Face to face with your sub-adviser

Private banks and wealth managers in Europe will increasingly choose to establish strategic partnerships with a small and shrinking number of selected asset managers. This will in turn drive growth of the so-called ‘sub-advisory’ business.

More than half of the 30 heads of manager selection and chief investment officers of institutions participating in our quantitative research believe this is the trend going forward. (Fig 1). Results from the ninth annual sub-advisory research survey carried out by PWM were also confirmed by 10 additional in-depth interviews carried out with major industry players.

Interest in this delegated approach to portfolio management is accelerating in anticipation of the far-reaching European MiFid directive. There is still major uncertainty whether this will outlaw trailer fees that distributors often clandestinely receive from asset managers when they sell their funds.

Even large private banks that today swear by open architecture distribution of third party funds are looking at the possibility of building their own funds, and delegating the management of clients’ assets to third-party managers.

“MiFid II is a big topic in wealth management and may force banks to reinvent themselves,” states Pascal Botteron, global head of the hedge funds and mutual fund investment group at Deutsche Bank PWM. “Deutsche Bank is very committed to the open architecture model, but we like to keep all options open,” he says, hinting that sub-advisory may be one of them. However, the fact that MiFid II is damping down its intention to ban trailer fees may slow down the outsourcing process, he adds.

Asset managers and distributors are already reorganising their business models to adapt to the UK’s Retail Distribution Review (RDR) which, coming into force in January 2013, will ban all payments from product providers to distributors, with the aim of giving customers major transparency. Asset managers operating in the UK are creating RDR-compliant share classes, with lower management fees to compensate the fact they will not have to pay rebates to distributors. Smaller, independent wealth managers are joining forces to increase their size of assets to be able to negotiate large sub-advisory mandates and face the increased costs of compliance with regulations.

Generating fees

Banks, on their side, will have two options: either they will charge a client a service fee to provide discretionary portfolio management or will ask the clients to pay a flat fee to gain access to the research on product selection, on an advisory basis.

Several banks in Europe have already made big steps in this regard and offer a service of paid-for advice, which enables them to generate recurring fees and also comply with regulation. For banks that have asset management capabilities in-house, creating their own funds and sub-advising assets to external partners would be a way to embed manufacturing fees in the mandate.

But regulation is only one driver, adds Mr Botteron. “The world is becoming more and more complex. For a global bank it is important to have a platform that is registered in all the countries in which it operates and sub-advisory is more regulation and cross border rules friendly than selling off-the-shelf funds.”

With a sub-advised product it is possible to have a structure that is compliant and approved in all countries. In some cases, it is very time efficient. “If there happened to be a problem with any of the sub-advised funds, we could simply close the mandate with that specific manager and appoint another manager, without having to inform advisers and clients to redeem that fund and buy a new fund,” he says.

Greater transparency on the positions of the fund and improved risk management are other major advantages of sub-advisory, which, post-Madoff, are especially appreciated by clients. This is especially true in the fixed income space, where portfolios have become more and more complex, says Mr Botteron.

Offering sub-advised funds would enable a bank to be more convincing in guiding clients to put their assets into their recommended list of funds and would solve one of private banks’ major headaches.

Any private bank has a big book of non approved products, of which the institution does not have full control. Generally there are no trailer fee arrangements on those funds, so their sale will not remunerate advisers, explains Mr Botteron, but a large sub-advised platform would help to address this issue.

Appointing a manager for a segregated mandate would also help avoid concentration risks in funds – the risk of owning too much of the fund – especially when products are comparatively small. “Sub-advisory and open architecture are compatible,” states Mr Botteron. “If a bank moves to sub-advisory, it is not about closing the architecture.”

Move to sub-advisory

However, the move to sub-advisory is not always a smooth one. Private clients like brands and tend to perceive, incorrectly, that they diversify their counterparty risk if they invest in different third-party funds, while the risk is concentrated if they buy the bank’s own products managed by third-parties, says Mr Botteron.

“One of the challenges when launching our own products sub-advised by third-party managers is to get the communication with our clients right,” adds Dirk-Jan Schuiten, head of strategy and business development at ABN Amro Advisors, the multi-manager centre of expertise of ABN Amro group.

“We have to make sure clients understand this is an open architecture approach, with funds managed by third-party managers, and not a move back towards introducing in-house funds,” he says.

Equally any type of “resistance” from advisers must be identified and dealt with. “It is important to explain to your own service force what the added value is for sub-advised types of products and how they should be sold to clients,” says Mr Schuiten.

AA Advisors started appointing sub-advisers in 2007 and today it uses around 20 managers for mandates, mainly in equity and fixed income, for a total of €2.2bn in assets.

These mandates are currently used within a multi-manager funds structure for discretionary accounts in private banking or the higher segment of the retail banking channel, although this structure of funds of mandates is currently being reviewed.

