Finding the best talent at an acceptable price

Sub-advisory roundtable, July 2010, London, UK. Participants:

• Ian Aylward, Head of Alternatives Research, Skandia Investment Management
• Katia Coudray Cornu, Head of Advisory Desk & Multi Management, UBP
• Guy Davies, Director, Portfolio Management, FundQuest
• Klaus Glaser, Head of Product Management, Raiffeisen Capital Management
• Alan Mudie, CEO, Oyster Funds, SYZ & Co
• Furio Pietribiasi, Managing Director, Mediolanum Asset Management
• Oscar Vermeulen, Director, Altis Investment Management
• Marius Wuergler, Managing Director, Head of Switzerland Distribution, Goldman Sachs Asset Management
• Panel moderator: Elisa Trovato, Deputy Editor, Professional Wealth Management

Elisa Trovato: Welcome to PWM’s seventh annual sub-advisory roundtable. I would like to focus our discussion on risk management, impact of costs on the decision to sub-advise and opportunities in the Ucits III hedge funds space.

How important are costs in the decision to sub-advise? Does sub-advising assets mean having to relinquish part of profit margins?

Klaus Glaser, Raiffeisen Capital Management

Klaus Glaser: Outsourcing is to some extent very efficient if you do not have the management capacity for a specific asset class, but it does increase cost, as you have to have your own in-house shadow accounting and risk management, for example.

Findings from a recent US study show the average management fee for equity funds has decreased from 200 to 100 basis points over the last 10 years. The reduction was even more extreme for bond funds. Competition is placing a burden on fees and cost cutting is the name of the game. This encourages in-sourcing, if you have in-house capacities which can be employed.

Sub-advisory is not the core business at Raiffeisen, as we use our own in-house management to a very high degree. We have outsourced some asset classes in the past and have in-sourced some equity and all fixed income funds during 2008/2009. In the short-term, when you in-source, you save on external management fees. In the long-term, however, it is not so clear, as you have to spend on in-house management capabilities, staff and possibly risk management.

If you do have internal capacity or qualified staff in a certain asset class, I would roughly estimate you could save half of the external management fees when you in-source.

Alan Mudie: We operate using both group expertise and external sub-advisors. The way our Oyster fund family is set up enables us to be agnostic when making the choice. For example, when we look at our P&L analytically, Oyster pays out management fees to the asset management arm of Syz & Co or to external sub-advisers on the same basis. Our profitability is based on our ability to control costs and to maximise the distribution of the funds. By thinking about it in this way, we remove from the equation any incentive to prefer internal over external managers. This enables us to manage in-house only those strategies where we have real expertise. In one case, two years ago we brought a global equity fund in-house that had previously been sub-advised, but that was because we had identified and recruited a very talented manager and not because we wanted to reduce the cost related to that particular product.

Katia Coudray Cornu, UBP

Katia Courdray Cornu: Over 80 per cent of our equity funds assets of our Luxembourg Sicav Ubam are managed externally. The rationale for outsourcing is looking for the best talents. In some regions or asset classes it is very difficult to set up internal teams with strong capabilities, track record and knowledge. This is why we sub-advised US equities and we set up a multi-manager Bric fund, for example. A sub-advisory agreement has to be pragmatic. It does not make any sense to delegate to a sub-advisor with a European distribution network. The decision making about sub-advising at UBP is function of a set of opportunity costs. If we have good opportunities to in-source we will, recently for example we hired a talented Turkish equities manager and we set up a fund for him.

Sharing the management fee with a sub-advisor can be costly and even more expensive than having your own team. in particular if the product is successful in terms of size. But on the other side, if the product is successful it is also due to the good returns. But when you start collaborating with a sub-advisor, you are sharing the business risk. it is probably a cost effective solution for both parties. Sub-advising profitability is all about size, breaking point and success.

Oscar Vermeulen: Altis, a Swiss multi-manager specialist acquired by ING in 2008, is also impartial in recommending clients a fund or a sub-advised mandate. As we take no cut of the revenue fees ourselves, there is no business motivation for us to look at the profitability of sub-advisory. But in order to gain clients, you need to control costs.

It depends on the scale as to whether additional costs – your own operational agreements, in-house custodian and monitoring of operational process – are punitive or not. Today managers are much less flexible on sub-advisory fees and negotiations take longer, while you can negotiate hard for high volume subscriptions to their existing funds. For the end client, sub-advisory is most attractive in the mainstream asset classes where you can give large-scale mandates, as opposed to speciality niche asset classes, be it emerging market debt or very specific high-yield categories, where it can often be more costly.

