Europe’s fund houses brush up on DIY skills

A large number of European fund distributors have gone against the widespread belief in open architecture during the past year, opting for the ‘do-it-yourself’ model rather than the ‘pay-someone-else’ approach. Some have even advised nervous clients to switch out of equity and bond funds altogether, directing them to in-house money market funds. Andrew Hutchings explains. If you own a house, you must maintain it and keep it in good order. That is a central aspect of house-ownership. As time passes, you need to attend to repainting, roofing and plumbing. You may even want to alter your house substantially, by adding or combining rooms. In the normal course of events, you have two alternatives. You can pay someone else to do the work, or you can do it yourself. Both approaches have advantages and drawbacks. The key advantage of doing work yourself is saving money. Every so often, many things will go wrong at once. The roof will start to leak. The plumbing will become blocked. The heating breaks down. At this point, you may consider giving up on owning the house altogether, and moving. As with houses, so with funds For many fund distributors in Europe, a lot of things went wrong in the last year. One of the key findings of Sector Analysis’ latest European Investor Focus survey is that many distributors switched from a ‘pay-someone-else’ model – using other suppliers’ funds – to a ‘do-it-yourself’ model – or using/promoting their own funds. At first glance, the shift does not look to have been particularly large. Chart 1 shows that, in 2002, other suppliers’ – or third party – funds represented 14 per cent of the entire funds market in Europe, according to calculations by Sector Analysis. The remaining 86 per cent consisted of the distributors’ own ‘in-house’ funds. Today, the corresponding figures have moved to 12 per cent and 88 per cent. Some countries have witnessed a huge shift towards the do-it-yourself model of in-house funds. Chart 1 shows that, in 2002, third party funds accounted for nearly half of the entire funds market in Luxembourg. A year ago, it seemed that the Luxembourg distributors were by far Europe’s biggest fans of the pay-someone-else model. Today, third party funds represent just 14 per cent of Luxembourg’s funds market – or not much more than across Europe as a whole. Switzerland, where fund distributors have moved in the opposite direction, is an exception. In 2002, third party funds represented 13 per cent of the Swiss market. This has increased to 23 per cent, suggesting the Swiss are more willing to pay external providers. Swiss investors give up on funds However, this is only part of the story. Investors can hold assets through funds or they can hold assets directly or through segregated mandates. For large numbers of European investors, last year was one bear market year too many. In terms of our analogy, they gave up on funds entirely. Chart 2 shows that, in 2002, 44 per cent of all investment assets in Europe were held through funds, while 56 per cent were held directly or through segregated mandates. This year, the split is 42 per cent/58 per cent. Switzerland is arguably the most extreme example of a national market where investors have given up on funds altogether. Last year, 56 per cent of all investment assets in Switzerland were held through funds. Now the equivalent figure is just 24 per cent. As we have seen, the apparent slump in usage of in-house funds has been even greater than the drop in third party funds. In Luxembourg, by contrast, relatively few investors gave up on funds entirely. In 2002, 62 per cent of all investment assets were held through funds. Now the corresponding number is 56 per cent. In other words, the move from third party funds to in-house funds – or from the pay-someone-else model to the do-it-yourself model – was the big change in Luxembourg. You can get a clearer picture of the changes by looking at how the assets of the third party funds have changed over the last year. This is shown in Chart 3. Three major changes appear to have taken place across Europe as a whole. The first is a minor shift away from equity funds. Secondly, demand for hedge funds and private equity has surged. Third, while bond and money market funds still account for 39 per cent of all third party funds, the share of money market funds has become much more important. In Luxembourg, the overall changes in the exposures of assets invested through third party funds have altered very little. Money market funds have become more important. Bond funds have become a little less important. That is all. This suggests the move from third party funds to in-house funds may have been driven in part by investors. Wounded by the fall in stockmarkets, and worried that the rise in bond prices was unsustainable, Luxembourg investors looked for money market funds. In some instances, Luxembourg distributors would have responded to this by using other suppliers’ money market funds. Far more commonly, though, their response would have been to switch to their own, in-house, money market funds. In some cases, this would be justified on the basis that a third party fund – the pay-someone-else model – is only needed when the distributor really needs the external expertise. For many of the Luxembourg distributors, cash/money market instruments would naturally be a do-it-yourself asset class. As we have noted, the in-house model has the virtue of not requiring the payment of money to others. Responses to tough times We conclude that the shift away from third party funds in Luxembourg has been driven mainly by distributors. In part, this has been in response to tough times in the asset management industry. In Switzerland, by contrast, the main change – away from funds altogether – seems to have been dictated by the investors rather than the distributors. To the extent that investors are still using funds (i.e. much less than in 2002), they are focusing more on equities and hedge funds: in search of expertise, the investors are happy to pay someone else. The Swiss distributors appear not to have persuaded the investors to switch into in-house funds. Instead, the investors are investing directly into low risk assets – such as bank deposits – directly. This is why holdings of money market funds in Switzerland have dropped. Will investors who have given up on funds return in the coming year? If they do, will the distributors prefer the do-it-yourself or the pay-someone-else model? These will be the crucial questions for the European funds industry in 2003-04.

Andrew Hutchings, research editor, Sector Analysis