When going ‘outside’ has to make sense

Elisa Trovato: Welcome to our fifth annual sub-advisory roundtable. The aim today is to discuss trends in the sub-advisory business, how drivers to fund management delegation are evolving, the rationale for multi-management and what are the pros and cons of fund management delegation versus third-party fund distribution.

Georges Wolff of ING Private Capital Management, private banks tend to say that asset allocation explains the large majority of portfolio performance. Quite often, product selection is seen as a technical rather than a strategic issue. If that’s the case, what’s the real added value of product selection?

Georges Wolff: It is widely recognised that asset allocation is the most important driver of performance in portfolios, but as we all know it is extremely difficult to generate out-performance by doing asset allocation. Although the contribution of the manager selection might be marginal, we try to use that lever also as a way of increasing our overall performance. Also, parts of our portfolios allocations are more strategic and less of a tactical nature; for example in the hedge fund space, and here, manager selection can definitely improve or deteriorate performance considerably.

Elisa Trovato: At what stage in the product creation process is the decision to sub-advise taken, as opposed to buying third-party funds?

Georges Wolff: At IPCM, which is the Luxembourg-based centre of asset management expertise for ING Global Private Bank, we are next to fund management in charge of selecting funds and managers for dedicated mandates. The questions we ask ourselves prior to looking at sub-advisory are: is it an asset class where we have critical mass? Is this critical mass persistent over time? Is the strategy that we would like to implement one where we can generate excess return? We think there are some asset classes and strategies where it makes more sense to have a dedicated management via sub-advisory compared to using funds. It is really looking at size, persistency of the assets and the capability of delivering superior returns that drives the decision. What is mostly defining the level of critical mass on a specific asset class are the sub-advisory fees we are going to pay.

Elisa Trovato: Lance, at Merrill Lynch the sub-advisory business is much more developed in the US than it is in its international business. What are the reasons for this different approach?

Lance Peltz: In the US, where our asset size is substantial, there is a huge business developed around separately-managed accounts because of tax reasons. Outside the US, the mutual fund, whether it is in a sub-advised arrangement or an externally branded and manufactured mutual fund, is the main way of delivering the solution to the client.

The decision between sub-advisory and external mutual funds comes back to cost, critical mass, tactical versus strategic.

Sub-advisory is universally cheaper than buying an externally-managed mutual fund, even if you drive a very hard bargain on an institutional class. Not only in sub-advisory can you usually strike a different type of arrangement. We cap and control our own expense ratios as well, which is not often spoken about when we talk to the public.

The difference is that there are many boutiques that do not want to accept that pricing structure, and then the trade-off that we have to make in doing manager selection is: “is our expectation of future net to fees performance going to be worthwhile and come back to the tactical, strategic time horizon?”.

Also, a lot of the tactical strategies are newer, less of a track record and maybe harder to justify bringing to a sub-advisory arrangement.

Elisa Trovato: James, some of the best investment managers are normally only willing to manage mandates for significant size of money for large institutions. What sort of size does a multi-management operation need to reach to have access to all types of investment managers?

James Millard: Our size – Skandia Investment Group manages around $115bn, including 100 segregated mandates averaging around $200m each – ensures we have access to managers of all types.

However, we have taken a very pragmatic approach and we offer a hybrid solution to make sure that we just access the best managers, regardless whether it is through a segregated sub-advised mandate or through a fund, unlike the pure fund of funds or manager of managers approaches.

We have to recognise that some investment advisers just do not offer segregated mandates, but if you have the capability, scale, the distribution and the depth of relationship with the sub-adviser as we do, then you do get access to those managers and can get sub-advised mandates very easily. In our Best Ideas funds, we actually combine 10 managers with each sub-adviser running 10-stock portfolios.

As a result of our scale and strength of relationships with sub-advisers we have got the likes of Roger Guy in there, creating a 10-stock portfolio for us on a bespoke basis.

Elisa Trovato: Alan, before joining Bank Syz & Co as CEO of Oyster funds you were CIO at FundQuest. At Bank Syz and Co, can you access all the sub-advisers you wish, even if the mandates you award now are of smaller size?