In sub-advisory, entry and exit costs are much more under your control because you see clients move in and out of your sub-advised mandate. If you are just buying into a generic fund it happens without your control. The costs are more visible but not necessarily different.

Guy Davies: I am more interested in the skill of the underlying managers and I am agnostic in terms of implementation whether it is by a mandate or a fund. Obviously there is greater transparency through mandates, which we prefer in terms of monitoring exposures and trades. I think there is going to be a greater drive for transparency following the last couple of years, looking right through to counterparty risk in underlying portfolios and funds.

In terms of cost, I have actually seen very talented managers maintaining pricing power now and we have to pay for talent. Being part of a bigger organisation is important to negotiate fees, but also important is the fact that we try to segregate various different responsibilities, so my recommendations and portfolios are based on a view that they are most likely to generate out performance or meet investment targets net of cost. It is for other areas of the business to look at fees and revenues and the profitability of those portfolios.

Ian Aylward: You often find the best managers, the ones you really would like to snare, are those most close to capacity constraints and perhaps the most difficult to cut a fee deal. It is about getting that investment integrity first and then having those fee negotiations go on in the background.

There is an element of demand pull, so our sales and product development team are saying which sorts of managers may sell well into different regions and telling us to keep an eye out for them, as we trawl the world for the best managers. Similarly, there is a supply push where if the research team comes across a great manager or strategy, which we think could be harnessed in a sub-advisory agreement, we can put forward ideas and take things forward.

We are seeing an increasing number of funds launching with a performance related fee in the retail space. While the annual management costs of funds are broadly steady, new launches with performance related fees on top obviously offers the opportunity for both parties to take a share of that and this could actually be a new stream of revenue for the likes of Skandia.

Furio Pietribiasi: Cost is a big element and driver in selection but service is an element that must be factored in to evaluate cost. If you compare two mandates that have similar characteristics and results, what really makes a manager more cost effective than another, assuming you feel you are paying fair money for the service and the mandate, is what you get in terms of support, transparency and access to the leading thinkers, the people who have views and who drive the decisions.

Generating good performance is nowadays the minimum requirement for a manager. Also, when you start a new product and a partnership you have to consider how much the manager is committed to the relationship, in terms for example of marketing support, working with your people for training or even providing exclusivity in certain markets.

Elisa Trovato: What impact has the financial crisis had on companies’ decisions to sub-advise?

Marius Wuergler: The crisis clearly showed us that private banks and other asset managers need to focus on their core competencies, which we believe plays into the sub-advisory business in general. However, we did not see a direct impact on people’s decision to sub-advise. What we have seen is that some strategies are no longer offered and it will take some time for companies to be confident those ideas will be successful again. Our experience was that helping our sub-advisory clients to provide transparency of information to their end clients was a very important factor for coming through the crisis.

In terms of costs, we have to look at the business potential and growth potential of the strategy. For some strategies it can make sense to compromise on pricing in order to maintain good relationships and be able to grow the business significantly.

However, it is very hard to negotiate fees for a very capacity constrained strategy. We are all in the asset gathering game and negotiating a couple of basis points on a sub-advised mandate is meaningless when you look at how many assets can be raised. Of course pricing is important but when selecting sub-advisers, it is not the only factor.

In the last five or six years we have clearly seen clients interest in performance fees in certain asset classes, especially on the fixed income side. That is something we like. We believe that performance fees help to have symmetry in terms of revenue and success, so we can share success with our clients.

Elisa Trovato: Does sub-advising help gather new assets and break into new markets?

Klaus Glaser: Sub-advisers can help build the investment story for your company as well, especially when using white labelling or co-branding. They can help bring new market ideas to an existing client base where you may have excellent distribution but not expertise. For example, 15 years ago we outsourced global equities to Capital International. It was a great success, not only in the retail client base but also among institutional clients.

Though we only have a few sub-advisers, we have a vision of longer-term partnership. Changing a manager is like divorce – a sad process we try to avoid. However, we did change the manager for global equity for several reasons, and we gave the mandate to London-based Investec Asset Management two years ago.

Elisa Trovato: Do sub-advised mandates have to be tailored to meet clients’ requirements or can they just be a replication of flagship funds available on the market?

