Drivers beat barriers in sub-advisory boom

The growth of the sub-advisory market is set to continue during 2007/2008, according to 71 per cent of the European institutions participating in PWM’s fourth annual study. Asked to provide insights as to how they see the market for sub-advisory developing for the next year, 55 per cent of them stated that the business will “strongly” or “significantly” increase, while 11 per cent said it will “increase”or just “slightly increase” (5 per cent).

Growth drivers range from the need for firms to focus on core competency to meeting client demand for new products, in particular in the alternative space. The increasing importance of open architecture will also encourage banks to look for dedicated sub-advisers, say the respondents.

Distributors are increasingly asking managers to target higher returns. And continued convergence of the traditional long-only and hedge fund industries, plus divergence of beta and alpha houses will provide increased opportunities for sub-advisory, especially in high alpha unconstrained areas, according to Rene Schneider, head of product management and development at Swiss bank Julius Baer.

Michael Jones, head of financial institutions at Fidelity International, says that large financial institutions are likely to continue reviewing in the future whether to keep an internal asset management capability or to appoint external managers, if these can achieve better returns.

“Combined with a drive by large retail banks and insurers to gather more clients, i.e. to focus on distribution and less on manufacturing, this will mean continued growth in the sub-advisory phenomenon,” he says.

Indeed, a major trend driving the growth of the sub-advisory market is the separation of manufacturing and distribution of investments. This is according to 78 per cent of the respondents. “The financial sector will increasingly resemble the retail distribution market, where retail stores sell goods but do not produce anything, relying on an efficient supply chain, focus­­­­ing on targeting customer demand and delivering advice,” says Poul Bendix Kristensen, head of strategic asset allocation at Danish asset management firm Nycredit.

The need for more specialised products will favour boutiques, believes Heinz Bednar, chief executive officer at Austrian firm Erste Sparinvest. “The industry is experiencing a tilt toward boutiques, which are specialised in specific asset classes. These will gain business by the ongoing separation trend.”

The scenario is different in Spain, according to Valero Penon Cabello, investment director at Ibercaja Gestion. “Manufacturing and distribution will be closely linked for a long time,” he says, predicting that the main players in the Spanish retail banking will keep on selling their own manufactured products, “since it is a profitable business strategy”.

Different attitudes

Attitudes to sub-advisory are changing. “While in the past asset managers saw it as a bad thing to bring competitors in-house, today many of the old bank-based asset managers have no alternative,” says Hanks Ek, head of intermediary sales at SEB Wealth Management. “Some of the global players might be able to [manage all their assets in-house], but I doubt that too,” he adds.

The Sweden-based asset management firm started outsourcing around six years ago and now delegates fund management to around 20 different suppliers, covering a total of 10 different geographical markets.

Investors increasingly value impartiality, says Nykredit’s Mr Kristensen. They appreciate those managers “who do not just fill their portfolios with their own products in order to maximise fees,” he says. “Customers want solutions and that can just as well include products sub-advised by other managers.”

Barriers to sub-advisory

Is there any barrier to this booming trend for sub-advisory?

Despite the fact that a good percentage of respondents (22 per cent) saw no single development that could stop the growth of the sub-advisory business in Europe, and almost half of them were not able to comment, around 30 per cent did mention a variety of ‘barrier’ factors, but these were mostly related to unspecified or potentially unfavourable developments in regulation, such as “protectionism” or “reversal of EU integration” or “legal impediments”. A handful of respondents saw in upward fee pressures and margin squeeze a potential obstacle.

“The growth of sub-advisory is limited by profit margin considerations,” says Ricardo Payro, head of corporate communications at Banque SYZ & Co in Switzerland. “In-house management being more profitable, management and shareholders tend to prefer them to externally managed ones.”

Furio Pietribiasi, general manager at the Irish division of Mediolanum Asset Management, believes that sub-advisory is under pressure “because the most innovative Ucits III products struggle to be implemented in a sub-advisory mandate in a cheaper and efficient manner”.

Moreover, this is exacerbated by the fact that more and more investment banks are giving access to managers returns through derivatives – either funds or managed accounts – and these products are simply becoming cheaper.

Different stages of maturity

The 85 companies taking part in this year’s sub-advisory study, who between them manage around ?5580bn, are at different stages of maturity with regards to the sub-advisory business. While 27 per cent of them have not embraced this structure yet, the large majority (73 per cent) have been delegating fund management for eight years on average.

In our sample, the more mature countries are Austria and the UK, where those companies who do outsource have ­long-standing experience in sub-advisory (nine and 10 years on average respectively).

In Switzerland and Italy, the average company started employing sub-advisers eight years ago. Of the main European countries, Spain has the shortest history in sub-advisory (four years).

Asset classes outsourced

It could be argued that the different stages of maturity of the European markets are shown to some extent in the types of asset classes outsourced and the sub-advisory models employed.

