Funds for the European palate

European investors have had a tough introduction to the world of long-term investing. Investment funds have been around for a long time but for many savers, the bull market of the late 1990s became an open invitation to join a new club – a club that offered promise of double-digit rewards. The last five years have been years of disappointment for those who signed up as the stock market bubble reached its peak. A new style of risk aversion became a feature of the post-bubble investment world and it was expressed through demand for greater levels of capital protection. Surprisingly, though, there was very little evidence of a mass exodus from funds. In each of the years that followed the initial stock falls, European investors maintained an average inflow of ?160bn of new money into funds.

The financial services sector is now entering the critical phase of recovery. It coincides with expanding support, at various levels, for the concept of open architecture and mounting pressure on individuals to take greater responsibility for financing their retirement. The opportunities are enormous but never before has the efficient delivery of investment solutions to European investors been more important and never before has the role of adviser, asset allocator and distributor been more critical. Their potential influence in matching products to clients’ needs is unrivalled; their role in delivering savings solutions that will meet the long-term liabilities of their clients is essential; and their involvement in the financial education of their clients is pivotal.

Successful management of these responsibilities could deliver a prosperous financial savings environment in which all participants can thrive. But, success of this magnitude can only be achieved through a proactive partnership between those who engineer the products and those who are answerable to the end-saver.

The European Fund Buyer (EFB) Survey was designed to be an independent conduit of communication to help asset managers understand the changing needs of investors so that they can design their products and services appropriately.

The distributor community

The role of the distributor is intrinsically local in its nature, and the closer the relationship with the end-client, the more likely it is that the relationship is based on geographic proximity.

However, the European markets are evolving in increasingly complex directions, involving various layers of activity which, to a greater or lesser extent, contribute to the delivery of investment solutions. Thus, the term ‘distributor’ now encompasses professional asset allocators, bank platforms offering order aggregation services for third party and internal organisations holding the end-client relationship, and wealth managers or advisers of various types and styles.

The EFB Survey encompassed representatives of all types of financial organisation but the emphasis was one of scale. Accordingly, the bulk of those who responded were from large organisations with full discretionary powers of product selection. The majority (68.5 per cent) of respondents were from organisations that formed part of a wider distribution network and a significant minority were part of a pan-European or global organisation. Just 38 per cent stated that their network was domestic only. (See Chart 2.)

Consistent with the pan-European or global weighting of the respondent organisations was the higher proportion of private banking and funds of funds buyer communities, most of which are an integral part of a wider banking network that will have a reach across Europe and beyond. Those polled were asked to indicate in which capacity they were acting and the extent to which they had discretionary powers. The largest number, and most particularly incorporating those buyers wrapping funds into other products, was clearly not subject to the direction or involvement of the end-investor. Only those who were client-facing – namely institutional investors, bank advisers and IFAs lacked full discretionary powers².

Investment fund commitment

The placing power of those that participated in the EFB Survey is significant. An exact measure is not possible because sensitivities regarding confidentiality constrained feedback on this issue.

However, respondents were prepared to indicate a business range. A significant number, 51, expected to place at least ?500m in mutual fund business in 2005, 30 of which expected mutual fund business to exceed ?1bn in 2005. (See Chart 3.) A basic analysis of these figures offers a low-side estimate of ?44.4bn and a high side of ?69bn. Since those in the ?1bn bracket were expressing a minimum, the higher estimate of ?69bn is arguably a fair approximation of expectations in 2005.

These anticipated volumes reflected an element of improved sentiment.

The majority (67 per cent) of those polled predicted that their purchasing power would increase by more than 10 per cent in 2005 (see Chart 4) and, of these, more than a third felt that the improvement would stretch beyond 20 per cent. If this sentiment is translated to an average improvement of 10 per cent, the 2004 volumes would equate to ?60bn, a figure that represents just under half (45 per cent) of ?133bn of net sales flows achieved by the mutual fund industry last year. Funds of funds accounted for most (?38bn or 63 per cent)³ of this business, leaving ?22bn with the other categories of fund buyer.