Ian Aylward: From an investment perspective we are very wary of asking a manager to tweak a strategy or amend a mandate away from something they are accustomed to doing. If there is an existing product similar to one you may want to launch into a region or a client base, a pragmatic solution is to limit the regions into which we sell the product and make sure we are not selling into a space with an existing white label offering with a very similar approach. With this, you end up raising assets for potentially whichever is cheapest or which clients have a greater relationship with, for example.

Oscar Vermeulen: Sub-advisory mandates often go to specialist boutiques with one flagship fund, which is their power and glory. If you have a smaller sub-advised product next to it, then make sure you get equal treatment. During the crisis, there was a suspicious case of abuse from a fixed income boutique. It emerged it ran a tweaked mandate to serve liquidity purposes for its flagship fund, in which the firm had two thirds of its business.

This case illustrates that you have to monitor very tightly not only holdings of the sub-advised mandate but also the holdings of the flagship product before you can trust the sub-adviser to tailor-make a mandate for you and get the best execution.

There will be discrepancies between the two portfolios and then it becomes a matter of judgement whether these discrepancies are acceptable. It is grey area, which you avoid by awarding a mandate that replicates the flagship fund. You run this risk with the very largest firms too but with a boutique it is more obvious because their future is tied to the track record of that single fund and everything is geared toward making that flagship product shine.

Klaus Glaser: Even if a flagship manager behaves correctly, there may be cases where you have a small fund, which you think is flexible in times of crisis but in reality behaves like a super tanker rather than a small vessel. You may hold a position that is easy to sell, but the manager holds an additional high amount in its flagship fund and does not want to sell for fear of moving the market. This is one of the disadvantages of being a clone of a large flagship product.

However, having a clone of a large flagship fund enables you to buy into the track record, which is a very precious element.

Alan Mudie: What is often important for us is exclusivity of distribution for an existing strategy. We are not seeking to modify a product for a particular segment or geographic market. For example, in US equities we have three sub-advisory relationships with small to medium sized US-based managers, none of whom had any presence outside of the States. None of them had any knowledge of the regulatory framework for a Ucits product. Therefore, a lot of work with a manager prior to implementation is to ensure that they have full detailed knowledge of everything that is required of them, so that their strategy can be transposed seamlessly into Oyster.

Elisa Trovato: Thanks to Ucits III regulation, we see an increasing convergence between the hedge fund and long only worlds. To what extent can the long-only team leverage on due diligence carried out by the alternative division inside your group?

Alan Mudie: Syz and Co Group’s hedge fund business, 3A, has been a fantastic resource for identifying potential managers, but it is the Oyster team which takes ownership of the due diligence for sub-advisors because we are, to paraphrase Klaus, getting engaged with a view to getting married and never getting divorced. The thought process and the work that we do is different to that conducted by our hedge fund analysts for a fund of fund portfolio.

What we are trying to do is design, build and deliver a product which is going to meet client needs and be an attractive part of their investment portfolios.

The next decision is whether you have the appropriate manager for that product in-house, whether you can recruit someone to join your team or whether you go down the sub-advisory route.

About a year ago, we launched two products, both in the hedge fund strategy and the Ucits wrapper space. One was Oyster Credit Opportunities, managed by Cairn Capital. This goes back to analysis that we conducted in late 2007, early 2008. We believed that the prevailing level of credit spreads would not last and our view was that once those spreads widened – and we had no idea they would widen as much as they did – there would be a very attractive opportunity for a manager to apply credit picking skills on both sides of the book, long and short. That led us to identify with 3A and then interview a short list of potential partners which was whittled down to the firm with which we went ahead.

The second case (Oyster Market Neutral) is a long/short equity fund, which we manage in house : we felt that our expertise, brand and value added in European equities stock picking could also be applied in a long/short framework, hence the idea of recruiting someone with the requisite background in shorting and managing such strategies to join our team and to implement that product.

Katia Courdray Cornu: In traditional funds with a non directional type of investment strategy, there is a convergence between these two worlds. Most absolute return managers with Ucits III funds have a risk limit measured by the VaR. Knowing that Ucits regulation authorises a VaR with a maximum of 20, it could induce an important level of leverage. Ucits, as such, is not a proctection against blow up risk.

