Evolution of three-way sub-advisory system

Of the five forms of sub-advisory arrangements originally identified by Goldman Sachs Asset Management (GSAM), there are three principal models employed by banks and distributors in today’s sub-advisory world, according to Alex Fletcher, head of European business development at GSAM.

These are: delegation of fund management; multi-manager arrangements, where a number of external managers used on a sub-advisory basis are blended together to manage one asset class; and use of a model portfolio.

White-labelling, where the sub-advised product is offered to clients branded with the bank’s own name, can be applied to each of the three main models, rather than being seen as a separate arrangement in its own right.

“We see that banks attach different levels of importance to promoting their own brand alongside the sub-adviser,” says Mr Fletcher. “Some see it as a positive, real virtue to be able to say that they are working with GSAM. Others don’t mention it at all. Then there are a lot of people somewhere in between.” This depends on the strength of their brand versus the sub-adviser’s and how they feel about it, says Mr Fletcher.

In Europe, the structure of the fund management delegation and multi-management models has remained substantially unchanged over the past few years, but there is definitely more use of both, says Mr Fletcher. The strong growth of these two sub-advisory forms is reflected in the expansion of GSAM’s sub-advisory unit, which has seen its assets double during the course of 2006 to reach the current $30bn (?22bn).

What has evolved most rapidly, however, is the concept of the model portfolio. The expression was coined by GSAM strategists initially to refer to the structure in some Nordic countries, where banks outsourced their portfolio construction strategy to external asset managers, as they were not allowed to delegate the management of funds.

Today it is used across the whole of Europe in the area of funds of hedge funds. Rather than delegating fully the authority to manage a portfolio of hedge funds, the trend is now for firms to embrace the model portfolio route, especially in this alternative asset class. Managers such as GSAM provide an advisory service and access to a platform of hedge funds, and companies construct their own fund of hedge funds, says Mr Fletcher.

LEARNING FROM BIGGER COMPANIES

This highly flexible model, he adds, enables any company with a small team of hedge fund researchers to piggyback and take advantage of a much bigger research team in large companies, while getting a good insight into a whole range of different hedge funds. The distributor is then free to follow the advice or not.

Mr Fletcher estimates that, nowadays, half of those funds of hedge funds employing sub-advisers do it via this sort of advisory model portfolio route.

Currency overlay, the form of sub-advisory where a bank would delegate responsibility for currency management to a third-party manager, retaining responsibility for the asset allocation of a portfolio, does not exist anymore at GSAM, says Mr Fletcher. “We don’t offer currency overlay anymore, but we now have very high volatility currency funds that seek to generate alpha through investing in different currencies.”

A bank can buy a small portion of GSAM’s high volatility currency fund and give its clients some exposure to currency fund management.

“A fund can be a very capital efficient way of delivering it,” says Mr Fletcher, explaining that with the higher volatility funds, there is only a need to buy a very little amount of them to add a lot more risk and return to an investor’s portfolio.

“It is quite complex to set up a series of separate accounts like that, it would not work very well,” he says, adding that the currency product offered is the same for each of their clients anyway.

“Some see it as a positive, real virtue to be able to say that they are working with GSAM. Others don’t mention it at all” - Alex Fletcher, Goldman Sachs Asset Management

Purchasing mutual funds and fund management delegation are often considered complementary, both having the main objective of filling gaps in a firm’s product range. Operational requirements may be higher in sub-advisory, but there are a lot of different reasons why a company might want to sub-advise rather than purchase funds, according to Mr Fletcher.

The first benefit is that they are able to have their own fund, despite not managing it themselves, and can control the range they offer very closely, as they are in charge of designing it. This total control enables them to have complete transparency in the investments, unlike when they buy a fund, says Mr Fletcher. Also, concentration limits in a fund, often set at 20 per cent, have been quite a big driver for some of the big banks who now use the sub-advisory model, he says. “When buying third parties’ funds, banks are limited as to how much they can actually invest into those funds, whereas by setting up a sub-advisory range there is no limit at all.” Moreover, banks can probably control the marketing materials far better in a sub-advisory range than if they were using other people’s fund ranges.

“They have complete transparency in what is happening within the product and so they can be very responsive if they don’t think that something is working very well,” says Mr Fletcher.

A large and stable client demand drives the growth of sub-advisory, according to the large majority of responses to this year’s sub-advisory study.

David Curtis, head of GSAM's sub-advisory business in the UK, agrees with the statement but does not see it as exclusive. “People see sub-advisory as a strategic business, to fulfil a long-term need inside an organisation,” he says. “But at the same time we have people who start off some very small sub-advisory relationships, because they need to get a product to market very quickly.” In those cases, he adds, assets will grow as the interest builds from their client base.

Certainly, one of the advantages of sub-advisory is its ability to bring new products to clients. “Often you have to bring the product before the client realises they want it. It is not always demand before product,” explains Mr Curtis.

Sophisticated insights

Indeed, product development is one of the value-added services most appreciated by European interviewees in the study. Sub-advisers like GSAM have the opportunity to work with a large range of often sophisticated clients in different economies, which enables them to get insights into which products are being developed and take that expertise to clients, says Mr Curtis. “This can really seed new ideas. Offering that kind of insight, as well as delivering performance, can be very valuable and it is a good way to start specific sub-advisory relationships.”

Poor product development – and lack of sophisticated systems to manage derivatives, for example – can be an important driver to sub-advisory. If a company is small, it might lose its clients to somebody else who has interesting and innovative products in their range, says Mr Curtis. In this perspective, size is definitely seen as a rationale to start thinking about sub-advisory.

