The road ahead

The rain clouds that have darkened the horizon of the world’s financial

industry for the past three years appear to receding at last. But the

outlook for European wealth management in 2004 remains unpredictable.

A poll of a wide range of industry figures has revealed differing views

on the future of the business of looking after the high net worth

individual (HNWI).

Some believe that revelations of improper trading, which began towards

the end of 2003, will damage investors’ appetite for funds. Others take

the polar opposite view, believing that investors are oblivious to the

scandals.

Further pundits predict that guaranteed funds will continue to be

flavour of the month, while their opponents claim that such vehicles

have no place in the new market climate.

The one thing that they agree on is that the “open architecture” approach to product sales is here to stay.

Trading shenanigans

The uncloaking of market timing and late trading at major fund

managers, such as Putnam Investments and Janus Capital Group, has

undoubtedly sent shock waves through the fund management industry. But

how will it impact those distributing the funds – the banks and other

intermediaries?

Market timing – when a trader invests in a mutual fund for a short

time, sometimes as little as a day, to profit from inefficient pricing

– is not illegal. But many deem it unethical because it chips away at

the funds of those who have invested in the vehicle for the long term.

Late trading, meanwhile, is against the law. It is a similar strategy

with one exception. Trades are placed after the market has closed, yet

the trader gets to buy in at that day’s net asset value (NAV) per

share. Generally, orders placed after the close of trade are

supposed to be valued at the next day’s NAV.

Thomas Balk, president of mutual funds Europe, Fidelity Investments, is

undaunted by the furore: “This might catch a few headlines in the short

term, but people will put things in perspective. It’s not the whole

industry we’re talking about here. It’s just a few investment houses

that haven’t followed the rules. Compared with the insurance and

banking sectors, the mutual funds industry has done well.”

He may have a point, especially since Fidelity’s figures, among others,

show that global flows into mutual funds during 2003 were three times

those of 2002.

Yet Mr Balk admits that gaining the trust of investors remains an

issue: “This is a permanent challenge for all financial services

providers. To win the trust of investors you have to run your business

in the highest ethical way.”

He adds that while the bear market we are emerging from is an “external

factor”, financial institutions need to explain it to their customers.

“We need to get across to investors that there will always be bear

markets, the market goes in cycles and the only way to tackle this is

to invest over the long term and in a diversified way.”

One of Mr Balk’s key rivals at UBS Global Asset Management holds a

different opinion. Andreas Mondovits, head of sales management for

Europe the Middle East and Asia, says that the exposure of improper

trading will require distributors to “regain investors’ trust”.

Mr Mondovits advocates “ensuring that an appropriate range of suitable

investments are offered to clients, and that the risk and return

characteristics of these investment choices are well understood [by the

client].”

So what will those investment choices be in the coming year?

Although it is widely thought that we are coming out of the economic

downturn, the consensus is that interest rates will stay roughly around

their current levels. Plus, anyone who invested in stocks during the

past three years will have been badly burnt.

Life in the slow lane

These factors make it likely that investors will remain cautious. This

suggests that 2004 could see another slew of structured and guaranteed

funds, especially those with equity components – as opposed to interest

rate-dependent bond investments.

N M Rothschild in Guernsey has been one of the first investment houses

to jump into this space so far this year. The firm is rolling out a

third tranche in its structured deposit range.

DepositPlus Issue Three offers the chance to invest in the FTSE 100

Index, while protecting the majority of the capital invested. Returns

from the product range between -5 to +10 per cent on capital. This

means that investors in the fund can only lose a maximum of 5 per cent

of their original investment.

Stephen Dewsnip, director of Rothschild Guernsey, says: “The economic

tide appears to be turning and a degree of optimism is being felt among

investors. But continued low interest rates are frustrating for savers,

which is why we are giving clients the option of exposure to the

recovering stock market, while protecting risk”.

Another facet of the fund that looks set to become popular in 2004 is

its short duration. Investors can get out after 12 months. This is to

give them the flexibility to take advantage of any acceleration in the

economic recovery, according to Mr Dewsnip.

DepositPlus Issue Three is available for deposits of between Ł100,000

(E144,000) and Ł5m. The closing date for investments is 12 March 2004

and commission will be paid to intermediaries recommending the fund.

John Reed, chief executive of private banking boutique Arbuthnot

Latham, is less enthusiastic about the future of the traditional

guaranteed fund, which tends to have a far longer duration.

“I think we’ll see capital guarantees falling away. Frequently you

might get the guarantee, but the time horizon is extremely long, say,

10 years. You start questioning the value of the guarantee when it

becomes inconceivable that the market would not outperform the

guarantee over that amount of time.”

Markus Hübscher, head of quantitative portfolios at Credit Suisse Asset

Management, believes that exchange traded funds (ETFs) will finally

start attracting high net worth investors in significant numbers this

year. He points to the lower transaction fees of the ETFs versus direct

investment, and the straightforward handiness of the product.

“ETFs can be the building blocks of asset allocation or used as part of

core-satellite strategies. They also are great if you don’t have

expertise in a market, but still want some exposure to it.”

