An open attitude that strengthens contracts

Regulatory changes and the increasing need for distributors to offer a wider range of investment products to their clients are contributing to the growth of sub-advisory arrangements across Europe.

According to Alex Fletcher, European head of third-party distribution at Goldman Sachs Asset Management (GSAM), the arrival of Ucits III is an exciting development for fund managers, distributors and clients.

“It means portfolios can be run with more flexibility using a broader range of tools that can theoretically generate more alpha,” Mr Fletcher says. “I think it creates new opportunities for sub-advisory that weren’t there before.”

Ucits III allows for the development of new investment products and strategies under a straightforward fund form. That could mean that banks that currently do not have those types of investments among their product range would consider including them. Then, if they don’t have the expertise to develop them in-house, this could lead to outsourcing to third parties.

It’s probably still early days to assess how big the impact of Ucits III will be on the growth of sub-advisory arrangements, but things look promising.

“At the moment there is a lot of focus on absolute return products, in particular in Southern Europe, and blending different Ucits III-type strategies into total return products is already happening,” Mr Fletcher says.

Types of relationship

Over the last few years, the number of banks and other distributors deciding to outsource the management of part of their investment portfolio to a third party has increased considerably. Depending on the particular needs of each individual bank, sub-advisory arrangements can take any of five different forms: delegation of fund management, multi-manager arrangements, range completion or ‘white labelling’, currency overlay, and model portfolio (see table).

The relationship between the sub-adviser and the client is more or less stronger depending on the type of arrangement in place, but in many cases it does evolve into quite a strong partnership.

“The client of a big bank is the client of the big bank, and if they get offered something that seems reasonable, I don’t think they are going to disappear off to another big bank to compare” - Alex Fletcher, Goldman Sachs Asset Management

Banks deciding to outsource sometimes are concerned this move can be seen as a weakness, ie not being able to manage everything in-house. But, more and more, outsourcing is being seen as a strength as customers recognise no-one can be good at everything and must trust their banks to choose competent partners.

“I think there might be a few people that still think of this as a weakness but they are very much a minority,” Mr Fletcher says. “I suppose the main reason why some people don’t do it is probably related to margin-type issues. When you are upgrading your portfolio management offering and hiring managers that have a proven record and a process that has delivered consistent alpha, that comes at a price.” Ultimately, he adds, that price is justified by the fact that it will lead to more sales and happier customers. “But in the short term there may be a gap where you are suddenly paying more for your portfolio management.”

David Curtis, head of UK sub-advisory at GSAM agrees: “People who have done sub-advisory successfully have seen that whilst the margin might decrease, they take much more in sales and, really importantly, they are selling more appropriate and robust products that are more suitable to their clients.”

Mr Curtis explains that different countries in Europe are at different stages of development when it comes to sub-advisory and open architecture. “In the UK, the move from with-profits into unit-linked has been very dramatic over the last few years and because of that the UK has been embracing a mutual fund culture at the same time as open architecture has been prominent in the marketplace,” he says. This, added to the fact that distribution in the UK mainly has been through the IFA channel, has resulted in this market moving into open architecture faster than others.

Mr Curtis mentions that the growth of fund of funds in the UK has been very significant, with increasing numbers of advisers offering these vehicles to clients. “Also, all of the big banks are now offering multi-manager products at the front of their investment product range not only to new clients but also to existing ones.”

Significant developments have been also taking place in France where banks are now much more receptive to sub-advisory than they were in the past. “There is a much more open attitude than there was two years ago,” Mr Fletcher points out.

“Also German banks, although they haven’t outsourced, they have taken a pretty aggressive approach to guided architecture which is a very close relative of sub-advisory,” he says.

Indeed the drivers behind sub-advisory and open architecture are very similar, being related to customer demand and the impossibility for banks to offer every type of product in this increasingly complex market.

Apart from Ucits III, other regulatory changes affecting local markets are also having an impact on the future growth of fund management outsourcing. In Spain, the expected development of the fund of hedge fund sector as a consequence of a new legal framework will probably increase interest from banks in sub-advisory solutions. “It will be very surprising if people end up doing it themselves, so that could be a good opportunity for outsourcing,” says Mr Fletcher, adding that as complexity increases, outsourcing becomes a more likely option.

