Bright future in a challenging climate

With the Eurozone crisis building and the West on the brink of double dip recession, the sub-advisory market has started to gain momentum as fund managers, private banks, insurers and distributors revisit costs and their service offerings to clients as they strive to succeed in this changing and challenging environment.

Although today, sub-advisers are having to work harder to win mandates, as those looking to appoint them are not just after alpha generators, but are looking for long-term partnerships with firms that they can trust and build long-term relationships with.

Frank Schäfer, head of sub-advisory relationships at Swiss Bank Clariden Leu, which has awarded a number of sub-advisory mandates over the last few years, says strategic partnerships are the way forward for the future of the industry.

“We consider sub-advisory as long-term oriented relationships; it is not sufficient anymore just to have ambitions and to chase alpha; we are interested in strategic partnerships,” he says. “Strategic partnerships are the most important thing to us; it’s all about the people, philosophy, process, performance and pricing.”

Mr Schäfer says the bank is looking to work only with value orientated managers with long-term strategies.

Few firms tick all boxes required to provide strategic partnerships – so sub-advisers are having to work harder to come up with the right products and make themselves attractive to potential clients. Mr Schäfer adds that transparency is also a vital consideration when picking sub-advisers, noting that his firm preferred to work with strategies that are Ucits IV complaint.

He says the bank preferred Ucits compliant funds as they allowed for funds to be distributed across Europe. “This gives us the broadest reach in terms of distribution,” Mr Schäfer explains.

Transparency

Since 2008, and in particular with the continuing market volatility, transparency and reporting requirements have pushed higher up the agenda when selecting sub-advisers, with investors demanding institutional-type services. Todd Ruppert, president, investment services, at T Rowe Price International, explains: “The key things which are considered when looking for a sub-adviser, also include: investment quality; the legal and compliance capability of the firm; financial stability; transparency and the ability to report in a timely manner.

“Quality is the driver of manager selection – if you are going to hire a sub-adviser, you are going to want them to be excellent.” he adds. “Quality is more important than retail brand – sub-advisory mandates are awarded to those of top quality, regardless of brand.”

According to Emanuele Ravano, managing director at Pimco, transparency is a key issue now and sub-advisers are being asked to be more transparent than ever before. “Reporting and access to information is also important now than it has ever been,” he explains.

However, in contrast to Mr Ruppert, he says brand plays an important role when selecting sub-advisers, and although there are a number of new players in the sub-advisory business, not everyone can be a winner.

“Since the financial crisis, I think investors have preferred to focus on the larger firms where the resources and access to services are greater. Having a recognisable brand and good performance is important to be successful in sub-advisory,” he claims.

Driving down costs has been one of the main drivers of sub-advisory as well as the desire to improve the quality of products and broaden the range of products on offer, says Pimco’s Mr Ravano.

“I think the driver of sub-advisory is the recognition of high costs – doing things in-house can be expensive, especially if you do not have the ‘know-how’ – so partnering with a sub-adviser can help.”

T Rowe Price’s Mr Ruppert agrees, saying in many cases, it was cheaper to outsource than build in-house expertise. “It may be less expensive to retain a third party manager than keep hold of a headcount of six.”

Mr Ruppert says product quality played a key role in the selection process. “When considering sub advisers, fund managers/private banks are looking at cost rationalisation, quality of product, and the breadth of product,” he explains.

However, outsourcing is not always the preferred option for some fund managers, who may feel that they have failed to some extent.

“I call it the NIH [not invented here] syndrome – some asset managers just want to do it themselves , even if they are not adequately prepared to do so,” claims Mr Ruppert.

But for others, outsourcing can be a sign of strength and forward thinking, particularly at a time of increased market volatility coupled with increased consumer demand, when outsourcing a particular fund can allow you to trim costs, add value, and maintain branding.

“At the end of the day, if they do not want to risk losing a client and want to provide them with the service, then sub-advisory can help, by providing them with a proven sub-adviser with consistent alpha in an asset class – it is a win-win situation for clients and distributors,” Mr Ruppert argues.

Clariden Leu’s Mr Schäfer says outsourcing has allowed the bank to focus on its key strengths and outsources what it does not have expertise in. “We are a focused firm and accepted the fact that we can’t do everything ourselves, so we decided to open up to excellent partners using sub-advisory.”