Several reasons were given for the anticipated uplift in fund business but the theme was essentially one of confidence boosted by the recently improving market environment. Respondents anticipated that the number of private investors returning to collective investments would continue to rise. And, consistent with this view was the fact that, as the survey questionnaires were being answered, FERI FMI data pointed to a return of mainstream investors. First quarter net sales flows were up 12 per cent on the same period last year and stronger than any quarterly total seen since the markets started to crash.

Investment strategy changes were also stated to be a driver of increased fund activity with a number of organisations moving towards fund selection rather than individual stock selection. This was very much the case for private bank and high net worth advisers who will tend to support funds when they are looking for exposure to international markets and in more sophisticated bond products – the more conservative and home-based the investment strategy, the less likely that these advisers will use collective schemes.

Gauge of open architecture

Until now, there has been no real measure of the development of third-party distribution in Europe. Various commentators have speculated on the scale of activity but have found it hard to translate anecdotal evidence into hard fact. The EFB Survey, while not offering the final answer, does deliver some solid data into the public arena. Clearly the sample of distributors was biased towards those with open architecture strategies. Just 12 per cent stated that their efforts were entirely in the proprietary arena but this, of course, does not represent the sum of in-house distribution activity. In addition to this segment, it is probably fair to assume that a larger portion of sales volumes (i.e. the 55 per cent unclaimed by the polled buyers) will be purely proprietary in nature.

External exposure

More interesting though was the proportion of third-party business that each respondent claimed. In this respect, exposure varied significantly from the token 3–4 per cent right through to 100 per cent. The average was just under half (49.6 per cent), although the median level was slightly lower at 40 per cent. Thus, of the ?69bn that distributors expected to place in funds in 2005, around ?30bn–?35bn could be placed in externally managed funds. In 2004 terms, our extrapolated estimate points to around 18–20 per cent of European net flows coming from open architecture platforms or third-party distributors.

Those advisers/buyers involved in third-party business also claimed that a bulk of their business (67 per cent) went to foreign groups, with a median that was even higher (75 per cent). This suggests the volume of expected business for foreign groups in 2005 will be ?20bn–?25bn. This ballpark figure is also consistent with FERI FMI data⁴, which showed 26 of the key cross-border players sourcing ?29.6bn from European third-party distributors in 2004. On the basis that the EFB survey was representative of the view that business volumes would increase by 10–12 per cent, foreign groups might expect total inflows of ?33bn–?34bn this year.

Business styles

The issue of holding period is an important one for asset managers in terms of their cost structures, since operational efficiencies increase with the length of the holding period. Against a background of comment that some funds of funds buyers have an unreasonably high portfolio turnover, switching from one fund to another equivalent performing fund in the same sector, to maximise fee income, the EFB Survey questioned respondents on their methodology and practice.

Unsurprisingly, most of those polled have their investments, or those of their clients under constant review. (See Chart 5.) Amongst, those that chose ‘other’, most indicated that their organisations reviewed funds on a monthly basis, or, a combination of frequencies. For example, macroeconomic reviews were carried out quarterly while individual fund monitoring occurred monthly or constantly. Furthermore, most changes in portfolio were driven by changing views on asset allocation. These usually resulted from macroeconomic factors or for fiscal/financial planning reasons. For example, poor equity conditions were likely to spark more defensive allocations in a portfolio. But discounting the impact of such allocation changes, the reasons cited for individual funds being shelved were: 

- underperformance

- changes in fund manager

- currency fluctuations, and

- cost.

The vast majority of EFB survey respondents (87 per cent) indicated average holding periods of at least one year. (See Chart 6.) More than half of the respondents (54 per cent) indicated average holding periods of between one and three years, while a third pointed to holding periods of more than three years.

Only 13 per cent of respondents claimed average holding periods of less than one year and there was very little variation by country. These answers were somewhat surprising given anecdotal comment from fund groups of increasingly shorter holding periods. Of course, one explanation would be that the selection and review techniques employed by the fund buyers are now advanced to the point of minimising selection mistakes, thereby reducing the overall turnover of funds.

However, there is an accepted ‘best practice’ response to this question, which will tend to be the default response. Whether holding periods are reducing is an issue that can really only be tested over time.

