Making the move

The financial crisis has exacerbated one of the major challenges that the mutual fund industry traditionally faces, related to private investors’ widespread practice of timing the market, which inevitably drives them to buy at the top and sell at the bottom. Both asset managers and distributors are taking measures aimed at addressing this issue, which has negative effects both on investors’ wealth and the whole fund sector.

“The biggest challenge for the industry in general in Asia is that most retail customers do the wrong thing at the wrong time,” says Bruno Lee, regional head of wealth management, Personal Financial Services Asia Pacific, at HSBC Bank.

“Retail customers are quite emotional about when to invest and what to invest, and our job is to help them understand that, for example, they can start a regular saving plan to prepare for retirement or for their childrens’ education regardless of market volatility. We feel there is potential for a lot more customers to use mutual funds as part of their investment portfolio.”

Mutual fund usage is still very low in Asia, says Mr Lee. For example, in Hong Kong, although the introduction of the Mandatory Provident Fund in 2000, a compulsory saving scheme for retirement, gave the industry a boost, only 13 per cent of customers buy mutual funds, versus 50 per cent who buy local stocks, according to a recent survey by HSBC.

The bank recently pioneered a wealth management solution, called FundMax, aimed at helping retail customers manage their assets and increase usage of mutual funds in Hong Kong. By paying a single monthly fee, which ranges from 1.75 per cent to 1 per cent, depending on clients’ total fund assets in their account, investors can switch between any of the 400 funds on the bank’s platform free of charge.

“This service allows customers to manage the portfolio without worrying every time they make a switch there is an additional cost involved,” says Mr Lee. There are plans to roll out the solution to other selected Asian markets, once the concept has been tested out in Hong Kong.

“There is no one asset class that consistently performs well over time. Fine tuning the portfolio to make sure it is allocated to the right asset classes in the right mix is very important, particularly for Asian customers exposed to highly volatile markets. If there is a cost for rebalancing the portfolio, that may deter investors from doing so.”

This new system aligns clients’ interests with those of the banks, the advisers and the fund managers, claims Mr Lee. Advisers will no longer be incentivised to push investors to buy and sell products, as their revenue will be linked to clients’ total asset growth. “We will spend more time helping customers to do the right selection and allocation to help then grow their total account size,” he says.

But there are a few challenges to overcome. The first one is to change the front line mentality from product focus towards a portfolio management approach. Also, if the programme does not help attract new customers, the bank would generate significantly lowers revenue for the first year, due to the lack of front-end fees. Moreover if the market volatility continues, customers’ investment appetite will continue to be low, making it difficult to test out whether the programme is successful, says Mr Lee, who yearns after the US market model, where 80 per cent of customers use no-transaction fee mutual funds.

Dramatic shifts

Although portfolios do need to be rebalanced, sometimes investors change their risk profile too dramatically to respond to market conditions and do too much short-term trading, believes Spencer Wang, vice president, research at Citi in Taipei. “Investors should not change their risk profile so dramatically in the very short-term. They often tend to deviate from their model portfolios because they chase returns, they focus on risky assets and invest in China or Russia, often influenced by the media,” he explains.

“It is always the same. After a market crash they argue with us that we should have not let them deviate from the portfolio, but we believe that clients should take their responsibility. After the crash they will hold a conservative portfolio, and after the market rise they complain their portfolio has not performed well,” says Mr Wang.

Asset allocation and the concept of portfolio diversification are difficult to explain to clients, and the advisers’ challenge is to explain to clients that they may incur losses, although more moderate, even if they have a very balanced portfolio, he says. “Retail clients have most of their money in risky assets or so called developing markets. There is a home bias, as investors think they understand Asia or China more and put their money in those markets. But that is not true, risky assets are risky assets and very conservative clients should not have large percentage of their money in the Brics [Brazil, Russia, India and China].”

Elaine Wong, Credit Suisse

There is no doubt that banks and advisers encourage investors to trade funds to get higher commissions, acknowledges Mr Wang, however trailer fees acquire more weight as the bank’s assets grow, as they guarantee stable income, even in a downturn. “When Citi started the business in Taiwan, the money we got was from the front-end fees, but after building the largest portfolios in the past 10 years, trailer fees have become more important than before.”

Strategic assets

Recently, the bank has introduced a new remuneration system in order to encourage advisers to focus more on strategic assets. “We give higher scores to the financial consultants when they allocate clients’ money to strategic assets such as global balanced, fixed income or global equities or when they introduce the dollar cost-averaging concept or regular savings plans to clients, as these allow investors to average out their risks,” says Mr Wang.