Temporary solution

Mr Hübscher believes that ETFs will garner investment flows from a

large number of HNWIs who are unhappy with their traditional active

manager and as a result need to park their assets in a suitable

investment vehicle while they look for a replacement.

This trend will be spurred by “either the bad performance or unlawful behaviour [such as late trading] of the active manager”.

Late trading is not an issue with ETFs, explains Mr Hübscher:

“Subscriptions to ETFs go straight into the fund. When you go into an

ETF you buy it from no one.”

Fidelity’s Mr Balk is putting his money on balanced funds. “There will

be more awareness of the need for diversification and following the

latest fashion will be hopefully increasingly less in demand”, he says.

“Investors will go for multi-manager funds due to their diversification

benefits, but also balanced funds that are geared intelligently to a

certain goal.

“In other words, funds with an asset allocation linked to your individual needs and life cycle. We call them ‘lifestyle funds’.”

So will 2004 spell the end of for in-house funds? Mr Mondovits at UBS

thinks not. He argues that instead, competition from external funds

will lead to an improvement in the internal range: “Asset management

firms are responding to the increased in-house competition by looking

more closely at performance and product range and at the creation of

innovative capabilities.

“Additionally, rather than just servicing the important in-house

clientele, asset managers have broadened their focus to distribute

through external channels, which again will help to hone their value

proposition. Growth still looks good, especially for the top players

with the top brands.”

As for the funds universe as a whole, while a degree of rationalisation

is taking place as a result of merger and acquisition activity, Mr

Mondovits does not expect to see much more consolidation in the overall

number of funds.

“We actually expect to see a shift toward the creation of more timely and innovative investment ideas,” he says.

So much for the fund managers. For the distributors of their products,

Mr Mondovits warns that the future could be less bright. He expects a

number of European distributors to disappear in the next 12 months

through mergers and acquisitions, albeit “at a less

dramatic pace”.

Expanding open architecture

“Open architecture” was the phrase on the lips of all wealth managers

in 2003. Signs suggest that 2004 will be no different and that the

debate over the optimum form of open architecture – selling products

produced by third parties – will continue.

Andreas Mondovits, head of sales management for Europe, Middle East and

Asia at UBS Global Asset Manage-ment, says open architecture will focus

on two main trends this year. “The first trend is toward the

realisation of ‘preferred partnerships’ as firms seek to work together

more broadly with fewer providers of investment solutions.

“Otherwise, clients are confronted with too broad a universe of providers or funds, which is proving to be unmanageable.”

Advice will therefore be the key commodity being sold by wealth

managers, according to Mr Mondovits. This trend is particularly obvious

from moves by players such as Germany’s HypoVereinsbank and the UK’s

Abbey National, which have axed their in-house fund management

operations altogether and now exclusively sell external products.

“The other trend,” continues Mr Mondovits, “is toward expanding open

architecture to include investments in alternative capabilities.

Investors have a strong appetite to

further diversify their portfolios and few firms can provide a full range of alternative solutions internally.”

Thomas Balk at Fidelity Investments, believes that the most successful

banks will be those with a limited number of preferred partnerships.

“This is the most convincing, pure form of open architecture,” he

argues. “In theory, a wide range of funds gives investors the most

choice. But let’s face it, funds are sold rather than bought. Investors

have a lower level of know-ledge in Europe than in the US. In 10 years

it might make sense to offer investors a broader choice.”

Living proof of these predictions can be found in private bank

Arbuthnot Latham. The London-based firm is set to implement open

architecture later this year.

John Reed, the bank’s chief executive, confides that he is still

deciding how “open” to be: “If everyone adopts complete open

architecture it will become a zero-sum game – there will be nothing to

differentiate us.”

One plan under consideration is to stick with in-house funds for

mainstream asset classes, in which the bank has considerable expertise,

and outsource only specialist alternative investments. The final

decision will be made later this year.

Outsourcing in 2004

The coming year seems set to see further fund managers and banks

‘focusing on their core competencies’. Outsourcing the back and middle

office will take one of two forms, according to Fidelity Investments’

European president, Thomas Balk.

“It can be outsourcing to a third party within the same country, for

example when you hand over record-keeping to a big, low-cost provider.

Or you can outsource to a lower cost environment, such as India,” he

says.

“Inevitably, for some it is best to outsource to third parties,

especially if they have no scale,” he continues. “For others, using a

third party is not the solution. Fidelity has some operations in India,

including call centres, processing and systems development.”

But outsourcing to a cheaper jurisdiction may have its drawbacks. A

recent report on Indian call centres working for British clients

revealed that standards of customer

service were lower than those of their UK counterparts. The study, by

specialist research firm Contactbabel, found this was principally

because calls to UK centres could be resolved faster, as customers

could explain themselves quicker. Mr Balk claims to be aware of this

issue and stresses that “substantial operations remain in Europe”.

Similarly, Investec Private Bank recently moved a chunk of its back

office to South Africa. But head of marketing Antonia Chambers explains

that the bank felt that in order to maintain a personalised service it

was necessary to retain a core of customer service staff in London.