Alan Mudie: Banque Syz is a privately-owned private bank based in Geneva. It is a very young organisation, founded in 1996, with three different business lines and brands: Banque Syz for the private bank, 3A for the fund of hedge funds business and Oyster for the long-only business, which is a Luxembourg Sicav, with $10bn in assets under management. From day one, it comprised both internally- and externally-managed sub-funds.

The business at Banque Syz is very different from FundQuest where some of the sub-advisory mandates were extremely large.

We speak to small, specialised boutique organisations, which resemble Banque Syz in many ways: our interests are aligned, we have better understanding and better commonality of respective business development plans and these boutiques are very entrepreneurial in the way that they are run.

Today, the bank has $32bn in AUM. Twelve years ago, the bank started without a captive asset base, so Oyster was designed as an asset-gathering mechanism for the group. We were aiming to build distribution, even as we were building the track record.

Our aim is to create higher alpha products to distribute to our client base. There are a number of areas that we manage in-house, such as European equities and asset allocation, where we think we are very good. Beyond that, our default decision has been to delegate to external advisers. About half of Oyster’s sub-funds are outsourced.

We distribute the products under our brand name to our client base, with the support of the sub-adviser to help us provide the information, the marketing support to make those sales and make those sales stick.

Throughout the bank’s history, the proportion of assets invested in Oyster by the bank’s own clients has remained quite low, around 10 per cent.

New asset classes

Elisa Trovato: HSBC has seen an addition with a real estate multi-manager last year, which was transferred from HSBC Group’s dedicated product infrastructure investment specialists, HSBC Specialist Investments. When do you decide you need a multi-manager approach for a particular asset class? Do you expect there will be new asset class additions in your multi-management team?

Philip Glaze: The incorporation of the property team within multi-manager was a natural development. The team manages a multi-manager Open Global Property fund, which sits alongside our other Open global multi-asset funds. These products were designed to meet a specific product demand and have done very well. In terms of building up research in new asset classes, we currently have research teams that focus on the traditional asset classes, as well as alternative areas such as commodities and of course property. We have extended, and will continue to extend, our research coverage as markets and investment opportunities develop and arise. Naturally we observe both the market as well as our clients’ needs, and form a view as to how our research focus should evolve in a proactive manner. Ultimately it’s an iterative process and we have the level of resources to be flexible. We cover all asset classes in our multi-management business except hedge funds, which are run by a separate hedge fund team within HSBC Global Asset Management. We run US$30bn in discretionary assets and we advise a further US $50bn.

Elisa Trovato: Barclays Wealth included new asset classes such as property, hedge funds, and infrastructure in its multi-management business last year. What has been the driver, perhaps the desire to meet broader client needs?

Ian Hale: Yes, there has been a driver and a request from retail clients to have access to this type of arrangement within the multi-manager product. Within our high net worth business we tend to do that separately outside the multi-manager, so not on a sub-advised basis. Even within the multi-manager product, it is very difficult to do some of the asset classes on a sub-advised basis. Our multi-manager product is actually a kind of hybrid scheme, because we have two layers: we have our single-asset class funds, which are manager of managers and sub-advised, and we have multi-asset class funds which are fund of funds that invest in the single-asset class funds.

In the hedge funds area, we have not felt that within the regulations or within our expertise we wanted to venture into creating our own hedge fund sub-advised account, because we can go out and buy the best hedge funds.

As a lead investment manager you have got to be happy with your own internal risk processes and controls, that you can in effect manage those underlying strategies. When you move into the more complicated hedge fund-type universe, for example, I think there are very few parties that will either decide to go that route or have the scale and expertise to be able to say “Well, I have got enough expertise to be able to understand what they are doing, but not enough that I actually want to do it myself”.

Nick Phillips: What is interesting, in a couple of countries something which has evolved over the last four or five years is where an entity or client does not have the expertise but would like to have it in the future. You have a sub-advisory partnership, but you are working with our client, they are learning from us and building up their own expertise. So that over a period of time, five, six, seven years or whenever they are comfortable, they would say “Okay, thanks very much but we can do this ourselves now. We have learned from you, we have had a strategic partnership, let us move on to something else”. That happens not just in bank or insurance company distribution but also with the big pension schemes.