Equity funds are still the real driver of the sub-advisory business in Europe, as shown by the high percentage of mandates in this asset class. Sixty-three per cent of all mandates awarded by European institutions in the survey are in equity, while bonds lag behind at 18 per cent. Alternatives account for 6 per cent of the total number of mandates, while balanced and liquidity represent 8 and 2 per cent respectively.

While these general conclusions are reflected in the results for each of the individual country, there are some notable discrepancies across Europe (see chart one). The percentage of equity mandates awarded on the total is very high in Switzerland, Nordic, France and UK, but in Italy and to a certain extent in Austria, the number of mandates is more balanced between these two asset classes.

Standard fund management delegation is the sub-advisory model most employed by institutions (43 per cent), while multi-manager arrangements, which represent 37 per cent of all mandates analysed in the study, are favoured by the UK, French and Nordic institutions (see chart two). Survey results show that sub-advised products tend to be offered to clients branded with the bank’s own familiar name with more frequency in the Nordic countries, Spain, Italy and Switzerland.

Most used sub-advisers

Goldman Sachs Asset Management (GSAM) is the sub-adviser most used by European institutions (23 per cent), followed by Alliance Bernstein (19 per cent). Schroders Investment Managers and Wellington are both employed by 15 per cent of the respondents.

Asked, unprompted, to name the top three sub-advisers they have had experience of, less than 50 per cent of the relevant European institution were willing to comment. The most highly rated, i.e. those falling in the top three sub-advisers list for each respondent, were Alliance Bernstein, Axa Rosenberg and GSAM (see charts three and four).

Impact of legislation

Ucits III legislation, by allowing a broader range of tools, has certainly had a major impact on shaping and widening the product offering of European firms and the trend is set to develop further. Sixty-two of all respondents stated that the new legislation has encouraged them to offer a larger range of products to their clients and 82 per cent are confident that it will continue to do so in the near future. However, the impact of Ucits III on sub-advisory varies greatly depending on the country (see chart five). The Swiss and UK institutions have been apparently totally unaffected by the legislation when considering whether to outsource, although this might eventually change.

Increasing number of mandates

The growth of sub-advisory is expected to continue apace. Over half of all respondents stated that they will award a higher number of mandates in the future.

The percentage is higher for those who already outsource (61 per cent), driven by development of open architecture, client demand for new and greater numbers of performing products, and the need for diversification. Assets outsourced will also grow accordingly, with seven out of 10 respondents who already outsource expecting a boost in money inflows.

Moreover, a wider range of asset classes will come to be outsourced. Most notably, over a third of all respondents plan to sub-advise alternative asset classes, including commodity, hedge funds, real estate and private equity.

Respondents also expect to be outsourcing bonds (8 per cent), especially in the area of high yield and convertibles. This represents quite an important break from the past, as fixed income has traditionally been the asset class to which they are more reluctant to appoint external managers (see chart six).

This development is due to a combination of both harder market conditions for this asset class and the availability of more instruments and techniques, which encourages firms to look for expertise in external managers.

Sub-advisory v purchasing funds

Purchasing third-party funds and sub-advisory are often seen as complementary practices, as they both enable a bank to complete its product range and meet client demand. However, when asked to rank in order of importance seven different factors which make companies prefer sub-advisory over simple fund distribution, 40 per cent of those who outsource ranked first that sub-advisory enables them to focus on core competency more than purchasing funds does.

Other important factors are that: (i) sub-advisory is a more efficient competitive differentiator than fund distribution (15 per cent); (ii) sub-advisers have greater control which enables them to perform better (13 per cent); and (iii) a sub-advisory relationship can be made to suit the distribution needs of the underlying clients better (13 per cent).

Concentration limits in funds, which may be a driver for big companies to start setting up a sub-advisory arrangement, scored the lowest in our sample (3 per cent). Unprompted, better reporting, higher control on mandates and better ability to monitor portfolios, were also mentioned as comparative strengths by those who outsource.

For and against

When prompted, 70 per cent of the respondents said that client demand is the strongest driver to start sub-advising or awarding more mandates (see chart seven). Product development and competitive pressure also play an important role in their decision.

The factors which make companies decide against fund management delegation lie in the confidence in their in-house investment management capability, according to 50 per cent of the respondents.

Almost 40 per cent of the companies interviewed, however, stated they prefer the flexibility of fund distribution, while about 30 per cent of the respondents see in the potential decrease of their short-term margins one of the major obstacles to their decision to delegate fund management.

Size of the market

It is difficult to find any accurate estimate of the size of the sub-advisory market, as some of the statistics include internal subsidiaries managing in-house money or count in mutual funds.

Almost a quarter of the respondents to the PWM survey believe that the market for European sub-advisory is worth more than ?250bn. In light of the survey results, this may well be an educated guess: the total assets outsourced by the 46 respondents in the survey who disclosed this figure amount to around ?125bn.