Bonds and alternatives gain sub-advisory share

While assets have fallen across most of the fund management and private banking world, the business of contracting out sub-advisory assets to third party managers has proved relatively immune to the financial crisis. In some quarters, the importance of this strategic decision to outsource non core assets to carefully selected, closely supervised managers, while leaving the relationship with retail and high net worth investors firmly in the hands of the originating banks and insurance companies, is actually gaining in importance.

“As a result of the crisis, people are increasingly focusing on the services they offer to their clients and the performance they can deliver,” says Alex Barry, head of wholesale sales at JPMorgan Asset Management. “This means we are seeing an increased interest in sub-advising.”

According to the results of PWM’s 6th annual sub-advisory survey, 84 per cent of European asset managers and distributors of investment products have not been affected at all by the current bear market when it comes to their decision to sub-advise (see figure 1). The sub-advisory solution is considered a long-term strategic decision aimed at meeting client’s long-term needs, rather than a short term fix to improve performance.

“The main driver to sub-advisory is the lack of in-house investment capabilities in areas that are outside our core competencies,” says Filip Kostic, senior partnership manager at SEB Wealth Management, the Nordic firm that delegates stewardship of €1.5bn from its €100bn total to external houses. “Market fluctuations have no impact on this.”

More than 90 per cent of PWM’s pan European panel of 50 major financial institutions employ external managers to run segregated mandates. Sub-advisers are employed, mainly on a white-label basis, to manage a wide range of asset classes totalling €73bn. Equity investments make up the lion’s share of sub-advised mandates in most European countries (see figure 2).

Although demand for delegating money to a handful of successful third party managers is holding firm, patterns of demand are changing. In the bull market, the desire to offer alpha-generating products in niche asset classes strongly contributed to the sub-advisory growth. The majority of respondents questioned for the most recent research, however, revealed that mandates they will award in the future will be in the traditional or alternative space, with global, emerging market and European equity expected to be particularly prominent (see figure 3).

But the full story is even more complex, with more interest in the sub-advisory space for cash management and fixed income, as clients move up the yield curve.

Many players in the industry are recording increased allocations to fixed income. The private banking arm of Fortis for instance, has moved from a 40 to 60 per cent bonds allocation in its balanced portfolio, and these needs of the wealth managers are being reflected in some of the mandates being won by third party fund houses.

“Three years ago there was a lot of demand for equities, particularly the most esoteric in the spectrum,” says JPMorgan’s Mr Barry. “In the last year we have seen a significant increase in sub-advising in the money market and fixed interest areas, but this is a reaction to the crisis. In the fixed income space, in particular, people are looking at going more global. Investors may allocate more of their portfolios to fixed income in the future, and there is awareness that they need to diversify the risk away.”

Compelling evidence of healthy activity in the sub-advisory space is indicated by the fact that 52 per cent of participants in the survey are planning to award new mandates during 2009-2010, although this is in some cases driven by the need to change current sub-advisers.

Across the board, European financial firms report that they decide to sub-advise in order to focus on their core competencies and to search for higher returns or alpha. Many large asset managers struggle to produce alpha across a wide range of products and need to compete with an increased availability of passive instruments such as exchange traded funds, even to supply clients with the market return, notes Christophe Girondel, managing director at Nordea Investment Funds.

The active-passive separation will increasingly drive fund houses to select and employ the best managers who can generate alpha, he says. The desire to provide enhanced offerings to clients, with the additional benefit that funds may be specifically tailored to clients’ needs, is also an important driver.

Sub-advisory is considered a competitive differentiator, even more so in a bear market. “Sometimes it is more difficult to be successful in a bear market and sub-advisory can generate an opportunity of differentiation with competitors if your results stand out,” says Furio Pietribiasi, managing director at Mediolanum Asset Management, an Italian firm that sub-advises around 75 per cent of its E11.6bn total assets under management to external managers. Mediolanum presents the classical sub-advisory model, in that it chooses institutional quality managers from around the world to run money for its retail and mass affluent Italian clientele.

ABSOLUTE RETURN TRENDS

Asset allocation products – generally multi-asset products employing a broad and dynamic allocation – have the potential to become more popular in this market environment, according to two thirds of respondents from the PWM panel. “Via a single investment decision, investors enjoy cost-effective, comprehensive, standardised portfolio management services which best meet their need for security and stability in volatile times, as well as their return expectations,” says a senior manager at UBS Wealth Management in Switzerland.

Indeed, balanced funds with fixed asset allocation have proved to be inappropriate in the current crisis, says Philippe Zaouati, head of business development at leading French group Natixis Asset Management. “As the equity market went down very sharply, balanced products, which just give a manager very limited freedom to adapt asset allocation and risk management, have suffered a lot.” These products are constrained as they remain very close to the strategic asset allocation. “The future is in tactical asset allocation and flexible funds, where allocation to equities can move from 0 to 100 per cent,” he says.

Approaching 40 per cent of respondents believe asset allocation products present interesting opportunities for external managers. Sub-advisers with a proven track record may be able to leverage their expertise and insight in different asset classes, but there is also some disillusionment over fund managers’ ability to offer absolute return.

In the funds of hedge funds space, there is already an established trend of firms seeking external advice and will continue to do this in the future (see figure 4). Advice can be in the form of ‘full management delegation’, which is the most popular option, involving the whole portfolio construction activity being outsourced externally; or there is also the ‘model portfolio’ approach, where the delegator employs an external house to provide an advisory service and access to a platform of hedge funds, but constructs his own fund of hedge funds in-house.

