Niche areas will drive market development

Evidence that the movement towards sub-advisory, or fund management delegation, is a long-term strategic decision is provided by the fact that, despite the credit crunch, difficult market conditions and widespread expectations of slower global economic growth, the industry’s appetite for this business remains healthy.

While 54 of the 90 respondents to the survey have outsourced assets worth ?135bn, it is estimated that the European retail sub-advisory market is currently worth more than ?300bn.

More than half of the respondents to PWM’s fifth annual sub-advisory survey have positive views on the development of the market during 2008/2009. Reasons for that include the search for product diversification, competitive differentiation and efficiency. A further 7 per cent expected limited or little growth, and 4 per cent believed that this market is stable.

Sub-advisers will be employed more in the future to manage alternatives, hedge funds in particular, absolute return and alpha products. Thematic investments and emerging markets will also drive the growth, according to respondents.

“Retail sub-advisory in 2008 will grow on specific management expertise like hedge funds, ESR (environmental and social responsibility) and absolute return,” says Dominique Sabassier, CIO at Natixis Asset Management.

But others are slightly more cautious. “I think the success of sub-advisory will depend on the competitiveness of their offer in terms of fees,” says Ignace Van Oortegem, COO and CIO at KBC Asset Management in Belgium.

The perceptions of how the business will develop also depend on specific market conditions in particular countries. In Spain for example, where the domestic fund industry has been badly hit by the credit crisis, Claus Grajmlich-Eicher, managing director of investment and asset management at Allianz Seguros says: “I see negative growth for this business in Spain as the main retail distributors are focussing on their balance sheet.”

Rafael Seves Dávila, head of equity, mutual funds and hedge funds at Spanish private bank Altae Banco Privado, sees that “demand for capital preservation and index products has increased. Not many clients want to assume risk by investing in high tracking error funds, for example.”

When asked to comment specifically on the impact of volatile market conditions, around 37 per cent think that these are detrimental to the fund industry in general, and to the specific area of sub-advisory as well, as investors’ risk aversion tends to increase.

On the other hand, 21 per cent of respondents believe the consequences of this volatility might be beneficial to sub-advisory. One of the reasons is that it may encourage firms to focus on their core investment competencies, which may lead them to outsource additional activities where they may not hold a competitive advantage. This environment also tends to highlight really good quality asset managers over bad ones. “Quality is rewarded by higher returns when compared to a low volatility environment where the range of outcomes is muted,” explains Michael Jones, head of financial institutions at Fidelity International.

Changing drivers

The decision to focus on core competency, the desire to offer an enhanced product range to clients and the search for higher alpha are the key drivers to sub-advisory, according to the survey results. (See chart 1.) Another important factor encouraging firms to seek external managers is the conviction that sub-advised funds can be specifically tailored to a client’s needs.

Around 20 per cent of respondents who sub-advise said that reasons for sub-advising investment products are different today than the past. In particular, the factors that today have gained more importance have been identified by respondents as:

l a greater desire to meet broader client needs in terms of products, especially in the more exotic or alternative asset class areas;

l competition and focus on higher alpha, which has led firms to focus on fewer capabilities in-house;

l the increasing gap between low cost beta products and top performing alpha solutions, which is driving the need for top performing funds to be brought to market. This leads firms to seek specialised managers, a trend which is fuelled by the wider selection of boutique managers now on the market.

Around a quarter of respondents identify in Ucits III legislation a positive drive to the growth of the sub-advisory business.

Tommaso Corcos, CEO at Fideuram Investimenti says the legislation, giving more flexibility to investment policy, will enhance alpha and performance of certain investment products, luring a higher number of investors. The Italian firm has recently awarded to GLG what is believed to be the first 130/30 mandate in Europe.

“In current market conditions some investors are increasingly looking for investments that are not directly correlated to the equity market. The wider investment powers available under Ucits III have enabled managers to develop products for these investors, such as absolute return products and multi-asset solutions,” says Robert Noach, head of UK financial institutions at Schroder Investment Management. “Therefore we have seen a wider variety of products, especially structured products, being available in the sub-advisory market.”