Manager hot list

Popularity can be affected by a varying mix of fund performance, brand security, product development, commitment to marketing spend and numerous service issues. As the fund buyer community becomes more biased towards the large preferred partner bank platforms, the importance of non-performance issues has risen. We asked fund buyers to name their preferred investment managers in three asset classes and, in the main, it was the heavy-weight brand names that rose to the top (see Chart 7), although the preferred names varied according to the asset class under consideration.

Individual markets, however, threw up quite different sets of answers with some local bias creeping in. (See Chart 8.)

Nevertheless, it was clear that for those distributors that use third-party funds, there was a strong recognition of foreign groups in all countries. Germany was something of an exception, though, in the bond arena, where three of the most frequently mentioned fund managers were local players. This should not be surprising given the traditional strength of German groups in the fixed income arena.

More interesting was the fact that Italy and Spain, both markets controlled by the local bank structures, featured a number of foreign players. France continues to retain some of its traditional characteristics with a French group in first place in each asset class. CCR is now part of Commerzbank but was formerly French-owned.

Many assumptions are made about the drivers of fund choice and such evidence that exists has tended to be anecdotal, coming from fund managers. The relative weighting of these drivers will depend on the particular strengths of asset management organisations that are giving their views, thus performance is usually cited as the critical issue. The importance of fund performance cannot be underestimated – no distributor will support a fourth quartile fund for very long – but the EFB Survey sought to isolate some of the other issues that are important. (See Chart 9.)

Interestingly, the greatest weight was placed on the manager’s experience and commitment to investment style. In other words, advisers and fund buyers view on-going performance as being determined by the individuals and the approach they take to the market. Therefore, past performance is a quantitative tool by which they make their short-list selection but in finalising their commitment to a fund, they will want to be satisfied that this past performance can be replicated in the near future. In terms of performance, the longer the history the better. Five years is preferred but respondents were not immune to newer stories, a factor that received middle-ranking support. New fund launches have been a significant driver of sales over the recent bearish years but in most cases their success has been linked to strong proprietary distribution. Where third parties are concerned, a new story will be heard with interest but a convincing story will have to be made to encourage fund buyers to make an investment commitment.

Nationality, once regarded as a significant barrier for foreign groups, is now a minor issue and one that is probably tied up with brand awareness. Fund advisers find it easier to attract the interest of their end-clients if they are recommending funds that are ‘known’. If a brand name is well recognised in a market, then its nationality tends to be irrelevant as long as all other considerations are equal. The requirement of investment to support the brand is an issue that has become relevant particularly for some of the emerging open architecture bank platforms in Germany. It does not, though, appear to be a commonly expected requirement.

Those respondents that ticked the ‘Other’ box most commonly quoted risk-adjusted returns as important to their choice of funds.

Savings mix

The long-term savings arena is becoming increasingly competitive. This has long been the case in the UK but, until recently, mutual funds in other European countries were rapidly increasing their share of the household wallet against other sectors that were relatively moribund. Life insurance remains the most important vehicle for long-term managed savings, in terms of overall percentage of household savings (30.7 per cent)⁵, but in most countries these vehicles are underpinned by fund investment.

Funds have suffered a great deal of reputational damage during the last five years and this has led to the rise of a colourful variety of alternative products. Certificates and structured notes – seen most prominently in Germany, the Netherlands and increasingly in other markets – are one such example of competition creep. The EFB Survey sought to clarify whether, as markets begin to recover, long-only funds can resume their pivotal role in the savings mix or, whether they have become merely an ingredient in an increasingly complex process of packaging, designed to remove risk from the investment equation.

Distributors were asked which three products they were most likely to recommend to their clients in 2005. Mutual funds received emphatic support, scoring almost twice as much as the structured or direct options – but, this reflects a distortion from funds of funds buyer who would necessarily include mutual funds as their preferred product. Charts 10a and 10b depict the results with and without funds of funds buyers. The pattern of recommendations remains fairly consistent in both cases although clearly the funds weighting is greatly reduced once funds of funds have been excluded.

Local markets did not differ significantly from the pan-European model. Mutual funds were the product of choice for all markets, with the exception of Switzerland, which gave more prominence to direct securities. Again, this was in line with our expectations.

Switzerland is a sophisticated, high net worth client market where portfolio managers pride themselves on their stock-picking skills and, as a result, manage complex portfolios of securities and funds on behalf of their clients. Germany was the only other major market that differed from the norm with funds and structured products placed equal first. Such positioning highlights the strong growth of these unregulated products over the last two years.

