of the people who are present at this table and other strategies we are undertaking with different companies. It has also been a major change for us because it gave us the possibility of providing more sophisticated and customer-tailored solutions.

“Our private bankers, who have the strongest relationships with the customer base, are using more products of external fund managers to meet demand for investment ideas” - Tommaso Corcos, Fideuram Investimenti

Our private bankers, who have the strongest relationships with the customer base, are using more products of external fund managers to meet demand for investment ideas. For instance, they used products of third party managers to enter geographic areas like India or China because we didn’t have the right products internally. It would be strange for us to start proposing ourselves as quality managers in such a far away market. But we have also seen private bankers channelling clients into internally managed products, which is the confirmation that we are a quality producer in certain areas. We have also seen investments re-directed from products like money marketing instruments and short-term bonds, linked to interest rates towards more dramatic stories like India and China.

We have also opened our platform for private bankers to buy the funds of selected asset managers. To facilitate this, we closed a lot of deals with the best managers around the world. At the same time we also use funds managed by third parties to enlarge our offer in managed accounts.

We use JPMorgan and Merrill Lynch for instance, to manage resources and alternative energy funds. Those are the stories that capture the attention of private bankers. Rather than substituting these for other products sold to customers, we have seen an enlargement of our offer.

So the seeds of this change were already inside the company. We were already choosing a certain type of asset manager to manage a certain type of niche market for us. We realised that as soon as the offer became larger and the sophistication of certain products increased, we would need a more flexible business, to give a clearer strategy. For instance, the agreement we have with Goldman Sachs Asset Management (GSAM) provides the type of sophisticated product customers asks for – a certain type of solution we would not be able to provide by ourselves.

So we choose to enter a certain type of partnership. While the asset management company can choose the product, the customer might have some particular needs because they like the story behind different types of products that provide extra yield or are more related to planning or investment for long-term needs.

Marcello Esposito: We do not have the case of sub-advised funds that are branded Xelion, because we are an open-platform, distributing funds of many asset management companies and we don’t have our own asset management factory. Having said that, we don’t think that offering Xelion branded funds, sub-advised to external managers, could represent a competitive advantage. On the contrary, if you are offering your own funds, sub-advised by different asset managers, the clients probably don’t perceive the difference with respect to a pure captive or mono-manager offering. In other words, in our opinion, there is an advantage in offering funds of different brands, leading to a greater transparency in the commercial proposition with respect to the clients, a more efficient service model and to better performance in terms of sales.

“The industry has to provide a deluge of data to the clients and it doesn’t translate into more information” - Marcello Espositi, Xelion Bank

When we have offered funds managed by Goldman Sachs, for instance, under GSAM’s own brand, the clients have perceived the difference with respect to the other funds already on the platform, and in our experience, the sales results have been good.

Since we opened the platform to third party managers, the share of funds managed by our captive company has gone down to 35 per cent. I expect this will go down further, because you do not expect to see more than 20-30 per cent concentrated in a single house inside a well managed portfolio of funds. If you are a good promotore, you are a good financial adviser, and will diversify the sources of alpha inside the portfolio that you sell to your clients. We invest a lot in training our financial advisors. We have advisory instruments where we rank the funds and the natural result is to build a balanced portfolio

Yuri Bender: How do you calculate the payments that reward the distribution? Is a very high kick back expected by distributors in the Italian industry? Does that alienate some managers?

Marcello Esposito: There are differences obviously in management fees and rebates across countries and financial markets. The real challenge for foreign factories, when they enter new markets, is that they need to have good sales people inside the country in order to understand what the local peculiarities are and in order to be very near to the clients’ needs.

It is impossible to sell products if you don’t do appropriate marketing, which means, among other things, continuous training of the sales forces and providing all sorts of informative support. We are in an industry where information is the king. If a company wants to enter a new market, it is crucial to inform the clients about the quality of its own products, and explain to them why they should change their portfolio holdings and buy its products.