But Georges Wolff, head of fund manager selection at ING Private Capital Management, says the impact of Ucits III could be negative. This is because “you might find more and more strategies in the Ucits III space that were previously offered only via segregated accounts and on a sub-advisory basis to institutional clients.”

Another important driver is the trend towards alpha-beta separation. Around 60 per cent of respondents believe this trend and the increasing interest of those who sub-advise to target higher returns might drive further growth in the sub-advisory retail business in Europe. “Alpha-beta managers will further diverge,” says Rene Schneider, managing director of product management at Bank Julius Baer. “Sub-advisory business will grow, with alpha generated more in niche markets. To reach cost efficiency and critical mass, beta must be highly scalable, and only few firms will offer indexing in the future,” he says.

Top sub-advisers

The most used sub-adviser is Alliance Bernstein, which manages 22 per cent of mandates awarded by all respondents who disclosed sub-advisers’ names. Goldman Sachs AM and BlackRock are estimated to manage 16 per cent of all mandates. (See chart 2.) Unprompted, respondents rated Goldman Sachs AM as the best sub-adviser, because of performance and quality of reporting. Other top-rated sub-advisers were, in order, UBS, BlackRock, Wellington, Crédit Agricole, JP Morgan AM, Credit Suisse and Schroders. External managers are chosen due to fund performance (37 per cent). Other criteria such as management team, investment style, reputation and track record fall way behind. While marketing support and training are only seriously valued by 6 per cent, 11 per cent of respondents who outsource said the ability of an external manager to propose new ideas and products is taken into account.

Assets outsourced and

sub-advisory models

There remains a net dominance of equity mandates in all countries in Europe, with the exception of Austria, where bonds account for a third of all mandates. (See chart 3.) In France, Switzerland and the UK, in particular, firms tend to award proportionally a higher number of mandates in equity than other classes.

But the variety of asset classes outsourced, either through fund delegation or third-party funds, is clearly expanding. (See chart 4.) Sixty per cent of respondents said they will start or continue sub-advising alternatives in future, including hedge funds, private equity, infrastructure, commodities and real estate.

There are two possible ways of outsourcing hedge funds, which are full management delegation and model portfolio, where the delegator constructs its own fund of hedge funds and employs the sub-adviser for providing advisory service and access to a platform of hedge funds. The importance of the model portfolio will grow in the future, according to our research; 12 per cent of respondents will be adopting this approach, compared to 6 per cent today. Full management delegation will grow in percentage terms at a lower rate – 12 per cent will eventually choose this option; today 27 per cent employ this model.

In terms of sub-advisory models employed, manager of managers is the most popular in the UK, where almost 60 per cent of mandates are part of multi-management programmes. In other countries, most notably Austria and Italy, fund management delegation is by far the most used sub-advisory model.

In Italy, the Nordics and Switzerland, white-labelling is preferred, where sub-advised funds are branded under the banks’ own brand. In the UK, France and Austria, co-branding is popular. In France and Austria, a third of mandates are branded under the sub-adviser’s brand name.

Overcoming barriers

Thirty per cent of respondents believe confidence in in-house investment management is the main factor which prevents financial firms from seeking external advisers in specific asset classes. (See chart 5.) Other important barriers are preference for the flexibility of fund distribution and little or unstable client demand. The high costs for setting up a sub-advisory operation and high fees also substantially affect European financial firms’ decision to outsource.

Thirteen per cent of participants stated that if sub-advisers worked on a performance fee, as opposed to a fixed fee, they could be encouraged to award a higher number of mandates. A further 14 per cent expressed interest in performance fees. However they stated that this is not a key element, as it depends on the absolute fee level and asset class.

Showing clearly cost/benefit at all levels and reducing fees are some of the recipes sub-advisers can employ to help overcome these barriers.

Concerns about loss of control and implications to brand and relationship also prevent houses delegating investment management to external players.

A few respondents said external managers should commit to intensive communication, improve risk reporting and transparency, and should fulfil highest standards in investments, corporate governance and risk management. Building a strong brand name, co-operating with the delegator to create investment rules and setting up a strategic partnership based on reciprocity were also suggested.