“Companies managing less than $100bn should be thinking about sub-advisory”, says Mr Curtis, explaining that the number used to be $50bn before.

Indeed, a broader range of products is now being outsourced, says Mr Curtis, and the business interests a wider range of countries, such as Israel and Greece or developing market economies.

“We have done a lot of business in hedge funds and private equity this year,” says Mr Curtis, “and these asset classes dominate the conversations we have.”

People want innovation and access to what the biggest and astute organisations are doing, he says. “People are realising that these are not fads but they are structurally important asset classes to include in portfolios.”

“People see sub-advisory as a strategic business, to fulfil a long-term need inside an organisation” - David Curtis, Goldman Sachs Asset Management

While in the mass retail market there has been a clear increase in the use of alternatives, which has led to more demand for sub-advisory, the need for sub-advisory is strong for core activities as well. The market has become a lot harder, says Mr Curtis, particularly in the fixed income area. The availability of a larger range of instruments, derivatives and more sophisticated techniques are encouraging an increasing number of firms to access the expertise of external managers.

People’s confidence in being able to manage fixed income in-house, also shown in PWM research results, comes from the positive results obtained in this asset class over the last five to eight years, when credit spreads have narrowed and yields have reduced. But things are starting to get a lot tougher, says Mr Curtis. “Now the outlook is much less certain, some companies will be stretched; people have started to recognise that they need fixed income managers to have a much wider variety of techniques than just duration management, such as bank loans, in emerging market debt, high yield or capital structure arbitrage,” he states, predicting that from now onwards, fixed income will be sub-advised much more than in the past.

There will also be bigger variety and flexibility in terms of investments as constraints within which sub-advisers operate have been lowered, partly because of the new legislation Ucits III, says Mr Curtis. “We definitely have more flexibility from the regulatory reform that the clients want to use. It is not all the way there, but there will be progress in the future.”

WHEN TO DELEGATE

Nick Phillips, head of third party distribution UK and Scandinavia and responsible for European global partners at GSAM, agrees that Ucits III has still to show its full potential.

Organisations are considering offering more sophisticated Ucits III products to their clients, including 130/30 products or fixed income absolute return. But they will increasingly delegate the management of these products, not having the experience or the ability to manage them themselves. “To have an absolute return, multi-strategy fixed income portfolio, it often requires a very big team of talented people, identifying different areas of alpha within the fixed income market and blending them. Not everybody can do it,” says Mr Phillips. This area has a high potential which is especially strong in Southern Europe, with products such as cash or libor +2, or +3, becoming very popular.

“When they see that our party does work with their sales force and they see the extra productivity and the extra results” - Nick Phillips, Goldman Sachs Asset Management

But in order for Ucits III to develop fully, a strong process of education must be implemented both from asset managers to distributors and from distributors to end clients, he says. “It is a question of familiarity of the end users and acknowledging that these products are positive for their portfolio or their pension scheme,” says Mr Phillips, adding that distribution of 130/30 funds (GSAM’s funds are actually termed 135/35) is rapidly growing, due to the education process and success that their customers are having with their end-clients. The next step is to sub-advise these new types of funds in the longer term.

Offering support and training to the sales force is very important. But distributors may­­ see support from the adviser as an intrusion. Mr Curtis admits that in a sales organisation, it is very important to keep the sales force very focused. “When you introduce another party, sometimes firms fear they can cause disruption,” he says. “But when they see that our party does work with their sales force and they see the extra productivity and the extra results, the better penetration and the better understanding of products, people become a lot more relaxed about it.”

Sub-advisory is still not a normal practice; internal management is by far the dominant method, but encouraging signs that the attitude to fund management delegation is changing comes from the mature and growing markets of UK and Scandinavia, where outsourcing is increasingly seen as a strength and complementary to the client portfolio, says Mr Phillips. Importantly, firms have also started taking it to the institutional market.

In Sweden, for example asset managers or banks who have outsourced their asset classes are now winning mandates by tier 1, 2 and 3 pension schemes, says Mr Phillips. Institutional clients have a very thorough due diligence process and being able to offer these products to them shows confidence that fund management delegation is adding value to their brand and their product offering, he says.

The performance fee factor

If there is an impediment to the sub-advisory process being more fully adopted, that is the lack of performance fees, says David Curtis at GSAM. When the client’s total fee is based on the performance of the products, there will be even more sub-advisory mandates, he says. At the moment if the manager performs well, the distributor who is paid a fixed fee can see his margins squeezed. “Passing on performance fees to clients aligns everybody’s interests,” says Mr Curtis.

Performance fees are becoming a lot more important in sub-advisory, because those who outsource are increasingly asking to target higher returns. This means that either fixed costs are going to be higher or there is going to be some participation. Clearly, from the distributors’ point of view, the better the performance the more assets they are likely to gather. They might get a lower percentage of their fees, but that fee is likely to be of a much larger amount.

However, typically sub-advisory mandates are based more often on a fixed fee, because of the risk that distributors might find themselves in sub-optimal situations, says Mr Phillips.

It would be possible to build in fee caps, so that there is a base fee and a performance fee cap to make sure that the manufacturer’s fee does not go above a certain level, says Mr Phillips. But from a structural point of view it is very difficult to do performance fees for mutual funds, which explains why products distributed having a performance fee tend to have a monthly liquidity rather than daily.