The real problem is then the investment the manufacturers need to make, the fixed cost they have to sustain in order to enter a new market or enter a new distribution network. They need to make a long-term investment in order to be able to win the share of mind of the local salespeople and their clients. Kick backs are not the problem.

Yuri Bender: If I can bring in Vincenzo Volpe from Goldman Sachs, bearing in mind what Marcello has been saying, that they are looking for the correct marketing from external partners, how close can you get to the actual sales people, the private bankers in the networks? Would you just be dealing with the likes of Tommaso and Marcello or do you have the opportunity to get very deep into the networks and deal with the promotori themselves and somehow influence what they are selling?

Vincenzo Volpe: Hearing what Tommaso and Marcello are saying, it is clear that communication has become quite a key success factor if you want to be picked as a sub-adviser. It is also vital in the final phase, working with the promotori finanziari, showing them exactly what you can do for them, how you can help them and how committed you are to giving them more information on the products and services you are offering.

“It is vital in the final phase, working with the promotori finanziari, showing them exactly what you can do for them, how you can help them and how committed you are to giving them more information on the products and services you are offering” - Vincenzo Volpe, Goldman Sachs Asset Management

This is mainly justified by the main changes that we see in the market, which impact products and services. On the product front, it’s not just a question of being very sophisticated and specialised, but being able to capture the new innovations and evolutions happening in the market. These trends give the industry the possibility to instil more efficiency into portfolios.

But creating more sophisticated portfolios is not just about manufacturing capability. It necessitates deep and careful communication when you speak to the promotori.

Advisory capacity also plays an important role in being picked by a distribution network, which needs not only your skill in providing ingredients for their portfolio, but also your ability to communicate how specific products may fit into the global balanced product. Another aspect of the advice is a new trend towards asset allocation products that we have been studying in the Italian market. Again, we are picked not just because we can be sophisticated or innovative providers, but because we can create asset allocation portfolios that may respond to VaR (value at risk) constraints or risk identification, and it is up to us to use the ingredients that we have got to provide the final investment solution for the promotori.

Again, in this case it is not only key to have an effective manufacturing centre, but also very, very important to the promotori and explain very clearly and in effective manner the value proposition of each of the proposed investment solutions.

Yuri Bender: Giovanni Bagiotti, foreign fund managers have been very keen in the past to get into the sub-advisory roster of the Mediolanum funds. There is a lot of competition to do this. You have distribution power and a very robust process of selling in this market. Vincenzo painted a picture of a process where the investment and the sales functions are very closely interlinked. But do investment policy changes such as liberalisation of eligible instruments laid down by the European Ucits III regulations, really have much space in your sales pitches?

Giovanni Bagiotti: Ucits III and regulations are issues and themes we communicate to our advisers, but they are not necessarily the most relevant ones. Vincenzo painted a picture, which we do not necessarily agree with. We want to create and manage directly the product cycle of our funds, so we don’t let external advisers access our network. This is because our sales process is very specific, has been built over time and an external interaction would not add much value.

“Our experience is that we end up not buying the whole array from an external provider, but we stick to what they do best. Finding out who these companies and boutiques are is key to our success” - Giovanni Bagiotti, Mediolanum

From a technical point of view, Ucits III is a seminal piece of work, and we have done some very interesting things with it on the technical side. But the product is a means and not an end. Basically, the client is not that interested in the details of how the product is managed. They are more interested in their asset allocation and the way their portfolio is built. We do different things to Xelion, but the idea is somewhat similar.

That’s also why we do not sell third party products but we have absolutely no problem in having third party managers manage our products. Given the structure and focus of our group, it is totally irrelevant whether we manage the money internally or externally. Because we think we cannot cover many asset classes effectively, we have most of our money managed outside. But let us not forget that often, we find there are some needs where exposure be more efficiently covered by index-linked or structured products.

Yuri Bender: Alex, he doesn’t like external managers having access to the networks. That’s forbidden. Is that fair enough from your point of view?