More techniques to create alpha

One of the most interesting factors to take into account is that all these developments are taking place at a time when investors have realised they can’t expect the same high return from equities they were used to years ago. “People realise now they can’t get the same nominal returns from just having beta that they had in the past,” says Mr Curtis. “They have to search harder for returns and one of the areas they look at is alpha rather than beta,” he says. “Ucits III gives us the ability to use more techniques to create alpha and hence people look for managers with specialities in those areas.”

As the market develops, the criteria banks take into account when choosing the right sub-advisory partner are also changing. Years ago, the selection was similar to an institutional asset management mandate, very much focused on looking at people, performance and process. Now banks are also interested in finding out more about how sub-advisers can help them by supporting their sales force, how good they are at product development and other added value services.

“Ucits III gives us the ability to use more techniques to create alpha and hence people look for managers with specialities in those areas” - David Curtis, Goldman Sachs Asset Management

“When we start a relationship with someone that hasn’t used a sub-advisory manager before, they are typically very cautious of giving us the exposure to the underlying clients,” Mr Fletcher says. “That changes over those first few years when you build more familiarity and you understand each other better. Typically they start to relax a little bit more and use you more widely to provide some of those added value services.”

Keeping it clear and simple

Banks are not necessarily too concerned about offering products that are exceptionally different to what their competitors are offering. They just want to offer products that are good and suitable for their clients. “The big banks want to be very clear about risk management and they want to have a clear, simple offering,” Mr Fletcher says. “At the end of the day, the client of a big bank is the client of the big bank, and if they go to the big bank and get offered something that seems credible, sensible and reasonable, I don’t think they are going to disappear off to another big bank to compare what they are being offered.”

Also, he adds, banks are not interested in offering thousands of products but just a well-selected range. “One thing that I think will happen less and less will be the big bank just offering a supermarket of funds,” he says. “People want choice but they don’t necessarily want to choose.”

Limiting the offering of investment products is the only way distributors can provide end customers with the information they need in terms of what they are buying and what they can expect from it. “An increasingly thorough regulatory regime means there is more and more focus on making sure the customer is treated properly,” Mr Fletcher says. “That in itself drives the banks and the big distributors to product offerings that can be very well communicated. If you have a tight range of products you are more likely to do this effectively than if you have hundreds.”

Although outsourcing is taking place across all different asset classes, Mr Fletcher says they have been particularly successful in attracting interest to their quantitative equity products. Looking at the future, he believes they will see more demand for fixed income products as people try to unconstrain this part of their portfolio.

Mr Curtis agrees: “Particularly in this market environment with rates rising, and perhaps a negative beta from fixed income, you need more alpha,” he says.

In terms of which type of sub-advisory contracts are more popular at the moment, Mr Curtis explains that in the case of the UK, range completion-type arrangements have been important over the last 18 months.

“A number of firms are saying ‘we don’t have the competence, so let’s go and hire it’. That gives me a lot of confidence that sub-advisory is going to be an even more important part of this marketplace.”

“We have seen examples of range completion in the investment trust markets, inside the banks and inside the insurance companies,” he says.

Mr Curtis explains that requirements to be able to offer a full range of asset management are getting more stringent. “We used to talk about businesses with less than £5bn (e7.2bn) being unable to offer full range fund management,” he explains. “But I think that bar has gone up probably to £30bn or £50bn.” The reason is that increasing complexity of products requires larger investments in people and technology that only the very large banks and asset managers can afford.

Increase in opportunity

“As regulation changes, in five years time it might well be that the thing you bought that was sold to you as an absolute return product, is really using the same techniques that a hedge fund is using now. So I think this regulatory change will force people to think more about the separation of alpha and beta and that in turn will generate more opportunities for specialist fund managers,” Mr Fletcher says.

Improving investment choice by using external expertise is the best recipe for banks to keep their clients happy and to focus on what they are good at. Although sub-advisers can get pretty close to those who hire them, when it comes to their clients banks still prefer sub-advisers to keep away.

“Distributors want us to be as helpful as possible and we certainly recruit people that are able to communicate our message in a simple way. But in most cases I would say that distributors want to rightly control the relationship with their clients.”