It was in the third-choice product that the greatest divergence occurred and where national characteristics shone through. For France it was insurance products – a key element of the household financial product mix because of its tax advantages. But for Italy and Spain, pension products dominated. Both markets are in the early stages of third pillar pension developments. In the case of Spain, some ?62.8bn⁶ is invested in pension assets and this arena has enjoyed around 12 per cent growth in each of the last three years, driven largely by tax incentives. In Italy the pension story has been about to happen for more than a decade but there is an individual pension vehicle that attracts small but consistent interest.

Surprisingly, cash made an appearance in the UK product line-up – ISA tax-wrappers are likely to be the main reason behind this move.

Clearly, the uncomfortable bear market period experienced by investors in recent years has not irrevocably damaged the attractions of the investment fund vehicle. Advisers are still willing to recommend funds and the vast majority felt that the range of mutual funds currently on offer was meeting their clients’ needs. The small percentage (13 per cent) that disagreed with this statement tended to be from markets where access to certain currently popular products was denied (e.g. guaranteed funds or property funds). There was also a request for more funds with low correlation to traditional securities.

The longer-term trend is likely to be away from fund investment as a speculative activity and towards the use of funds as part of a savings solution. The incorporation of funds into more complex product packages is an early symptom but however it is structured, manufacturers will be increasingly removed from the end-client and this trend will put distributors and fund buyers who are involved in developing ‘solutions’ firmly in the driving seat as far as future buying patterns are concerned.

‘Must-have’ products

If fund buyers and distributors are primary influencers of investment behaviour, what then are their predictions for mutual fund asset allocation the 2005? More specifically, EFB Survey respondents were asked which mutual fund sectors were likely to offer the best value or growth opportunities this year, marking each option on a scale of one to 10, one being the most favoured sector. The answers were then aggregated and weighted but, despite the weighting, most asset classes scored very similar voting levels. In fact, the difference between the highest scoring sector and the lowest, (discounting ‘other’), was a mere five points.

The broad spread of interest amongst the EFB Survey group is symptomatic of the lack of clear direction in the current market environment.

This was the case in 2004 when, for much of the year, investors simply sat on their hands waiting for some consistent movement in one or more investment sectors. In 2005 there appears to be a greater commitment to invest but the direction of this investment is likely to be volatile; flirtation with one sector can come to an abrupt halt if the positive progression of that sector begins to falter. (See Chart 12.)

Equity and hedge products took the lead in terms of EFB support. The strength of their vote for equity funds reflected the recent rises on the European bourses at the time the survey was conducted. Since then, markets have suffered a volatile patch, which may have dampened some of the sentiment evident in the survey. Nevertheless, interest in equities was offset by an equal weighting of support for hedge funds, viewed by many as defensive products, with their ability to deliver returns that are uncorrelated with the markets.

The more confident investment mood also showed through to the slightly lower ranking of guaranteed funds. This was a sector that attracted the largest volume of net sales in 2004 but it is hard to read too much into its middle-ranking in the survey. Its reduced position reflects the nature of some of the fund buyers polled, namely wealth advisers who regard the products as expensive. Guaranteed funds find their strongest support amongst proprietary bank channels, particularly among Spanish and French respondents where guaranteed funds have been most successful.

Index tracking and exchange traded funds (ETFs) received rather diffident support despite their obvious attractions in a rising market. This apparent anomaly is probably explained by the commissions and fees that accompany actively managed equity funds.

ETFs remain a relatively new phenomenon in the market and their use by retail investors is slight. However, as they become a more accepted part of the fund arena, they offer numerous potential attractions to fund packagers and asset allocators to funds of funds. We may well, therefore, see support for passive management options increase in the next few years.

The ‘other’ category included the opportunity for respondents to cite their preferred assets and here they isolated real estate, structured notes, derivatives and private equity, with real estate and private equity being cited most frequently.

In the past 18 months, European product development has predominantly focused on three types of products: guaranteed, hedge and absolute-return products. The EFB Survey asked respondents for their specific views on each if these product lines.