“We are currently using mandates in multi-manager funds of mandates, but we are transforming them in single mandates and we will be awarding new mandates going forward,” explains Mr Schuiten.

“Even in a world where rebates are banned, we still envisage a much greater future for segregated accounts and mandates, because of the added value they offer.”

In addition to increased transparency, these give ability to access institutional managers which otherwise private investors would not be able to access and flexibility to build tailored solutions.

Boosting revenues

By giving a mandate, banks starved of profits can immediately generate new revenues without having to add costs to build in-house expertise or build technology, argues Emanuele Ravano, managing director Europe at Pimco. “With sub-advisory, banks who want to increase profits are not adding a lot of costs but have greater control of their revenues.” Moreover, banks need to offer bespoke products that are more attractive to investors.

Pimco’s sub-advisory business has grown remarkably and since January this year it has expanded from $15bn (€11.5bn) to around $19bn today. Two thirds or more of these assets are in bespoke solutions. The growth has been mainly through partnerships, with a handful of selected banks.

“We are trying really to concentrate on the partnerships with a few distributors that understand our approach,” explains Mr Ravano. “The combination of good products and good commercial effort has led to mandates that have grown a lot more than the average sub-advisory mandate,” he says, with a handful of them having swollen to above the billion dollar mark.

“The difficulty for banks is they are used to working with a high number of providers. In sub-advisory you really want to establish a limited number of partnerships that are more meaningful and having to get down to a smaller number of providers is a barrier,” he says.

But to some extent, this could be a useful exercise for the banks themselves, which could perhaps lead to fewer larger, flagship funds, whereas many firms have focussed on specific ideas which translate into focussing on small, very sector specific mandates, which are not commercially viable.

This is the model that Italian-based Fideuram Investimenti has embraced, which recently accelerated the expansion of its sub-advisory programme started several years ago.

Even though the number of mandates has increased, encompassing a total of €4.5bn assets, the firm employs a limited number of sub-advisers, including BlackRock, GLG, Marshall Wace, Franklin Templeton and Pimco, with Fidelity being the latest addition.

MULTIPLE MANDATES

Some of these firms manage more than one mandate. GLG for example manages global, European and US equities as well as convertible bonds. And in some cases different managers are placed in competition with each other. Over the past year, BlackRock and Fidelity were given the same mandate in global high yield, as the Italian firm realised that its internal capability in European high yield had become too narrow in light of the European debt crisis and had no interest in developing internal expertise to manage global high yield in-house, explains Mario Bortoli, head of the multimanager team at Fideuram.

“It is important to find a sweet spot between the need to diversify assets amongst different sub-advisers and the need to have relationships as deep as possible with the managers you have selected,” he says.

It is also important to be able to compare the performance of different managers, as in some cases they may employ different investment approaches to the market. But there is also the need to establish with each sub-adviser a strategic partnership, where each of them provides a regular flow of ideas and updates on the markets.

With the firm’s focus on portfolio diversification and dynamic portfolio management, Fideuram has strengthened education programmes for the bank’s advisers around these topics. “In all asset classes, including the ones that we sub-advise, we reserve the right and duty to change our allocation, depending on the opportunity we see in the market,” says Mr Bortoli, expecting to hand out another mandate in a new asset class before the end of the year.

This concept of fuelling competition amongst managers on the same mandate has also been put in practice by Allianz Bank of Italy, which four years ago launched a unit-linked platform where 10 big brand names including BlackRock, Carmignac, Franklin Templeton, JP Morgan, Morgan Stanley, Pictet, Allianz Group’s Pimco, Schroders, Swiss & Global and Allianz Global Investors were each given a mandate to manage a multi-asset, flexible portfolio. The managers choose the asset allocation but the underlying funds must be the manager’s own products, and there is a 10 per cent limit to the average annual maximum volatility of the portfolio.

In 2010 Banca Generali too took the sub-advisory route in its multi-brand fund of funds Luxembourg BG Selection Sicav, created a couple of years previously. In addition to the existing nine compartments, where in-house professionals select in-house and third-party products, the bank gave a mandate to 22 international managers to manage 26 new mono-brand compartments of a fund of funds in specific asset classes.

There is also another form of sub-advisory that is worth noting, where banks ask their partners to launch funds specifically to their requirements, often asking for exclusivity of distribution in the country where they operate.

This is the case for example at UniCredit Private Banking, which has implemented its preferred partners approach in its core markets of Italy, Germany and Austria over the past few years. From its ten preferred partners, Unicredit sources between 1500 and 2000 funds, of which 160 are placed on its recommended list.

Two years ago, in collaboration with some of its partners, the private bank started offering bespoke Ucits funds in the fixed income space, mainly buy-and-hold products with a fixed maturity. This combination of corporate bond, high yield and emerging market debt products was launched by GSAM, JP Morgan and Pioneer, in the name of the asset manager, specifically to meet Unicredit’s needs and investment views.

