Evolution and innovation in the ousourcing arena

The reputational risk which a private bank or insurance company attracts when deciding to outsource specific mandates to an external asset manager is not to be underestimated and was one of the key topics of the discussion at PWM’s recent summit in Paris, where many leading thinkers and pioneers of the sub-advisory model gathered to discuss changes and developments.

“We always have to very cognisant of the reputational risk that the individual firm who is outsourcing is taking, and work very closely with them to understand their goals,” says Nick Phillips, head of third party distribution for Emea at Goldman Sachs Asset Management and one of the keynote speakers at the Paris event, pointing to the increase in sophistication of monitoring and tracking sub-advisers’ performance over the past decade.

“In a partnership context, the more you understand each other, the more value you will extract from each other, the more powerful the partnership and your alignment of interests will be fulfilled.”

The evaluation of managers is being conducted in a more and more professional manner and it has driven sub-advisers to become increasingly transparent about what they do, believes Mr Phillips. Operational due diligence has grown in the long-only world on the back of the very high degree of operational due diligence employed in the hedge fund market, especially over the past three years.

“Developing tail-risk hedging strategies in the sub-advisory spectrum is something that has really come to the fore in the last couple of years,” he says.

The menu of services an institution can acquire from the sub-adviser has evolved significantly, leading to an unbundling of services. This development also meets the growing demand for cost efficiency, adds Mr Phillips.

An example of this is in the hedge fund space, where increasingly private banks have recognised they can have the ability to both construct portfolios and assess risk within them, but they may not have the resources to do operational due diligence, which is outsourced.

Investment innovation is driven by the desire of an institution to deliver products in areas where they do not have expertise, such as emerging market debt, high yield, or alternatives including hedge funds and private equity. Regulatory changes, such as Ucits III, which offered the flexibility to use more sophisticated instruments in the mutual fund space, have driven product innovation, says Mr Phillips.

Often, the desire to innovate is driven by the intermediaries’ need to enhance the product range for end clients that don’t have the ability to manufacture in-house. However, solutions such as currency hedging or tail-risk hedging are definitely a push from the asset manager, he says.

Another recent development in sub-advisory is knowledge transfer, where the institution sub-advises an asset class with the aim to develop its own capability in it. From experience, adds Mr Phillips, in these cases “the cord is never cut” with the partnership continuing to develop in other areas.

Moving on

The sub-advisory relationship is also moving beyond traditional portfolio management. Added value services, such as training and advising the clients’ sales force to make them more efficient, have become far more important, and denote the concept of alignment of interests between the end clients who want better products, the intermediaries who want to sell more and the sub-advisers, whose success depends on that of their clients, explains Mr Phillips.

Whether an alignment of interests between sub-adviser and client can be achieved was a hot topic at the conference. According to Peter Sartogo, managing partner at GWM Group, in practice in the industry there is little alignment. Sub-advisers are interested in getting a percentage of the assets they manage, and they are quite reluctant to change their fee structure, given that 90 per cent of the managers underperform a given mandate.

The alignment of interest does not just exhaust itself on performance fees but is a broader concept.

“In constructing a portfolio we will use a fund for specific reasons – we need to share these reasons. I think it is important that if the manager achieves that goal, he is allowed to be paid extensively and if he does not, he should share the pain and underlying subscribers should benefit from a reduction in fees. This is how we try to build the portfolio,” says Mr Sartogo.

Claudia Itschner, head of manager selection, investment management at Zurich Insurance Company – who stressed the importance for a sub-adviser to be able to manage risk, especially for an insurance company where asset managers are trading directly on its balance sheet – questioned whether there is real alignment of interests with performance-based fees.

“If you believe markets are efficient and risk and return are related, then the performance-based fee would only increase risk,” she says. “The asset manager would have an implicit incentive to increase the return, which would mean increasing risk too. I am wondering whether performance-based fees really generate an alignment of interests. Perhaps they are a good thing for the asset manager but perhaps not for the client, who carries the risk.”

Entry point

Sub-advisory is a great market entry strategy, believes Gavin Ralston, global head of product at Schroders, as it allows a manager’s capability to be recognised without having to spend much money on marketing and setting up fund ranges. However revenue margins and costs tend to be lower in sub-advisory than in branded funds.

“Typically, selling branded funds comes at relatively high margins and that reflects the costs of going into this kind of business, but there is also a payback for the investment in marketing the brand and sales presence. Typically the fees we get on the sub-advisory mandates are much closer to the institutional fees than they are to branded funds.”

The key differentiating factor is the longevity of the business. “A typical mutual fund in Europe changes hands about once every 21 to 24 months,” says Mr Ralston, while a typical sub-advisory relationship will last for six to seven years. There is a return on the investment you are making on the sub-advisory relationship, which reflects the fact that the intermediary is committing more of his reputation to a sub-advisory relationship, and it is more difficult, even if the investment performance is disappointing, to withdraw from that commitment.

When selling branded funds, a manager has the full range of asset classes to address, including core funds such as global or European fixed income or global equity. Sub-advisory mandates revolve around the more exotic or differentiated asset classes, such as emerging market equities.

In order to make a partnership work, there are some issues it is important to talk about. The first is exclusivity, as the client may want an exclusive distribution arrangement for a particular product in a particular geography. “That’s often a significant part of the negotiation and from clients’ perspectives, it is absolutely key to establishing or differentiating a product,” adds Mr Ralston.