Elisa Trovato: Georges, you also delegate fund of hedge funds. Do you delegate manager selection and you do the asset allocation in-house in a model portfolio fashion or do you do delegate fully the portfolio management?

Georges Wolff: We took the decision nearly five years ago to systematically outsource all the fund management in the fund of hedge fund space. We wanted amongst others to delegate the problem of managing the capacity to external managers. Another driver was transparency. We also wanted to create bespoke multi-manager products with a strategy-specific orientation, and create building blocks that we could use in our discretionary portfolios as for example: a multi-manager product that is mostly a long/short equity product, or another product that is more invested in the relative value strategies, or one focussed on commodity strategies. We took the decision at that time also to go for what we call sub-management, a solution where the underlying manager has the full responsibility for building the portfolio, selecting the managers and implementing the trades, so it is really full discretion for the management of the fund of hedge fund portfolio that we delegate.

Narrowing down

Elisa Trovato: Lance, what is the process that leads you to reduce the list of 900 strategies that you offer in your advisory platform to 40 in your discretionary business?

Lance Peltz: The advisory platform is in excess of 900 strategies, where obviously there is a lot of duplication. When we come down to the discretionary offerings, we end up with a focus at any one point of between 30 and 50 strategies. Somewhere between those there are the advisory recommendations as well. What we are trying to do in any category is find good managers that we have a high conviction will deliver the excess return with the appropriate degree of risk. Therefore our selection process screens and then drills down, but you have to match the selection process to the amount of resources. With 900-plus strategies available to our clients and an even wider universe out there to expand the platform, we are very selective. We use a quantitative and qualitative screening process. We also try and cherry-pick, in that we use other sources of recommendations and confirming inputs before we drill down in selecting managers. It comes back to the philosophy that if we left something behind that has outperformed, it is not a problem as long as what we actively recommend and support delivers a performance.

Elisa Trovato: Ian, you use about 20 different sub-advisers, but you also select 350 funds for the advisory business and the same asset classes are covered by both manager of managers and fund of funds. At which point in client portfolio construction do you decide whether to use manager of managers or fund of funds for clients?

Ian Hale: They are different client propositions. Some clients within a discretionary portfolio like to see lots of lines of stock on their valuation, they are less happy with seeing, say, one multi-manager fund and they will get a portfolio of funds; private bankers use the focus list of funds on an advisory basis with clients globally. The sub-advisory that we use is purely within the multi-manager products, where we describe the way that we use them. It is more a decision of which proposition the client wants, which will then drive whether they use a sub-advisory product or whether they use funds of funds.

Elisa Trovato: Do you believe that the role of multi-management platforms assumes a specific importance in the UK given its peculiar distribution system where 70 per cent of all the sales of financial products are sold by IFAs [independent financial advisers], who are mainly small companies, and do not have the systems to create their own platforms, as opposed to what happens in other European countries, where banks are the dominant distribution channel?

Ian Hale: Yes. In the UK, the multi-manager competes with IFAs doing a portfolio of funds, which often is not discretionary-managed, so it is kind of a one-off hit where the IFA will look at the portfolio in a year’s time on the anniversary, come back to the investor, review the portfolio, recommend changes. The multi-manager platform is a solution that is managed every day, with sophisticated tactical asset allocation overlays, as well as the fund manager selection alongside it. It is a much more sophisticated offering than the IFA market.

James Millard: I do not think it is necessarily competing; multi-manager complements IFAs business models. Most of our distribution is through IFAs, and it is about the regulator saying to the IFAs “Look, you should be focusing on your clients’ needs”, and the IFAs then questioning themselves: “Well, if I am going to do manager selection, do I really have the resources and capabilities to deliver that consistently on behalf of my clients?” The answer is often no, so the IFA can choose multi-manager to provide the right solution for clients. As Ian says, that would be a very effective way of making sure that clients do get what they hoped to achieve, on an on-going basis as well as at the start of the programme.