Alex Fletcher: Yes. I think that ultimately the end client is really what matters here. If the end client is getting a sensible asset allocation that’s been well explained by someone, then I don’t think we have a lot of value to add. I think there are lots of different ways you can approach this, according to which model you are operating in. For instance, one of the UK banks sells our private equity fund of funds. We’ve never been asked by them to come and have any kind of contact with their private bankers as far as the multi-manager product is concerned. However, when they wanted to introduce our private equity fund of funds into their private banking sales force, they absolutely wanted us to come and talk to them.

“Ultimately, the end client is really what matters here” - Alex Fletcher, Goldman Sachs Asset Management

Yuri Bender: In Italy’s ?600bn fund market, in 2005 alone we saw ?12bn in foreign fund sales and similar outflow from domestic Italian funds. Is the exodus from domestically-managed mutual funds by Italian investors an indication that they don’t trust the products on offer?

Giovanni Bagiotti: If we consider the way funds are often created and marketed, I notice growing obsolescence of the fund as a vehicle and the value it offers to the client.

Currently, approximately half of our sales are in structured products and this happens for very specific reasons, which I’ll try to explain via an analogy. If you decide to marry, you do it with a certain time horizon – hopefully infinity! The same kind of process applies when you sell, for example, an equity mutual fund where you are supposed to have a more finite 10-year investment horizon. Once you have agreed what that specific investment horizon is, other products, such as capital guarantees, may provide you with a more interesting payoff than plain vanilla mutual funds. This explains why banks have not only an incentive, but also an ease in selling other products beyond funds.

Vincenzo Volpe: Looking at quarterly reports from the Bank of Italy, we see the vast majority of money is still invested in cash and very liquid products. This is a sign of a very expensive market, when you end up buying products from the classic banks or distribution channels. Final clients currently invested in short-term fixed income, absolute return or cash products are not receiving the returns they expected.

We should also consider the effects of Ucits III on returns, because the use of derivatives, allowed by Ucits III, help to save on trading costs. The new techniques in portfolio management also help manufacturers to provide more active products in a more efficient way. This allows old investment solutions such as funds, to be reshaped and to gain more space in the market, in particular in comparison with what we see happening with structured products.

Marcello Esposito: The percentage of mutual funds directly held inside a typical customer’s portfolio has shrunk dramatically in recent years. A big part of this is due to the distribution priorities of the major banks, which put more emphasis on wrapped products, like unit-linked policies or segregated accounts, embedding a financial advisory content and then allowing for a premium price with respect to stand-alone funds.

Yuri Bender: Xavier from BNP Paribas Fundquest, when you design products for external clients – looking for instance at the BNP Paribas merger with Italy’s BNL, where you have successfully sold multi-manager products designed in France through Italian branches – how is the decision made whether to include sub-advised, external segments in those funds?

Xavier Sement: At the private banking level in BNL, we tried to replicate the business model that we had at the private bank of BNP Paribas in France, which operates as a joint venture between the retail network and private banking. Whenever the retail network identifies a client who could be raised to private banking status, they move them up and do not lose out.

“The rationale behind this rebranding was to better reflect our philosophy” - Xavier Sement, BNP Paribas Fundquest

This is why the relationship goes so well. We tried to replicate this business model at BNL and in terms of product, our philosophy at BNP Paribas has always been to stay well ahead in terms of open architecture, but we would rather talk about ‘guided’ open architecture. The degree of openness is different according to the clients. For the private bank, for the affluent portfolios, open architecture, I would say, is mixed, whereas for high-net-worth individuals with high-net-worth portfolios, open architecture is complete.

We are controlling this open architecture through Fundquest, where the manager selection efforts of the BNP Paribas group are concentrated, in order to always provide clients with the best products.

Yuri Bender: Are you using the large, big-brand managers, or are you working with the boutiques as well?

Xavier Sement: We are working with talents, where we can find them. There are many talents in boutiques obviously, but we can also find talents in larger asset management groups. I think we have no pre-conceived ideas on that. Our research efforts, though, are concentrated on finding active managers, as part of the core allocation of our portfolios can be managed through trackers.