“Two years ago, even if you had given higher scores to the financial consultants, it would have not been easy to allocate money to fixed income.”

The general mutual fund industry guidelines, applied by Citi, prescribe that mutual funds should not be subject to short-term trading, and should be held at least 90 days.

“Ninety days is short, but it is better than letting the clients trade them like stocks,” says Mr Wang, explaining that investors tend to trade equity funds more often than fixed income portfolios, which are held for years.

A couple of years ago, in order to encourage investors not to use mutual funds for short-term trading but only exchange traded funds (ETFs) or stocks, the bank set up a trading platform for ETFs and stocks to offer this service to its clients.

Steve Chuang, senior vice president wealth management, Personal Financial Service, HSBC Bank in Taipei observes that Taiwanese customers have shorter investment horizons than before the crisis. “After the Lehman event, investors are very sensitive to any market movement and they are looking for short-term gains,” he says.

“More clients have doubts on the traditional asset allocation, because they experienced that all asset classes fell at the same time. They are increasingly cutting their core portfolio, they are moving to the tactical side and the product turnover has increased a lot since last year.”

Emerging market equities have become a core holding in clients’ portfolios, although the bank’s reference portfolios have little allocation to emerging markets and higher exposure to more mature markets.

“The key role for financial advisers is to give long-term growth portfolio advice, but at the same time people tend to have three or four bank accounts and they like to get all the different advice, so it is challenging for any of the financial advisers to really help the customers to execute the investment strategy. A long education process is needed,” says Mr Chuang. “We observe a much higher demand for updated market information, and that is why we started investing online and video to provide the most updated information to our customers.”

Last year the bank introduced semi-annual portfolio review reports to their premier customers, who are the retail banks’ top tier or affluent clients, having a minimum threshold of $100,000. “We do see more and more customers who are taking action after they view their report, so the process is kicking in.”

On the other side, asset management companies are finding it increasingly hard to gain distributors’ trust and enter the privileged list of funds they recommended to their customers. “It is a highly competitive market place. Getting shelf space is very demanding, and many distributors have implemented managed open architecture, limiting the number of third-party providers,” says Christof Kutscher, head of Asia Pacific for UBS Global Asset Management.

This has also been a consequence of the increasing regulatory pressure. Distributors which have fiduciary duties towards their customers find it easy to have close relationships with providers that they know well, from which they can source different products and brand has its role, he says. “If distributors talk to clients about brand names they are already familiar with, that helps, so brand name is certainly important,” he says. In-house products also play an important role in banks that own an asset management company and they are often favoured by advisers.

Distributors should select funds based on solid investment process and fund research, and not just on past performance, believes Mr Kutscher. “Every distributor advertises that they select the best funds in the world but they always sell the best performing funds of the last three years or last year. But any study shows past performance is a very bad indicator of future performance.”

“It is easiest for client advisers to persuade clients into buying funds based on past performance, but this is not optimal for clients. I do believe that a lot of value could be added through fund research and understanding of the investment process,” adds Mr Kutscher. One of the hurdles is due to the fact that client advisers in retail banks are confronted with a very complex world and lots of products, and they cannot really be experts in everything, he says.

The regulator in Hong Kong has introduced “draconic measures” to make sure that retail clients are advised properly. Another way of dealing with the issue would be to request that products which are put on the shelves go through a very thorough analysis, he says. In Australia, where gate keepers have developed a rigorous system of fund selection, investors can buy a mutual fund in five minutes, while they take 45 minutes in Hong Kong to go through all the papers, but the process behind the sales in Australia takes much more time, he explains.

Also, since many markets in Asia are highly IPO (initial public offering) driven, funds will need to be launched in those areas which have performed, which is not necessarily beneficial for the industry or the customers.

“It would be very good to launch a fund at the trough of the market cycle, but in Asia you will not find any single distributor who will put it on their platform,” says Mr Kutschner, acknowledging this behaviour is human nature. Even having professional gate keepers who select the fund would not make any difference if investors show no interest.

The penetration of funds or managed products is “pathetic” in Asia but the trend is towards employing more of them in clients portfolios, believes Mike Imam, head of private banks distribution Asia for Schroders. While before the crisis, private banks were operating much more on an execution basis, offering very little portfolio advice, that’s changing a lot, as a consequence of 2008 events, he says.

“All the major private banks are putting huge efforts behind proper portfolio allocation processes, and understanding of the risks,” says Mr Imam, previously head of private banking advisory for Asia at Credit Suisse.