New Products and Innovation

Elisa Trovato: Alan, can the longer time that it takes to launch new sub-advised funds represent an issue?

Alan Mudie: It does take time, and it has to take time if you want to do it properly. I would argue that the only way to deal with that is to structure a process whereby attention is focused as far into the future as is possible. What we do with the CIO of the bank is spend a day off-site every six months. The upshot of that meeting is designed to be a shortlist of products that we would consider launching on a 12-18-month timeframe. We are not looking for the agriculture or infrastructure fund that happens to be flavour of the month; we are feeding our pipeline with good concepts, strategies or areas we think will make a useful adjunct to our range in the longer-term.

To add to that, one thing we have been doing is developing the synergies that we have between my team, covering long-only managers, and the other team at the bank, which covers hedge fund managers. In many cases, the new products that we are working on are ideas that have been generated through that interaction between the teams. In collaboration with the hedge fund analysts, we are identifying managers whose business plan includes looking at launching a Ucits-III-type of vehicle.

Ian Hale: I would not have said that launching a sub-advisory fund takes any longer, because you have got a regulatory timetable for launching a new fund anyway, and the period it takes to you to go through that you could maybe be doing, in parallel, the work you need to do to do the sub-advisory bit.

Elisa Trovato: Nick, do you think that it is very important to propose new products all the time? Are these products innovative in a way, or is this just a way of drawing the attention of the clients?

Nick Phillips: It entirely depends on the relationship we have with our clients, and the type of business and their distribution, whether it be retail, high net worth or through pension schemes. If the dialogue we have is interesting, if we think we have an ability to create a consistent and high information ratio based on our judgement, we would put that in front of a client and he would make his own judgement about whether it is an asset class that he wants, or whether we have the ability to achieve that information ratio in the future. There is continuous innovation. There are a couple of trends in the markets, one is thematic funds. Depending on the business model of our client, they like to offer tangible products to their clients, because the client can relate to them. And we have seen the trend for multiple asset allocation products, which is growing.

Ucits III making a difference

Elisa Trovato: James, what has been the impact of Ucits III on your multi-management business?

James Millard: Ucits III gives us a new opportunity for us to access manager skill sets that have only been available in an institutional space before, and package them together in multi-manager products and get those out into the retail space. At the end of last year, we launched the first multi-manager Ucits III long/short product in UK Strategic Best Ideas. We have also got plans in the next few months to launch our new Alternative Investments fund, which I think will for the first time give the retail investor the ability to access a range of alternative asset classes in a UCITS III vehicle which will complement their existing long-only property, fixed income and equity portfolios. We should not forget the regulatory oversight that also comes with a Ucits III fund is powerful protection for investors relative to some of the offshore funds that are available.

Matt Mack: Ucits III is very exciting for us as well, because it pushes us into a new client base. The barriers to entry into the hedge fund world are huge if you want to buy a single manager, or even accessing a fund of funds: for the retail investor, at the very smallest it is up into the millions. That accessibility, and also the liquidity and due diligence that you can provide to a retail investor is massively important.

With Ucits III, investors are going to have to be extremely careful with the houses that they go for, because learning to short is the hardest thing a hedge fund manager can do. We have been doing the GSAM plan for a long time, we are geared up to short. I think there will also be an enormous lack of understanding from some houses of the implications of Ucits III. I think investor education on the implications of the framework of Ucits III is going to be absolutely vital. As we have gone down the road of putting our products into the Ucits III framework, our product guys have gone to the Luxembourg regulators saying “What can we do within the Ucits III framework”, and they have become real experts over the last three years. We are working with some of the sub-advisory investors and multi-managers to educate them about how they should structure their portfolio.

Elisa Trovato: Jaime, in Spain more sophisticated Ucits III products have not really been very popular. Is that correct?

Jaime Perez Maura: Yes, they haven’t been. It is a question of market timing. Having new instruments allowed by Ucits III in your hand is a big opportunity, but at the same time I think we have to be cautious on the selection side when considering Ucits III and alternatives, because at the end of the day many of them are beta one or have no track record. It is a great opportunity that will need time to mature.