Yuri Bender: Looking at the way BNP Paribas Asset Management has re-branded itself as ‘BNP Paribas Investment Partners’, in a so-called village of boutiques structure, does this mean that now you’ve got this whole group of boutiques in the same company, you are more likely to outsource management internally, rather than to outside groups, because you have so many specialist centres within the company?

Xavier Sement: No, because the objective is to find the best product for the clients. If we find them inside the village of boutiques, as you pointed out, we do it. But if we don’t, we go outside. To give you a concrete example, in portfolios that we manage at FundQuest, only 5 per cent of the underlying funds come from the BNP Paribas group, so it’s a very small amount.

The rationale behind this rebranding was to better reflect our philosophy, but sharing resources such as risk management and compliance, as well as distribution.

Vincenzo Volpe: I believe we are talking about a sign of the times. You can call it open architecture, you can call it sub-advisory, you can call it a village of boutiques. You want to be excellent in the way you serve your clients, so it’s up to your business model and the effectiveness of the interaction you can have with potential partners. It allows you to distil solutions in different markets and different segments.

My strong perception is that the more you go up in the sophistication of the final client, and specifically the more you approach the private banking profile, the more you have to offer open architecture products or multi-manager products. You have to step into some external villages because this is what eventually the market asks for.

Also, you need to create a positive set of synergies whereby you understand where you want to buy in external expertise, and where you want to grow internally in order to align your interest, the interest of the potential distributors and the interests of the clients. This is something we will see more and more in the future.

Yuri Bender: The German fund industry has seen similar trends to the Italian one in terms of outflows from a lot of the German groups. Do you see any preference for assets managed by groups outside Germany?

Roman Trageiser: On the one hand, that reflects a Ucits III factor, because many institutional clients with a Ucits III fund now have the possibility to build real, cross-satellite products and use international asset managers either for their core and/or satellite investments. They don’t have to build a segregated account for some dedicated asset class, but they can buy an institutional share class in the Ucits III fund.

“From a German point of view, the asset management industry is still not sensitive enough to costs. As a result, the sub-advisory business will grow in the future. We have asset managers with a team of six to eight portfolio managers, managing assets of below ?1bn, and that cannot be cost-effective” - Roman Trageiser, Allianz Global Investors

The other reason is that retail clients are much better informed due to the work of the press. They see that, for example, a Fidelity product might be better than a DWS product or an AGI product and they might choose that one.

From a German point of view, the asset management industry is still not sensitive enough to costs. As a result, the sub-advisory business will grow in the future. We have asset managers with a team of six to eight portfolio managers, managing assets of below ?1bn, and that cannot be cost-effective.

Yuri Bender: Something that many people often overlook is that the back office is often doing due diligence regarding sub-advisers. Due to operational matters, these people have to be able to work with a sub-adviser they can interact with. In reality, how much of the choice of the sub-advisers is down to these operational factors rather than investment matters?

Roman Trageiser: Still too little from my point of view, because that’s exactly my core business. I have to work together with all these people and I have seen many times in the past that a financial consultant or a fiduciary manager has chosen be the best manager for emerging market equities but it took at least 8 to 12 weeks until we were able to buy this product and the market went up 25 per cent at that time.

I told the financial adviser, from a very early starting point, that we would have problems with that particular sub-adviser and I offered him the one we knew, who we worked perfectly with, but he stuck to his recommendation and at the end of the day, our common client lost his money.

In the segregated account business, financial advisers also look at the track record of the manager and want to choose the best manager. But in a segregated account under German law, it might be much worse than his normal track record reflects, because he is not aware of the specific German Investment Act and its restrictions. That’s part of the plan that might influence performance.

Yuri Bender: Do sub-advisers prefer to target a global distributor, with outlets in several countries, rather than a local bank that would only have a reach in a country or region?