The private bank has gathered around €1bn in assets through these ad-hoc products, but it is difficult to say whether they provide an easier sell compared to the other off-the shelf funds, says Jean-Francois Hautemulle, head of fund selection at UniCredit Private Banking.

“The bespoke products are offered at very specific times and with a special sales effort, when we see a compelling investment opportunity which we can offer in a buy-and-hold structure. They also targeted specific client segments, which tend to be invested in individual bonds and are reluctant to use open ended funds,” he says.

Offering bespoke products is complementary to the off-the-shelf funds range. One of their major benefits is they give possibility to offer an “exclusive story” to the clients, explains Mr Hautemulle.

“Bespoke products enable us to have much more control on how the product has been structured and its underlying investment themes as we can completely align our investment view with how we implement that view,” he says. “They also enable us to hold clients’ money for a long period of time.”

The fixed income space lends particularly well to these tailored products, as a bond is built with a maturity closer to the maturity required for the fund. Also, he says, many Unicredit clients have a conservative risk profile and are fixed income oriented.

Mr Hautemulle would like to launch these types of products with “as many as possible of the bank’s partners”, but only a few of them are willing to do this, or are better equipped in terms of infrastructure or respond faster.

New solutions

The large majority of the survey’s respondents, more than 80 per cent, believe their clients’ needs are currently being met in terms of mutual fund product availability (Fig 5). But low yield, low risk, stable income generating and absolute return strategies are still widely sought after (Fig 4).

Top 10 selection criteria

• Long-term consistent fund performance

• Management team

• Investment Style

• Risk Management

• Product development

• Track record

• Top quartile fund performance

• Competitive advantage

• Brand/reputation

• Incentive structure for management team

There is already a lot out there and “I would rather see managers do a better job with the fund they manage than create new funds,” comments Mr Hautemulle of Unicredit, “but it would be good if managers could come up with income-generating solutions.”

On the fixed income side this is a fairly recent development. Although rates of “safer” government bonds are very low now, and the spreads from corporate and high yield are dropping, there was an assumption that income would be generated on the fixed income side. But this is not happening, he says. “With the baby boomers generation getting closer to retirement, they have to find better solutions for them.”

Credit Suisse is also on the lookout for suitable solutions. “We have recently re-launched our ‘beyond cash’ campaign, where we are making a strong case that in this low yield environment, investing your money in cash may erode your capital,” says Lars Kalbreier, global head of investment funds and ETFs at Credit Suisse Private Banking. “Hence, it is extremely important for us to look for solutions that preserve capital.”

Also, given increased quantitative easing, it is important to identify solutions against inflation. “We are looking at solutions especially in the fixed income space, where investors take a bit more credit risk but compensate inflation by getting a high yield.”

Credit Suisse offers segregated accounts to the ultra high net worth individuals, especially in the hedge fund space, but it fully embraces the open architecture approach, with around 70 funds in the recommended list, which can vary on the region, which are sourced from a universe of 9,000 funds.

Asked whether there is need for ad-hoc products, which selected sub-advisers can provide, Mr Kalbreier says: “I don’t think we need new, bespoke products. If you look at the fixed income market, it is very rich in terms of providers and we have found very good solutions for our clients.”

Europe remains a little behind in terms of products meeting client needs, because they tend to be too narrowly focused, and too sector specific or too benchmark specific, says Pimco’s Mr Ravano. “The guidelines we operate under are very often guidelines that are established based on historical returns, but we live in quite exceptional times, so you have to adjust those guidelines. We are in a world where we want to be more absolute return oriented, more flexible in our style and less benchmark specific.”

For example, he says, when the fund manager believes a specific sector has the potential of offering good returns, he has to be able to structure investment guidelines in a way that can buy that sector in an amount sufficient to make an impact on performance. Guidelines that reduce that flexibility would automatically decrease returns.

Offering embedded advice is the key characteristic of Pimco’s products. “We constantly tweak the guidelines so they can be the best performing funds,” says Mr Ravano. “That embedded advice extends to our sub-advisory business.”

Top of the class

Pimco is the most used sub-adviser in our sample (Fig 8), together with Aberdeen and both occupy the top spot in the best sub-advisers league (Fig 9). Aberdeen received unprompted praise from the survey respondents, about its performance in global emerging markets, its competent client relationship team, access to the portfolio management team as well as the respect they have shown to their investors by soft-closing their funds.

In terms of manager selection criteria, long-term consistent fund performance, management team and investment styles are the most important selection criteria, followed by track record, brand and top quartile fund performance (see box on p21), consistent with past years. It is interesting to note that 40 per cent of asset managers managing assets on behalf of other firms, believe top-quartile fund performance is one of the top three criteria their clients use to select their sub-advisers.