Clariden Leu currently uses Wellington as sub-adviser for sector and theme-based equity strategies such as energy, infrastructure and commodities. The Swiss bank also collaborates with Oaktree Capital Management for convertibles and high yield bonds as well as Partners Group for private equity. Olympia Capital is the partner for funds of hedge funds, Polunin Capital Partners for emerging market equity and Sparx for Japanese equities.

“Where we don’t have the skills, we outsource 100 per cent. Outsourcing plays an important role for us, and it is an important pillar of our asset management strategy,” says Mr Schäfer. “Over time, as we look to further diversify our product portfolio, we may well establish further sub-advisory relationships.”

Commenting on market volatility, he adds that this should not be a concern when selecting sub-advisers. “We do not want our managers to spend too much time on macro forecasts. We prefer managers that have a solid bottom up understanding of the companies they are investing in. We think that this is the most reliable way to weather the current market uncertainties.”

Emerging markets

Mr Schäfer says the increasing demand for emerging markets is potentially another key driver of the sub-advisory market, where a fund manager or private bank may not have the expertise, but are having to offer such products as investors’ requirements change.

He expects more money to flow in emerging markets in the coming months. “Most investors are under-invested in emerging markets and there might be only very few that have an exposure that is close to the weight of these economies in global market indices,” says Mr Schäfer. “However, we don’t think that many investors are underweighting emerging markets on purpose – so going forward I anticipate that this will change, with more money going into this area.”

He adds: “With growing experience in these markets and increasing levels of investor sophistication, clients may want to see greater investment options and more differentiated approaches to emerging markets investing. This could in turn lead to more sub-advisory mandates for emerging markets being awarded.”

T Rowe Price’s Mr Ruppert agrees, saying a greater interest in emerging markets could well drive the sub-advisory business, particularly for emerging market debt funds and country-specific funds, where funds managers have had to bring in extra resources.

Reducing risk

Pimco’s Mr Ravano argues that investors are generally trying to move away from market weighted indices, particularly at a time when market uncertainty continues. “There has also been a lot of exiting of European bonds and balanced funds in the last 12 months, with investors looking for more global or inflation plus real return type funds – leading to more sub-advisory mandates.”

Clariden Leu’s Mr Schäfer adds: “Many investors can’t stand the high volatility of equities, but clearly need to generate a certain return – which in a low interest environment leads many investors to search for yield on the credit side. We see a lot of interest for specialist credit strategies.

“Once the risk appetite of investor’s comes back, yield-oriented equity strategies might also come into demand. Overall, we expect more and more demand for strategies that are smoothing the volatility of the market,” he comments.

As investors demand to put their assets into different asset classes, sub-advisers may be drafted in to help fund managers and banks provide services in such asset classes where they do not have the in-house expertise.

The use of sub-advisers is also fuelled by the need for greater diversification, with investors making demands for asset classes that were previously not on their agenda.

When weighing the costs, for many, the value added by sub-advisers makes sense rather than trying to build an internal team for every asset class in demand. It is also argued that sub-advisory can be cheaper than funds of funds.

Apart from the psychological issue of feeling like a failure and suffering from what Mr Ruppert describes as the NIH syndrome, there are arguably very few barriers to sub-advisory, according to industry experts.

“We don’t see many barriers.,” says Clariden Leu’s Mr Schäfer. “Theoretically, the regulatory framework might become a limiting factor. Today, however, we don't see any formal barriers, but for individual companies, it’s about finding the right balance between in-house and externally managed strategies.”

It has also been long argued that the development of open architecture platforms, which would give the end consumer access to a wider range of funds and managers, could help the sub-advisory market develop. However, open architecture has not been fully embraced in Europe and continues to be somewhat of a struggle. Whether this trend will pick up remains to be seen.

What is clear that the future for sub-advisory industry is bright. Investors’ needs are different and fund managers, banks and insurers cannot ignore the fact that just offering plain vanilla products is not sustainable.

But with the complexity of demands, the desire to keep costs low, sub-advisory is certainly the way forward.

But for sub-advisers, even though they may be offering niche, specialist services, bagging those mandates will not come easy with high transparency and reporting demands and a greater emphasis on team cultures, performance and quality.

Proving you can add value will be key as well as the ability to be willing and to be able to build strategic partnerships and long term relationships. With a heavier focus on liquidity and risk management as well, trust will also play a bigger role.

And although there is more emphasis in understanding how the managers generate alpha and excess returns, performance and finding the best talent at the right price continues to drive the market.

Todd Ruppert, T Rowe Price