The uneven spread of misery

France and Italy have shown increasing demand for third party funds, unlike the UK and Switzerland.

It is fast becoming clear that “open architecture” is far from the one-tablet solution for all ills as claimed by its supporters – the international fund companies. Many banks still prefer to use their in-house fund company. Some have even tried to use funds of external managers, but have subsequently changed their minds, and preferred home comforts after all. In previous editions of PWM, we have explained how many European fund distributors chose to focus on their own funds, rather than those of other suppliers, during 2002–3. Fund suppliers also had to contend with volatile financial markets. Based on the interviews that we conducted in early 2002 and early 2003, we estimate that total demand for “other suppliers’ funds” – or third party funds as we normally call them – dropped from about $1200bn (E1000bn) to $981bn in that period. Chart 1 shows how the $219bn fall in demand for third party funds through 2002–3 was spread over the various national markets. At one extreme, the greatest reductions were in the established markets of Switzerland ($104bn) and the UK ($84bn). The third greatest drop was in the Netherlands ($57bn), home to a large and established asset management industry fighting to defend its profitability. Demand trends Absolute demand for third party funds also fell in three other national markets that have excited commentators over recent years. These were Germany, Spain and Luxembourg. Chart 1 also shows how there was very little change in the very small Belgian market. By contrast, we concluded that demand rose in Sweden (by $20bn), France ($39bn) and Italy ($93bn). The bottom line is this: the misery was not spread evenly. Other insights become apparent if you look at where third party funds were invested rather than nationality of buyers/distributors. Chart 2 looks at how the $219bn drop in demand for third party funds was spread over various asset classes. In absolute terms, the biggest gain was made by funds investing in cash and money market instruments, while largest falls came from European bond funds. The chart also shows asset allocation shifts. As explained in last month’s PWM, hedge funds were just 2 per cent of third party fund assets in early 2002, but 7 per cent in early 2003. The shift towards hedge funds was, therefore, 7 per cent minus 2 per cent. It was even higher, at 11 percentage points, for cash and money market instruments. If the importance of hedge funds and cash increased, it follows that the importance of other classes decreased. For instance, US equities fell from 15 per cent of third party fund assets to 9 per cent. Given the performance of US stocks from early 2002–3, the shift may only have been partly due to decisions by investors and third party fund distributors. The second largest negative shift was from European bonds. In early 2002, they represented 21 per cent of third party funds. By early 2003, the corresponding figure was just 16 per cent: the shift was, therefore, five percentage points. Quite unlike stockmarkets, European bonds were generally producing positive total returns for investors in 2002–3. It therefore follows the shift was almost certainly driven by distributors who switched from using third party funds to their own in-house funds. However, very few distributors felt confident enough to take a “Do It Yourself” approach to European equities. In spite of a brutal bear market, European equities accounted for 27–28 per cent of third party funds throughout 2002–3. The $62bn fall in holdings of European equities in third party funds was entirely the result of the slump in share prices. Chart 2 also shows that shifts for all other asset classes were fairly minor. The obvious conclusion would be that 2002–3 was a year in which investors lifted weightings to hedge funds and money market funds, and further reduced their holdings of US equity funds. Meanwhile, many distributors were increasing use of their own funds to provide investors with access to European bonds. Equities eschewed Chart 3 shows that, across Europe, equity investment through third party funds slumped $168bn between early 2002 and early 2003. Equities dropped from 54 per cent of third party fund assets to 49 per cent. The trends varied hugely from country to country, showing a much more complex set of pictures. At one extreme, investment in equities through third party funds rose in absolute terms in France, Italy and Sweden – the three countries in which total demand for third party funds actually rose over the year. In Sweden and Italy, the increase took place in spite of a shift away from equities by distributors and investors. Conversely, investment in equities through third party funds fell in absolute terms by over $30bn in Spain, the UK and the Netherlands. In the UK, this appears to have been due to global bear markets. The percentage of third party fund assets invested in equities actually increased. In Spain and the Netherlands, on the other hand, the asset allocation shifts away from equities were substantial, at –25 and –41 per cent respectively. Spain stood out because distributors focused more on their own funds, as opposed to third party funds. The implication is that large Spanish distributors perceived they could do at least as well in equity investment as other asset management groups. Dutch investors moved away from mainstream equities – and bonds – towards hedge funds and private equity. For this reason, the Netherlands also experienced the largest shift away from non-European assets, as Chart 4 shows. The Netherlands accounted for about one-third of the $154bn drop, in absolute terms, of non-European assets held through third party funds. US falls from favour Elsewhere, investment in bonds and equities in the US, Japan and elsewhere typically fell by $10–20bn in absolute terms. Sweden was the exception in that investment through third party funds into non-European assets rose by $14bn. In part this was due to overall growth in demand for third party funds. However, Swedish investors also made an asset allocation shift away from Europe. After the Netherlands, Italy, Luxembourg and France were the three countries with the greatest shift away from non-European assets. Italian, Luxembourg and French investors, far more than their counterparts elsewhere, focused on cash and money market instruments. Chart 5 summarises changes that took place in absolute terms. Thanks mainly to investors in France and Italy, holdings of cash and money market instruments through third party funds rose by $91bn overall in 2002–3. Growth of third party funds markets in both countries limited the fall in European equity holdings to $62bn. Distributors in most countries were moving away from third party funds specialising in European bonds. One of the biggest challenges for fund suppliers in Europe was that, in each of the various national markets, investors and distributors were reacting differently to the stock price slump and drop in bond yields through 2002–3.

Andrew Hutchings, research editor, Sector Analysis