Time for a health check

The colossal Madoff fraud, orchestrated at the expense of many investors around the world, combined with widespread gating imposed by hedge funds last year, heavily restricting redemptions, have painfully brought to the fore the importance of having a robust due diligence process. Risk management, especially within alternative investments, is now firmly on private banks’ agendas.

At major Zurich-based player Julius Baer, advisers are no longer allowed to recommend single manager hedge funds or single manager private equity funds. “This is now our new in-house policy as we don’t think these products are suitable for our clients,” says Yves Robert-Charrue, head of funds and product management at Bank Julius Baer. Moreover, now that the bank has split from its asset management arm, and GAM is no longer its in-house alternatives provider, there are no specific internal recommendations to make, he says.

All the funds of funds managed by the firms with Madoff exposure were systematically banned from the Swiss bank’s selected fund list at the beginning of the year, says Mr Robert-Charrue. The bank also made further investments to improve hedge funds of funds operational due diligence. “We want to make sure we select only those funds of hedge funds that have a very thorough and very clear investment and selection process in order to minimise any risk,” he says. Bank Julius Baer has stated that it did not have any Madoff products on its recommendation lists, nor did Julius Baer branded funds and distributed funds have any exposure to Madoff. The only exposure to Madoff was through external managers the bank was custodian for and through some self-directed clients.

The regulated hedge fund space is also gaining traction and it is hailed as an interesting evolution by Mr Robert-Charrue. “We do tend to prefer hedge funds expanding into Ucits III, to the traditional managers moving into that area, as they are just more experienced with shorting, and more exotic type of instruments,” he says. “We have made some recommendations in that space, but we are doing that gradually because we want to see some track record first.”

Because of this development, the fund selection process in the so-called long-only arena needs to borrow some of the techniques used in the hedge fund space, says Katia Coudray, head of manager and fund selection at Union Bancaire Privée (UBP), the Swiss private bank reported to have an overall exposure to Madoff funds of more than SFr1bn (€660m). This is a remarkable admission, bearing in mind the circumstances.

“When selecting a hedge fund strategy wrapped in a Ucits III structure, you are really working like you are analysing a hedge fund,” says Ms Coudray, responsible for setting up the long-only fund selection business at the bank in 2001.

“Absolute return means anything and nothing,” she says. “You have really to clarify with the manager what kind of investment objective he has in terms of performance, risk or maximum draw-down.”

The long-only team leverages on existing in-house research on the hedge fund side. The bank admits the hedge fund team was responsible for selecting Madoff-related funds. But there are also important differences to take into account when analysing a Ucits III fund, for example the structure of the equity swaps and the counterparty used, says Ms Coudray.

The liquidity aspect is also paramount and the analysis of the portfolio needs to make sure that it will be able to face inflows and outflows at least twice a month. Currently, two Ucits III sophisticated funds are included in the UBP’s preferred list of 120 funds – which span across equities, commodities, absolute return funds and marginally, fixed income – but there are a few more in the pipeline, says Ms Coudray.

“There is demand for hedge funds that offer higher liquidity, transparency and investor protection, and the Ucits III format is meeting those needs,” she says. UBP has decided to liquidate the New Castle Market Neutral US Equity fund. New Castle Partners is currently embroiled in insider trading allegations in the US. The fund was distributed in some EU countries through Ucits III vehicles, which UBP maintains “offer a safe regulatory environment to investors.” The bank says the entire amount invested will be returned to clients.

According to Christoph Blaettler, head of portfolio management at Vontobel private bank, what gained importance after the crisis “was the whole risk management process and the concept that a fund needs to be analysed over the full market cycle, not just in a bear or bull market.”

The bank, which Mr Blaettler says was not affected by the Madoff events, works closely with Harcourt Investment Consulting, the funds of hedge funds supplier and part of the Vontobel group, which decided to transfer its operational due diligence to its risk management team, in order to improve fund monitoring. The fund and manager selection process is made by the alternative investment committee at Vontobel, made up of private banking and asset management people and Harcourt acts as an adviser, explains Mr Blaettler.

“What we also see is a trend towards increasing demand of better liquidity and transparency which a managed account platform gives,” he says. Harcourt has now opened a managed account platform.

One of the pioneers in this area is Lyxor Asset Management, Société Générale’s wholly-owned subsidiary. At Société Générale Private Banking the focus on operational risk has increased too and more resources have been allocated to monitor clients’ assets in managed accounts, explains Stéphane De Vaulx, global head of alternative advisers.