Guaranteed funds

Responses on the questions relating to guaranteed funds were fairly even split between the three suggested answers but a small majority claimed them to be expensive regardless of the market conditions. (See Chart 13.) Below the headline figures the market-level responses were markedly different. The bulk of respondents from France (55 per cent) and Spain (75 per cent) – markets where guaranteed funds have been extremely successful – stated that guaranteed funds were always attractive. Where guaranteed products are not a strong feature of the market, the figures diverged significantly: In Switzerland only 16 per cent thought they were always attractive, in Germany, guaranteed funds got the vote from 15 per cent and in Italy the figures were 27 per cent.

Support for guaranteed funds can be correlated with the importance of proprietary bank distribution in each market. They are an ideal product for the relatively unsophisticated bank branch sale and will therefore score highly where this is a characteristic of the market. Italy stands in contradiction of this general view but in Italy the guaranteed structures are linked with insurance products, not mutual funds.

Those respondents that commented on the expense of guaranteed funds tended to be wealth advisers and IFAs.

Total/absolute return strategies

The use of derivatives in a portfolio under Ucits III has led to an expansion of absolute return strategies or products that use derivatives within the portfolio to ensure a positive return regardless of market movement. In an environment where investors are increasingly unhappy to accept correlation with a benchmark that is heading south, funds boasting absolute return strategies have received strong support.

The results were emphatic – two-thirds of respondents believed these strategies to be important, regardless of market conditions. (See Chart 14.) Of the remainder, half felt that the absolute return phenomenon was just the latest fund fashion and the remainder felt it had validity but only in a bear-market. These results were replicated at the individual market level.

Hedge funds

Given the regulatory concerns about the suitability of pure hedge funds for the retail market, a surprisingly large number of EFB respondents believed hedge products to be generally appropriate for all types of investor, although an almost equal number believed they were appropriate only for high net worth clients. Nevertheless, it is a product line that received near unanimous support – a view that was replicated at the market level. Since the EFB Survey was completed, the hedge fund industry has suffered some damage flowing from the corporate bond bets taken on some key US companies that were downgraded to junk status. This may have acted as a dampener on adviser and fund buyer support but, given the strength of their vote, it seems likely that hedge funds will continue their positive momentum.

Investor priorities

A complex mix of desires and practical demands drives investor choice. In Continental Europe the strength of state social support has encouraged a short-term saving mentality. With retirement needs taken care of by the state, savings were for short-term projects such as holidays and rainy days. This environment is in the early phase of change with savings taking on the liability characteristics associated with pension and other longer-term challenges. The EFB survey looked at the issue from the perspective of the adviser/fund buyer and from the perspective of the end-investor.

EFB respondents were asked what they were trying to achieve on behalf of their clients. Higher-growth opportunities scored the strongest response as being the reason driving most product recommendations, although it was followed closely by capital preservation and risk-aversion. (See Chart 16.) These answers are entirely consistent with an investment environment where interest and inflation rates are low and economic growth is modest. It also reflects the somewhat unrealistic expectations of European investors to achieve capital growth for little or no risk. The challenge for advisers, though, is to balance their clients’ aversion to risk (which can be equated to their demand for capital preservation) with a marginally stronger requirement for growth.

In this context, growth opportunities may well be sacrificed in favour of capital preservation. Indeed, the popularity of guaranteed funds is based on a formula that places risk reduction at the very centre of the product equation and this has been accepted by the end-investor even though the price may be a loss of capital.

The mix of capital growth, preservation and risk control will always be central to financial advice. However, the question for the future is how these drivers will be translated into product packages and product recommendations. For now the greater weighting is on security, mainly because the investment culture in most countries is one of lump sum commitments, which deliver a more heightened sense of volatility. The greater acceptance of regular monthly savings schemes is the next distribution opportunity and their development will encourage a more holistic portfolio view – one that is less subject to short-term market fluctuations.

The EFB Survey looked at the extent to which these issues were recognised by the end-investor by asking them to indicate, on a scale of one to nine, which were of most concern to their ultimate clients (see Chart 17):

- The need to build up a savings pot for retirement/ education fees;

- The recovery of loss on past investments;

- The cost of the fund (i.e. fees and charges);

- Capital preservation;

- Improving return on investments;

- Investing with a recognised brand name;

- General diversification of risk; 

- Tax efficiency; 

- Other.