Almost 30 per cent of respondents reckon performance issues faced by hedge funds last year, lack of liquidity and transparency, as well as event risk which culminated in the Madoff fraud in 2008, has increased the need for sub-advisers in the hedge fund space. There is greater awareness of the due diligence required and the resources needed to support it, as well as full understanding of the importance of risk management (see figure 5).

Andreas Feller, head of wealth management solutions at Switzerland’s Vontobel Bank points out that the size of many hedge funds has reduced to the point that it no longer makes economic sense to keep in-house selection teams. This is one the reasons that leads firms to seek sub-advisers in this alternative space. But others indicate that reduced client demand in the alternatives space, due to the poor returns and negative publicity last year, may imply reduced demand for sub-advisers.

Four per cent of respondents are looking to bring hedge funds of funds back in-house. The decision is driven mainly by the need to ensure that clients’ capital is not affected by the liquidity issues in the market and to have more control of portfolio construction. Six per cent of respondents have stopped or plan to stop offering hedge funds to their clients because of reduced demand.

In total, around 11 per cent of respondents will bring one ore more asset classes back in-house. In addition to hedge funds, these spread right across the board to include equities, bonds, cash and structured products, the latter a clear consequence of the collapse of Lehman Brothers and increased concerns around counterparty risk.

At Raffeisen, for example both emerging market equities and debt will be brought back in-house. Enhanced internal competency and cost factors drove the decision, says Klaus Glaser, head of product management at the Austrian bank.

LEADING PLAYERS NAMED

The most used sub-advisers by our panel of respondents are Goldman Sachs Asset Management and JPMorgan Asset Management, which tied for first place. Both houses are employed by 23 per cent of all the companies that have awarded mandates to external firms and have disclosed which sub-advisers they use (see figure 6).

Pictet, followed by BlackRock and JPMorgan were named as the top three sub-advisers.

Looking at manager selection criteria, 40 per cent of respondents said they selected sub-adviser based on long-term consistent fund performance. Management team, investment style, top quartile performance and track record are considered the other key criteria. What has changed compared to 2008 is the emphasis that firms put on risk management: in 2009, 7 per cent of respondents saw risk management as the most important manager selection criterion, versus none last year.

Similarly, the factors that drive firms to replace one sub-adviser with another are mainly fund performance and personnel changes, followed by falling service levels (see figure 7). Unprompted, seven per cent of the respondents mentioned that change in investment style/process is the most important driver for replacing a sub-adviser. Deterioration or lack of transparency was also mentioned by 4 per cent of respondents as a key reason to fire an existing sub-adviser.

Alasdair Prescott, multi-manager product specialist at HSBC Global Asset Management, explains that the manager “sell” discipline is part of a thorough and well prescribed investment process. “Any sell decision on a manager can be driven by our loss of conviction in their ability to outperform over the long-term. Equally, a sell decision can have nothing to do with the current manager and merely reflect the fact that we have found a manager we believe is superior.

“There can be a single reason or a combination of reasons that lead to a loss of conviction,” says Mr Prescott. “Fund performance itself is not enough to lead to replacement of a manager, as managers will not get it right all of the time. However, poor performance is always a cause of analysis and on reflection can be the symptom of a deeper problem within a manager’s investment process.”

FUTURE OUTLOOK

Only 16 per cent of respondents believe retail sub-advisory business has grown as much as they expected over the past five years. The bull market before the crisis led many asset managers to build up new in-house capabilities, without worrying much about the cost basis associated with this expansion, notes Peter Labhart, head of alternative investments at Swiss private bank Clariden Leu. The result was a lower than expected growth rate for the retail sub-advisory sector.

The bear market and the reduction in assets under management are considered the main reasons for its limited growth, while there were a few mentions of costs and loss of income as the factors that can limit sub-advisory. Peter Lindhal, head of global funds at Nordic group Evli Fund Management notes that a lot of products on the market are run in-house by small teams with few resources. “Higher costs and profit margin considerations are the reasons why firms do not sub-advise,” says Mr Lindhal. “It is more profitable to manage products in-house.”

But Mussie Kidane, head of fund selection at Pictet Wealth Management, believes the debate around reduced profit margins in sub-advisory is in reality a false debate, as people erroneously base their calculations on the assumption that the same product run in house will grow as much as the sub-advised product.

“Whatever you manage internally is more profitable if you can build assets to the same level [as the sub-advised product], which implies you have the same type of capacity and the same sort of competencies; but in that case, you don’t need to sub-advise,” says Mr Kidane.

A bank may retain 100 per cent of the fees on a product run in-house but the asset base may be much lower. “It is the absolute figure [of total fee revenues] that we have to look at; this is a false debate,” says Mr Kidane. “I believe investment managers will continue to identify core areas of specialisation where they have real edge to excel and delegate non-core areas to other specialists.”

Tommaso Corcos, CEO at Fideuram Investimenti and an influential figure in the Italian wealth management industry, predicts that in the next couple of years, numbers of mandates will decrease and will focus on total return strategies. But overall, in the medium term, sub-advisory is considered as an upward trend. Almost thirty per cent of respondents believe the retail sub-advisory sector will grow by between 5 and 10 per cent annually over the next five years in Europe (see figure 8).