While banks’ book of business has less concentrated exposure to specific products or asset classes, the trend is towards using fewer trusted providers and investment strategies within the asset classes themselves. “Before 2008 there was total proliferation and over-diversification of providers, little understanding of the potential risks involved in the products. Private banks were focused on the latest best ideas and best performing managers and were responding to client demand. Now they are really focusing their assets around fewer partners, as they want to be much more aware of who they are using as providers. This is definitely a way banks want to manage risk.”

Multi-asset diversification

Because the whole selection process is becoming more sophisticated and more professional on the private bank side, there will not be free lunches for anybody.

“There is a massive difference between funds being available and being recommended to clients, and the more structured private banks get in their advisory process and portfolio allocation and how they implement it, the bigger the difference will become,” says Mr Imam. “You will only be able to position yourself where you are very competitive, and that means there are no free lunches.”

According to Mr Imam, one of the products recently launched by the firm that can enhance private banks’ product range is the diversified multi-asset fund, which should be used as a core solution within clients’ portfolios, and around which advisers can build more tactical calls.

This solution, which is very dynamic in the way it is asset allocated, leverages on the firm’s track-record of managing multi-asset solutions for institutional clients, but addresses private investors’ need to preserve their wealth while participating in market growth. It includes an element of downside risk management, as it aims not to lose more than 10 per cent, despite including many risky assets. Unlike other many global asset allocation products, it invests 70 per cent of its assets in Asia, to cater specifically to Asian investors who have a very strong home bias.

“Often private banks are not really aware that it is not only time consuming but it can be very sub-optimal to manage clients’ portfolios, especially if the accounts are smaller, if they try to come up with individualised asset allocation processes,” says Mr Imam. “We know that it would be very difficult to run efficient segregated portfolios or portfolio allocation implementations for smaller clients.”

The next 10 years are going to be very volatile and private banks are going to need products that are nimble and that invest in the market with appropriate timing, he says.

Room to manoeuvre

There is more room to increase the penetration of core funds, such as diversified bond funds like the Pimco Total Return or Templeton Global Bond, believes Elaine Wong, head of advisory and sales Hong Kong at Credit Suisse’s Private Banking division. “We have been trying to educate the relationship managers and we have actually seen the penetration of these core funds increasing,” she says.

“Every single client should have some of these funds, which should not be really traded,” says Ms Wong.

While the use of structured product providers has been limited, as a consequence of the Lehman crisis, the range of third-party mutual funds is still wide, and has not been affected, she says. Private clients can access a total of 1000 funds, which are included in the fund master list emerging from the quantitative and qualitative screening process.

“On the structured product side, we are limiting the number of counterparties but in terms of mutual funds we still use open architecture,” says Ms Wong. At Credit Suisse in Asia, 40 per cent of clients’ assets in funds are with third-parties. However, proving that there is a big difference between a fund being available on a platform and a fund being sold, 80 per cent of fund sales go into the “high conviction offering”, which represents the list of 40 funds that are recommended to advisers, and are reviewed on a weekly basis.

“We have a good process to communicate these products to the front and a very good sales service off this high conviction offering,” says Ms Wong.

Tony Stanton, head of investments at LGT Investment Management, believes the most difficult challenge private banks are faced is striking a balance between having open architecture and becoming a supermarket.

“Clients do not want a fund supermarket,” he says. “They want carefully chosen managers that are well researched, and that have gone through earnest due diligence. Managed open architecture by definition is necessary for us to be successful. Historically we have seen the majority of our clients invest via our flagship offering and as a result we have never become a supermarket nor do we have any intention to become one.”

More behavioural finance will need to be applied to the asset allocation concept going forward, believes Mr Stanton.

In the past, asset allocation has always been based on the historical performance in the markets and the optimal blend of assets was derived from the history of the return series and the correlation between asset classes, without really addressing the timing for allocating to markets.

“Behavioural finance incorporates a necessary contrarian view point to try and identify the behavioural biases of investors. Essentially it enables you to try and apply logic to what is a very emotional issue, namely reacting to the fear of monetary loss.”

Mr Stanton stresses the importance of employing a “shortfall approach” to asset allocation, which involves assessing the risk of under-performing the minimum target return needed to achieve clients’ goals’ and ambitions.

“Essentially, we are managing towards client-defined liabilities and expressing the likelihood of achieving these targets. Our emphasis is on the risk of not achieving these targets. This is a much more sophisticated approach than you often see, whereby advisers devote their energies merely to the identification of opportunities rather than addressing the risks inherent in these.”