“Managed accounts offer strong operational and risk management control as well as enhanced liquidity, and address what are the two main investors’ concerns on hedge funds,” reiterates Mr De Vaulx. Their clients’ assets on the managed account platform have seen tremendous growth, five-fold over the past 12 months, he says. The French private bank currently focuses on 20 of the 90 single hedge fund strategies offered by Lyxor. At present the private bank is in the process of assessing other managed account platforms too, in line with the open architecture model it champions, says Mr De Vaulx. The firm also actively promotes 14 different funds of hedge funds to its clients.

The preferred list

The bank’s four centres of expertise are responsible for the analysis, selection and monitoring of funds in all asset classes. The institution recommends 270 mutual funds sourced from more than 100 different fund providers, explains Stéphane Rotceig, head of sales and marketing at the funds research centre of expertise at the French bank.

Fund recommendations, supplied together with key figures and analysts’ comments on the products, are communicated to advisers through the intranet. In order to provide further guidance to advisers, all the recommended funds are then marked with a buy, hold or sell rating. “This is not a market timing rating, but a quality rating,” explains Mr Rotceig.

Advice offered by the local investment team, the centre of expertise and the regular seminars organised by the bank as well as its periodical publications highlighting the best ideas or best products in the best sectors, in line with the top-down views from the investment committee, help advisers to pick the best products to offer to clients, he explains. “Our customer relationship managers rely on our centres of expertise when it comes to investment products and solutions,” says Mr Rotceig.

“One of the great values that the centre of expertise gives, beyond fund selection, is the after-sale service, which has taken huge resources in terms of time and staff in the past few months, as clients and bankers had a lot of questions on markets and products,” says Mr De Vaulx at SG Private Banking.

One of the lessons of the Madoff fraud was the importance for private banks to rein in their advisers in a more structured approach and tie in clients’ portfolio construction with their in-house fund research. Notably, a senior manager at a large Swiss private bank – in an off-the-record interview with PWM – effectively blamed the bank’s advisers for having slipped Madoff funds into clients’ portfolios, against fund research recommendations.

If advisers are going to pander to investors’ wishes, what is the sense of fund research?

Ms Coudray at UBP confirms it is up to the clients to decide in which funds they want to invest. However, individuals rarely invest in funds different from the ones on the preferred list, currently comprising 120 funds, of which 30 represent the bank’s best picks. “If a client comes up with a fund idea, we compare it with the one we have on the list. Finally he decides, but very often the decision is in favour of our list.”

In compliance with German regulation, advisers are allowed to actively recommend to clients only the funds that have been screened both quantitatively and qualitatively, explains Chris-Oliver Schickentanz, head of research and fund selection within the private client-business at Commerzbank.

The German bank’s list of 80 quantitatively and qualitatively screened funds is a shortlist of the total 140 funds – sourced from the whole universe of funds available in Germany – which pass the quantitative process. And the quantitative process was recently strengthened following the merger between Dresdner Bank and Commerzbank completed in September, explains Mr Schickentanz.

Sales units for the different client segments within the bank then create their own shortlist, which indicate which funds should be in the advisers’ focus. Any investor, though, has the freedom to invest in any specific fund registered in Germany, even if it is outside the recommended list of 80 funds.

“If a client decides that our advice is not the best for him, then we have to accept that and execute the deal for him,” he says. “The adviser, in this case, is able to give the client only a quantitative rating on the fund.”

Focused approach

Commerzbank’s eight strategic partners, including AGI, Blackrock, DWS, Schroders, Fidelity, HSBC, JP Morgan und Templeton account for approximately two thirds of the 80 recommended funds, on average.

“There is a big advantage in having strategic partners, as the relationship with them is very close,” says Mr Schickentanz. “We have a much better access to the fund manager and we have a proactive communication policy with them, so for example we are informed when fund managers change even before this is officially announced.”

Mr Schickentanz believes that it is important to partner with large fund management houses in the core peer groups, but, especially in wealth management, it is also equally essential to be able to invest in more specialised boutiques, which are indeed selected to cater to the high net worths’ needs. While the eight firms are the legacy of the original 11 Commerzbank partners, of which three were dropped in September because of poor performance, in Dresdner Bank the funds managed byAllianz Global Investors, its previous parent company, dominated clients portfolios, says Mr Schickentanz.