In my opinion, if the convergence between traditional and hedge fund industry is increasing, mentalities are still different and at UBP too we have two distinct research teams. We have a short track record regarding Ucits compliant hedge funds and it is too early to effectively measure the cost of liquidity, for example. Also it is important to consider that any outflows in Ucits III funds will have an indirect impact on the offshore versions, in particular if both portfolios have a significant degree of overlap. At this stage, I am agnostic rather than bullish or bearish over this format.

Elisa Trovato: Do you see client demand for Ucits III hedge funds?

Ian Aylward: Madoff and those sorts of blow-ups in hedge funds have pushed investors towards the perceived benefits of Ucits, although Madoff was also in Ucits.

Ucits is not a badge of security and just as we have always researched in depth for long-only managers so we will continue to research in-depth those that come into Ucits. But we are agnostic, and sometimes we find the best managers are those coming from the hedge fund space and sometimes it is actually those who may have been what is perceived as long-only houses. Nearly three years ago, Skandia launched one of the first UK long/short Ucits funds and over that time we have awarded a dozen segregated mandates to hedge fund managers to run those and it has been a great success.

Furio Pietribiasi: A lot of hedge funds who are moving into Ucits very often do not have a clear understanding of what the Ucits framework implies. Many strategies are not fully 100 per cent convertible into a Ucits framework and a lot of them are sub-adaptations of their own strategies in order to gather more assets, mainly. A lot of people and strategies, who are open to give more transparency, are moving into hedge funds managed accounts, such as some of the successful hedge funds we are investing in. We have used some Ucits funds in fund of hedge funds for the past two years, as we wanted to generate more liquidity to meet our client needs. I believe that Alternative Ucits or Newcits pose a big question mark since their results compared to the ones of the traditional hedge funds vehicles are alternating.

Marius Wuergler: We see high level of interest in outsourcing capabilities from our clients, for example to put together a Ucits III hedge fund of fund structure. I would tend to agree that so far there is a question mark over how much demand there will be from the end client. A lot of banks have already set up their own Ucits III hedge fund of funds, but the inflows seem not to have been as large as expected and I believe there are two reasons for this. Firstly, there are only a very limited number of single managers who are qualified Ucits III managers and different hedge fund of funds tend to have all the same managers in their portfolios; diversification is a big issue and the portfolios are very concentrated. The second factor is that in order to put together a hedge fund of funds with Ucits III managers only, you need quite a large scale organisation because there are a lot of different jurisdictional rules as to how to set it up in different regions; it requires a great deal of resources.

Oscar Vermeulen: It was a somewhat tasteless analogy that I once heard, but I think a very valid one, that the early years of Ucits III are like the early years after the introduction of the VCR or DVD. The technology is great and it is a good container concept. However, just like the Vcr, the first batch of content for this new technology is not always the best; there were certain types of movies that helped the Vcr to break through and only afterwards did quality movies become available. I think this is very true for Ucits III as well, with exceptions – high quality Ucits III funds - clearly in existence but not exactly in the majority.

This has not so much to do with the vehicle itself but with the content that first moved into it. We have seen low appetite for hedge funds or Ucits III. The hedge fund industry hides this lack of market demand by being offshore and not being too transparent and spinning a nice tale about growth, but Ucits III is much more measurable and you can see there that the appetite for alternative investment products is is not exactly growing rapidly.

Elisa Trovato: Which asset classes do you expect to sub-advise in the future and what types of managers will you select? Does the growth of ETFs impact your decisions?

Guy Davies: It is interesting to examine which asset classes or sectors are are experiencing the most new managers and boutiques. It is not necessarily emerging markets or Asia; mainstream asset classes are seeing an awful lot of new boutiques reflecting opportunities, but also due to expertise. All new boutiques struggle with distribution as well as delivering investment returns; those are two of the most important elements of an investment management firm. It is also interesting to see how many firms like ours are hunting out those small boutique firms. I would see that as a source of added value.

Furio Pietribiasi: Strong active management and active decisions are what investors demand, as shown by success of small-medium managers like Carmignac and DJE Kapital. There is an increasing separation between passive and very active management. I do not know how much is strategic and how much is defensive. Many asset managers launch ETFs. This may be to retain assets because ETFs are straightforward and less and less of them are able to generate the expected high alpha. I see much interest in people who can generate high alpha.

One strategy I believe is becoming more popular also in the institutional space is low volatility equity. These strategies may not always beat the benchmark on the upside, but certainly protect capital on the downside. This can be achieved in different ways, for example by using very strong and qualitative stock selection, buying lower beta stocks or by making strong asset allocation decisions.