“The criteria to select the best sub-advisers have not changed over time,” argues Furio Pietribiasi, managing director at Italian group Mediolanum. “But in some cases at the moment what is really important is the marketing support. While this was a secondary aspect in the past, today it has become increasingly important to have support from the sub-adviser’s management team because our distributors want to speak to the underlying managers of our funds.”

Sub-advisers’ managers must also to be willing to go on roadshows to present their products and at the same time must have a “certain marketing skills”, he says.

Increasingly, due diligence is focused on the operational side too, as well as the quantitative and qualitative side. It is also important to make sure to align the guidelines that the delegator gives to the sub-adviser’s strengths.

“You need to respect the style of your manager, because if you constrain your manager too much, then they will not generate the same kind of results that you got in the past, on which you based your manager selection for the quantitative side,” says Julien Moutier, head of portfolio management at BNP Paribas subsidiary FundQuest.

Communication, transparency and reporting are paramount to make the partnership work, believe the majority of the participants to the survey.

Fiduciary duty

The prospect of an increased regulatory burden posed by the European AIFMD directive has led offshore hedge fund managers to launch regulated funds in Ucits wrapper or “Newcits”, but sub-advisory may provide an interesting avenue for hedge fund managers to distribute their products.

However, the great majority of respondents to our survey expressed reservations on the ability of the hedge fund managers to provide full transparency, which is even more important in a segregated mandate.

There are increasingly hedge fund managers knocking on the doors of manager selectors offering absolute return strategies in regulated instruments, but the majority of them still have issues in disclosing they way they do their research, or how they analyse companies or use derivative instruments, in particularly the smaller hedge fund houses, says Didier Chan Voc Chun, head of multi-management at Swiss group UBP. “When you sub-advise, you have fiduciary duty towards your clients, so we need complete transparency, even more than when we just buy funds.”

Hedge fund managers also have to compromise on fees, believe Katia Coudray Cornu, head of Syz Fund Research & product development at Banque Syz & Co. “Hedge fund managers have not yet adapted their mindset to the pricing of the more regulated fund industry,” she says.

Ms Coudray Cornu has been looking for the right hedge fund manager for some time to launch a regulated absolute return strategy, but this has proved challenging also due to the difficulty of finding a strategy replicable in the Ucits wrapper “without making too many concessions to the performance”.

A way into emerging markets

Global emerging markets offer the best value and growth opportunity in the medium-long term, according to PWM’s survey results (Fig 2 and Fig 4). And wealth managers are launching innovative investment solutions and appointing new sub-advisers in this space.

The Syz & Co Group recently launched a more balanced strategy for investing into emerging markets based on a proprietary emerging markets index, developed by the in-house fund analysis and manager selection unit. This new index is equally weighted between the 21 countries that make up the MSCI EM index, with an adjustment for market liquidity, explains Katia Coudray Cornu, head of Syz Fund research and product development at the Swiss bank.

This is in contrast to most of the emerging markets funds, which concentrate on stock markets with the largest capitalisations and suffer from a high concentration of geopolitical risk and an excessive weight allocated to countries that have already “emerged”. The largest five countries in the MSCI EM index, China, South Korea, Brazil, Taiwan and South Africa account for 65 per cent of the index.

“Country allocation is extremely important in emerging markets because correlation between country performance is very low. Our benchmark enables us to offer a very good country diversification to end investors,” she says. This new index excludes any frontier markets, because they are considered too illiquid.

The management of the fund has been entrusted to Boston-based Acadian Asset Management, which manages €10.7bn in emerging markets.

A fund in emerging market debt in local currency is the latest addition to Barclays’ multi-manager platform, which was started five years ago. The product, due to be launched before the end of the year, will be managed by two asset management firms, based in the US and London respectively, anticipates Jaime Arguello, head of multi-management and fund selection at the firm.

Barclays’ clients have been able to gain exposure to emerging market debt in local currency through off the shelf third-party funds so far. Only recently this asset class has been added to the clients’ strategic asset allocation, which included emerging markets in hard currency only.

“With a number of countries building their own local currency curve, both in governments and corporates, we believe emerging market debt in local currency has a place in clients’ asset allocation from a long term perspective,” says Mr Arguello.

Blending different managers using different investment styles, generates a much more stable relative performance, he says. Multimanager funds are customised to the bank’s guidelines, including for example constraints to the number of off index positions sub-advisers use.

“When we give mandates we will give some leeway for off index allocations, but we will certainly limit them more than in their retail mutual funds,” he explains.

“Also, a segregated mandate gives much more transparency. We know exactly what the managers are doing and also in a fund as a whole, so we know what our position is in terms or risk, sector or country allocation,” adds Mr Arguello.