Vincenzo Volpe: I would answer that question in two parts: first, with a comment on the phenomenon of consolidation that is happening Europe-wide and, second, with a comment on global distributors, which are a consequence of consolidation. We might take the Italian example or the European example. Consolidation is another sign of our times. We are seeing it in Italy and in Europe. Our strategy is to focus our attention on very big players, so that we create deep, thorough and long-term relationships that may justify, through additional efforts, our ability to win business.

This is particularly true when you end up striking sub-advisory deals, because the sub-advisory business, in essence, is a step forward following the purchase of certain funds. It is a proof of trust that a big company gives you, which is why concentrating our efforts on a few big counterparties makes a real difference for us. If you apply this strategy to global distributors, you try to follow them as deeply and as thoroughly as you can, while also trying to follow their life and evolution. An Italian example is the UniCredit Group, which became, a few years ago, a very important Italian distributor, enjoying an open-platform approach. It is now becoming, de facto, a global distributor, through which we can have access to many interesting markets in Europe.

Yuri Bender: We should also mention the Markets in Financial Instruments Directive (MiFID). With MiFID’s requirement for bankers to have a deeper knowledge of products sold by their bank, might there not be the scope to sell such a range of external and sub-advised products?

Alex Fletcher: I think it is likely, or at least possible, that it will move people, to a certain extent, from offering third-party fund links towards the model of picking underlying managers as sub-advisers. At that point, if it is a Dresdner or Mediolanum fund that happens to be sub-advised by us or, indeed, by the in-house asset manager, I do not think that that creates an issue from a MiFID perspective.

Marcello Esposito: It has a number of unintended consequences. A relevant consideration in terms of further development of this industry is in fact becoming the level of additional regulation imposed, which sometimes, although well intended, goes beyond its scope and risks to become the real entry-barrier for those companies that are unable to sustain increasing compliance costs. Moreover, sometimes we wonder if some measures, concerning for example the “disclosure” of commercial information, goes in the long-term interests of the clients. At the end, in fact, the industry has to provide a deluge of data to the clients and we are not sure that more data always translate into more information.

Tommaso Corcos: I would add that, generally speaking, most of MiFID is based on two main pillars: reducing conflicts of interest and introducing more deeply the concept of transparency. What can be brought forward by this directive is the creation of a more open European arena, so it will be more difficult for companies that are not performing in certain areas to sell their own products and will probably push more companies to choose open platforms.

But, more generally, I see the sub-advisory mandate becoming increasingly rational within the asset allocation solution, the provision of which has become the main duty of banks. I do not think that private bankers must choose the best product or the best market, since that translates into a search for the best performing share. At the same time, sub-advisory can work in an integrated solution of asset allocation. Probably the most interesting thing in the future is the approach of the hedge fund industry in the long-only fund sector, proposing solutions that might be an alternative to short-term bond funds, such as cash-plus or long-short, beta-neutral solutions.

Giovanni Bagiotti: As I commented before, most of our assets are managed externally. We do it because it is quicker for us to have an external adviser and then to build core competencies when they are required. Sometimes we notice that some specific sub-advisers are pulled along by client demand, and this requires careful consideration. Currently, it is a favourable environment for companies who focus on the client and packaging solution more than on manufacturing. As a buyer of these sub-advisory services, I would like to stress that, although I fully agree that size is relevant in some specific activities such as securities lending and administration, this is not necessarily the case for alpha generation. Ultimately, our experience is that we end up not buying the whole array from an external provider, but we stick to what they do best. Finding out who these companies and boutiques are is key to our success.

Vincenzo Volpe: To me, sub-advisory looks like a more natural way of introducing innovation to products, as well as efficiency and transparency. The more I think about it, the more I believe that this is what the markets really need.

Marcello Esposito: If we are talking about direct distribution of funds, sub-advisory is the last line of defence for captive factories. If MiFID is not applied by the financial distribution industry in an unintended and paradoxical way, but allows for a move towards a real consultancy and advisory model, there is no reason for another layer between producers and clients. At least as far as direct distribution to clients is concerned, in our opinion, the multi-brand solution will be the winning one, rather than sub-advisory.