Lance Peltz: We would approach this with a different philosophy. We are looking for the 130/30 or hybrid strategies that by design have a beta close to one. I think with the benefit of hindsight, some of the things that did not work over the last nine to 12 months probably had a beta of much more than one, and their risk control was not as good or as stress tested as it should have been, given the market we went through. We are definitely not viewing these as alternative asset classes, or even absolute return asset classes. They are just out there to leverage our managers’ skill to generate higher information ratio.

The interesting areas we have seen are actually in emerging market categories. There are some vehicles that are running a net exposure of more like 70 per cent. They are quite interesting because the liquidity and skewedness of some of these benchmarks means that if you went into a long-only manager you would get a shape of portfolio – say, a commodity portfolio – which is not the theme or the idea that you are trying to implement.

Elisa Trovato: Philip, did you introduce new products in your multi-management business, benefiting from the new powers offered by Ucits III?

Philip Glaze: Ucits III quite clearly introduces the potential for new, interesting products. At the moment, we are currently working towards that.

Ucits III enables products to develop in a way that is more interesting at the same time it also broadens the whole investment opportunity set. However I would note that when individuals look to invest, the danger is that new things appear overly seductive, and seductive things can be dangerous. They all come with a health warning and with risks attached, and that is why you need a strong multi-manager who can help you tiptoe through this minefield. Ucits III presents opportunities, but these do not come without risks.

The analytical process is critical. In selecting managers, you need two things: either an information advantage, or an analytical advantage, or you need both. You either need to know something about a manager that is different, that nobody else knows, which is quite difficult – it is a little like market inefficiencies – or you need to be able to interpret the information you have about them incisively, and better than other people.

Elisa Trovato: Jaime, what has been the impact of new hedge funds legislation in Spain on the sub-advisory business? Have banks started looking externally for expertise in selecting fund of hedge funds?

Jaime Perez Maura: I think the best way to look at the Spanish market is to look at the Italian market. The Italian market is four years ahead of the Spanish one; they have suffered and gone through the same business cycle I think. At the first stage, everyone thinks that they have a wonderful idea which they are going to sell to everyone in the marketplace. Then, they realise that the institution that should be buying their fund has already launched its own hedge fund. There has to be a clean-up over the next two or three years when they will see that some of these products cannot be distributed in the local market. Only those sub-advisory relationships that make sense, like the one Allfunds has with Goldman Sachs, will succeed. It is the commitment of the sub-advisory relationship in the fund of hedge funds that we consider crucial.

We are very positive, but, again, the market timing is not the best one to launch a hedge fund, because investors have sold their funds and are invested in deposits. Investors have had certain experience with hedge funds because the money market enhanced products have a lot of dynamics that belong to the hedge fund world. They have suffered out of that and are a little bit reluctant to be involved with hedge funds. At the same time, the big institutions have been very quiet on whether they want to bet on this issue now or stay quiet for a little bit longer; we have to wait for two or three years to see the market mature. Currently there’s not room for everyone.

Manager turnover

Elisa Trovato: Matt, how does the sales process in sub-advisory compare to selling funds? Is the money likely to be more sticky?

Matt Mack: I think the sales process has changed enormously in the last five years since the emergence of the sub-advisory mandates. The sub-advisory relationships are much broader and deeper for us than with third-party distribution. That is very much transactional, and easy to get in and out. Our business model is very much working with a small number of large distributors who can give those great big tickets. They can still come out very quickly, but we can work with them in a partnership to produce really exciting products for their clients that they might not have considered in the past. For us, although you say sticky money, it is going to be dependent on performance.

Ian Hale: One the interesting aspects of sub-advisory is that it is not quick and easy to sack a manager and change them. There is a process that you have to go through in terms of actually transitioning the assets; there are normally notice periods that you have to give to the underlying manager.

James Millard: I guess I would disagree with you in that. At Skandia we make sure that in our multi-manager products we have got one day’s notice on all our managers, even if they are running sub-advised segregated mandates. We make manager transitions within a matter of days of the decision to replace them. It can be as nimble as the fund of funds model if it is implemented correctly.