After Commerzbank’s asset management arm, Cominvest was sold to Allianz, earlier this year, the bank is looking to strengthen its commitment to open architecture.

“The big advantage of the new Commerzbank is that we no longer have an in-house asset manager, that means that we are fully committed to open architecture, but via these strategic partners,” he says. However, from comments made by insiders within Commerzbank it appears that the use of external managers, which the bank’s top management increasingly told advisers to ignore, may be further reduced. This is because the sale of Cominvest to Allianz contained a clause which made Allianz Global Investors the preferred provider for the majority of products sold through the two banks’ combined branch network.

Dresdner Bank advisers, who were not familiar with Commerzbank’s third-party funds, are now being educated on the new selection process, and trained intensively on the products, says Mr Schickentanz. “From the feedback we get, Dresdner advisers are very satisfied with the new process. There are no longer differences between the old Commerzbank and the old Dresdner Bank in terms of fund recommendation,” claims Mr Schickentanz.

The trend towards working with a limited number of external providers is growing in popularity in European banks, as the Julius Baer case proves. Following the split from its asset management arm, completed in October this year, the Swiss bank is planning to move to a so-called “managed open architecture model,” which involves working very closely with a smaller number of partners than the bank has today, in a bid to increase quality of performance and service to clients.

“As a pure play private bank our focus and value proposition is now exclusively on asset allocation, on distribution and no longer on manufacturing funds,” says Mr Yves Robert-Charrue at Bank Julius Baer. “The bank has always operated in an open architecture framework, but when you have an in-house factory, you definitely have a preference for in-house products.” Currently two thirds of the total €30bn clients’ assets in funds at the bank are managed by what was previously its in-house asset management company, now renamed Swiss & Global Asset Management. The fund house has a special branding agreement with the bank to continue to market its funds as Julius Baer funds.

This percentage of “in-house” products is much lower than that held by some of the bank’s Swiss competitors, which can push up to 80 per cent of their own products to their clients, believes Mr Robert-Charrue.

Bank Julius Baer has distribution agreements with more than 100 managers, but the preferred list of 170 funds, which advisers actively recommend to clients in Switzerland, out of the total universe of 7,000 funds, are sourced from around 40 fund managers.

“We want to have a more focused collaboration with a smaller number of managers for our active recommendations and we are in the process of contacting all these managers,” says Mr Robert-Charrue. “I prefer to be a good client to fewer managers than a small client to many,” he says.

Clients, relationship managers and professionals on the product side alike want to understand the manager, the company, or the brand behind the fund and this is possible only when you work with a more limited number of fund managers, explains Mr Robert-Charrue. “Also, the level of cooperation is just higher with a small number, so you can do more, in terms of content and education.”

Customers will still be able to invest in any fund provided by the 100 plus managers they have agreements with, but the funds which will be actively recommended, which will not decrease in number, will be sourced from around 20 managers, estimates Mr Robert-Charrue.

The bank is going to limit its recommendations of Julius Baer funds only to the top performing products and what percentage they will represent on total assets will depend exclusively on their quality, he says.

The preferred list of providers will be made up of a mix of large houses, with a broad range of products, and some very specialised boutiques, which may be preferable in the alternative and high alpha space, he says.

Selecting partners

The important characteristics to look for in strategic partners are the quality of their offering, performance and service, says Mr Robert-Charrue, but dedication and focus in certain asset classes are also key.

These 20 or so providers are expected to have a longer-term relationship with the bank, but if a manager or its fund is not performing there, there will be no qualms about removing it from the client offer, he says. Most of these partners will be sourced from those the bank works with already, but others will be new, anticipates Mr Robert-Charrue, revealing interest in those fund houses which have been active in the institutional space but less in Swiss private banking.

“Overall we expect to have a higher penetration of funds, ranging from exchange traded funds (ETFs) to hedge funds, because now we can actively recommend other products

that we could not do before,” he explains. For example in October, ETFs, which Julius Baer Asset Management did not offer, made their way in the bank’s recommendation list for the first time.

A enhanced intranet tool and specialised sales channels are the main means through which funds recommendations are passed on to advisers. Also, clients’ portfolios are regularly screened and “health checks” are applied. “Our recommended funds cover just one part of all the funds in clients’ portfolios. Some clients may just want to invest in some specific funds and that is an execution business for us,” says Mr Robert-Charrue. “But to enhance clients’ portfolios’ quality we systematically try and channel asset flows into our recommended funds, which we think are the best.”