Unsurprisingly, the views of the advisers were translated into a similar response on behalf of their clients. It is impossible to know whether the adviser community is responding to, or driving, client demand and, most likely, both dynamics are in action to a greater or lesser extent. Certainly, the fund buyer community will be influenced by certain base-level expectations from their clients i.e. capital preservation, but how these demands are converted into asset allocation, will generally be the preserve of the financial professional.

The drivers affecting the end-investor involved a more complex mixture of issues, which all vied for attention. There was little to distinguish one requirement from another, although they were ultimately converted by fund buyers into the tripartite demand for capital preservation/growth for minimal risk.

Strong indications

This first EFB Survey sheds light on some of the dynamics that influence fund-buying patterns in Europe. The sample size is representative in terms of the volume of business delivered. It does offers a strong indicative view of the flavour of the issues that are important to investors right now.

Many of these issues are best evaluated over time, to test the impact of the changing market environment on investment preferences. The strength of the partnership between product producers and those that act for the end-investor is reliant on the quality of information available to both. A full understanding of investor needs is vital to the development of suitable products to meet those needs. In this respect, the EFB Survey most importantly confirmed that the investment fund product was still very much alive and critically important in delivering the savings solutions required by investors.

The recent bear market has not damaged the mutual fund brand; rather, it has stretched the flexible characteristics of the product to deliver to a different set of expectations. Today it is a vehicle required for capital protection. Five years ago, a similar survey would have probably showed a much greater demand for growth and index-beating strategies.

Notes

¹ FERI FMI, combined with trade association data from some markets. Data as at 31 December 2004.

² Respondents that fell into the ‘other’ category were typically pensions advisers, consultants and institutional managers.

³ FERI FMI data on funds of funds investing in third-party products showed this sector contributing net sales of ?23bn for the same period. The larger figure suggested by the EFB Survey is not inconsistent since other funds of funds buyers not participating in the survey will include those contributing redemptions.

⁴ SalesWatch Online survey of the sales flows of cross-border groups by country of sale. Twenty-six groups contribute to this monthly survey and their sales volumes are estimated to account for 70 per cent of all cross-border flows.

⁵ Percentage based on data from Germany, France, Italy, Spain, UK and Sweden.

⁶ Inverco. December 2004.

Methodology

The European Fund Buyer Survey was a joint research initiative, conceived and sponsored by Credit Suisse Asset Management. The survey was designed by FERI Fund Market Information, PWM magazine and Credit Suisse Asset Management.

During the three-month period of March to May 2005, the research teams of PWM and FERI FMI contacted selected fund buyers and distributors to invite their response. Questions were asked predominantly through one-to-one interviews.

The research focus was on those individuals responsible for significant business volumes and those who are particularly pro-active as distributors.

In all, 131 responses were received from 15 European markets. (See Chart 1.) These distributors and fund buyers accounted for around 45 per cent of Europe’s ?133bn1 of net sales flows in 2004.

Since the May cut-off date, an additional 44 responses have been received to the survey. These responses will form part of the full analysis of the European Fund Buyer survey, which will be published in September 2005.

Contact: infoplus@feri-fmi.com, +44 207 940 0010

Key points

• The quality of respondents to the EFB survey was extremely high and their purchasing power significant. In 2004, their combined sales accounted for 45 per cent of total retail fund flows across Europe.

• European advisers and fund buyers, who responded to the survey, expect to place ?69bn in mutual funds in 2005. This represents an uplift of over 10 per cent on 2004 commitment, with increased confidence cited as the main reason for this additional support. Around e35bn of this will go into third-party funds.

• Third-party distributors and open architecture platforms accounted for around 18–20 per cent of European fund business in 2004.

• The bear market has not damaged the mutual fund brand.

• Investment funds remain a critical ingredient in the investment solutions required for European savers. However, in the current risk-averse climate the demand is for products that can offer capital preservation and growth regardless of market volatility.

• Equities and hedge funds are regarded as the products most likely to deliver the best growth opportunities in 2005.

• The distribution challenge for the next five years will be to develop long-term savings solutions that move clients from the more speculative culture of lump sum investments to regular savings plans that are liability-driven.