We have a reserve bench of sub-advisers and transition managers who are ready to act at any point in time. Should we decide to replace a manager, we can transition the outgoing managers portfolio to the new manager’s portfolio, and hand it over within just a few days.

Elisa Trovato: What is the main reason for deciding to replace a sub-adviser? Is it when they are not doing what they are supposed to in the mandate? Are you more willing to accept under-performance in the short term?

Philip Glaze: This issue is both simple and complex at the same time. Firstly to know when to fire a manager, it is important to understand what the alpha drivers are in the product concerned and to understand how robust and durable these are. Then you have to be confident that they will endure going forward as opposed to having just worked historically. Then, if that product still has integrity, and that type of manager still has a place in the portfolio, then it is appropriate to hold on through a period of poor performance.

If you have a sub-advised mandate, your proximity to

what is going on is that much closer. You see what is happening in the portfolio, you see it in real time, you

see whether this manager is actually buying the stocks that they say their process is supposed to be buying. This

should enable you to identify when something is broken and to do this earlier than others. With fund of funds things are a little different, as this is potentially a faster-trigger process, in this area you have to ensure that the trigger-puller knows what he is doing, as there is a risk of being trigger-happy.

Lance Peltz: The ability to switch is partly coloured by your structure or your framework. If we ignore that, mutual funds have a high degree of liquidity, and there is an attractiveness of paying a higher fee in a mutual fund than a sub-advisory account for being able to get in and out, or maybe get into the more esoteric strategies which we know, as investment managers, is not a strategic view. You probably then may not create a sub-advisory relationship for that. There is a flip side: if you are a large holder in a mutual fund, you will probably trigger a dilution clause, or even a gate, so you have to spread your divestment over a number of days.

Jaime Perez Maura: It is also a question of size. All of you come from big institutions, but there are medium-sized institutions where sub-advisory is a step that has to be taken as a very high-level of commitment, which is restricted to core asset classes where they consider whether to take that step.

Nick Phillips: I think there is a clear distinction in the sub-advisory world between having a multi-manager and managing a particular product for a client. If you are managing a fund for a client where you are a multi-manager, then there is a different thought process and there is often a different reason for hiring a manager, which can lead to different levels of turnover.

In both cases you are hired to do a particular role within a certain risk requirement against a particular benchmark. Within a multi-manager framework, you are being blended with other managers for our client to put together a product for their end-client.

Where we are managing a particular fund for somebody, they have decided to have a fund to be distributed to a particular client segment. As long as you continue to do what you were hired to do in the first place, then you will keep the mandate. If you do something different which you are not hired to do then they are going to put you under review.

Or, because it is more of a partnership, you are managing a fund, they may even use your brand, you can sit down and have a conversation and say “We should tell them before we change”, or “There has to be a reason for us to change for it to deliver a certain alpha”. It is more of a process which happens along the way.

Final conclusions

Elisa Trovato: Do you think that the trend towards alpha/beta separation and increasing interest of those who sub-advise to target higher returns might drive further growth in the sub-advisory retail business in Europe? What are your views on the retail sub-advisory business going forward?

Georges Wolff: Private banking clients are often indiscriminately looking for high absolute returns rather than risk-adjusted returns, so we have to find managers that are active and that can potentially deliver these returns. As we do not have all that competence in-house, and as there is an emergence of new markets, new strategies, you can argue that all this is helping to develop the sub-advisory industry. For more passive investment approaches, outsourcing via sub-advisory does not make a lot of sense, as there are a lot of instruments and tools available today for getting cheap access to beta. I would say that the sub-advisory is suitable for managing strategies that are skill-based and where we could potentially generate higher alpha.

Ian Hale: If you look at Barclays as an organisation, there is Barclays Global Investors with trillions of dollars of assets under management, Barclays Wealth with about £132.5bn of assets, and our funds business is around £30bn of assets. Only c£10bn of this uses sub-advisory.

Putting it in context, sub advisory is a very good solution for clients,

Elisa Trovato