Potential conflict

Before an arrangement is set in place, any potential conflict deriving from having a branded fund business sitting alongside the sub-advisory business should be discussed and any conflict between a fund sold by the sub-adviser off the shelf and the specific sub-advised fund must be resolved.

The discussion should also revolve around how much capacity the sub-adviser makes available, which is related to the price that has been paid for it. “If we are accepting a lower price for a sub-advisory mandate, we look at how much capacity it makes sense for us to make available,” says Mr Ralston.

This is also in view of the fact that some sub-advisory relationships as they become more successful, are often brought in-house, because the assets have grown to a level where it makes sense for them to be run internally. This can lead to the loss of the mandate or to a split of the mandate, which is particularly common in the US market.

“A lesson we have learned from sub-advisory is where a product disappoints in terms of asset raising, it may or may not be down to performance, but typically it is just down to a change in customers’ appetite for product, and it is important to have an exit strategy and be able to close or merge funds. What we don’t do is a whole bunch of small sub-scale funds,” says Mr Ralston.

Especially when entering a new market, it is critical to choose the right partner, especially if that means the asset manager is sacrificing opportunities with other partners. This goes back to the quality of the distributor and its ability to raise assets from their clients from sub-advisory relationships in the past. “There is obviously a leap of faith in the ability of the intermediary launching a new fund, so we do quite a lot of work to understand the scale of their distribution,” he says.

Debating the challenges of manager selection, Michel Meert, senior investment consultant at Towers Watson emphasised that in the industry, too much emphasis is placed on quantitative research, as that can be done easily, at low costs, by a relatively small team.

On the other hand, only combining it with in-depth qualitative research, involving meeting managers on site, is it possible to outperform over the longer term by choosing the right managers. That is very time consuming and requires specific skills.

Discussing whether manager selection is an art or a science it is generally assumed the quantitative element is the scientific part and the qualitative element is the art factor, noted Raphael Sobotka, CIO, Multimanager (Emea) at HSBC Global Asset Management.

But selecting managers using past performance is not scientific. On the contrary, there is evidence that it does not work, as returns eventually move back towards the mean or average. Past performance on the other hand, is useful to analyse whether the style or risk bias in the portfolio is consistent with what the manager claims.

“The question is not really art versus science, but it is about being objective versus being subjective,” believes Mr Sobotka. In the decision to appoint a sub-adviser it is key to assess whether or not it is possible to pinpoint a competitive advantage, which may be a knowledge advantage, in terms of industry research or in asset allocation, and look at the strengths and weaknesses to make an objective judgment.

“What is a bit more artistic is that at the end it is a judgmental call, we don’t have an algorithm which says ‘this strength makes a manager good or bad’, so the weighting algorithm is more in our brain, in the experience of the analysts and that is our job.”

In the fund management industry there are massive behavioural biases, explained participants at the debate. Not only does an analyst go and meet a manager who has had a strong performance with a more positive attitude, but the manager will be much more confident during the meeting and will be perceived as such by the analyst.

To try and reduce this behavioural bias, fund selectors should analyse research reports and put the manager performance into perspective by looking at past market conditions. Also, they should hold several meetings and have forward looking views on alpha generation, considering for example whether market conditions will be favourable to the fund manager.

One of the drivers of establishing strategic, long term partnerships on a sub-advisory basis is the desire for performing and innovative products, often required to be offered on an exclusive basis, allowing internal staff to focus on the firm’s key strengths and contain costs, according to Frank Schäfer, head of sub-advisory relationships at Clariden Leu.

“Depending on the organisation we partner with, and given our negotiation power relative to that of our partner, we are looking for exclusivity of brand or exclusivity for a specific strategy in a specific market,” he says.

One of the advantages of sub-advisory mandates, as opposed to mutual funds, is they offer the possibility to the bank of being able to be much more in control of clients’ money, which is only invested for that specific firm’s investors, says Michael Simmeth, head of multi manager products at LGT Capital Management.

On the contrary, when buying a mutual fund, it is possible the value of the investment is eroded by actions of the other investors in the fund. But in selecting a sub-adviser it is also very important to have an understanding of the client base the manager already has. The ability to communicate with the distributor, to support its sales and marketing, plus sharing requested information is also paramount.

Digging deeper

Sub-advisory offers full transparency in the holding of the portfolios but sometimes it is important to have a good understanding of what the counterparty policy is, says Mr Simmeth. “Transparency is to me how people responded to critical questions in 2008. If you want to find out whether their funds had exposure to Lehman, if it takes them quite a long time to give you an answer, this also tells you something.”

Michael Grüner, head of third party distribution, Germany, Goldman Sachs Asset Management, emphasises the importance of limiting the number of sub-advisory relationships to a manageable number. “The best dialogue I have with my clients is where we have brainstorms, where the distributor has a particular idea, and where he has understood what we can offer and build and what we cannot build, where we are good and where we are not. Then based on those discussions, we ultimately arrive at the solution,” says Mr Grüner.

“All of this is only possible when the strategic relationship is in place, and that you can’t have with a limitless number of sub-advisory relationships, because then it does not work any more.”

Nick Phillips - Goldman Sachs Asset Management