Private banks seek help as they follow alternative path

If there is one thing investors have learned since the crisis, it is that doing due diligence on hedge funds – whether it is manager selection or operational due diligence on asset allocation – is a highly valued skill, believes Nick Phillips, head of third party distribution, Europe Middle East and Africa at Goldman Sachs Asset Management.

The institutions that have recently been approaching sub-advisers for these skills, many of them for the first time, have mostly been private banks. And it is the alternatives area which they are particularly interested in. Typically, they would not have in-house expertise, explains Mr Phillips, as they had been previously selling other firms’ funds of hedge funds. Now they have decided to take the plunge and offer their own products to their clients, but they realise they need outside help to do this.

“As a result of the crisis, these organisations would like to have more control and more transparency, as they believe it is beneficial from their own risk and reputational purposes,” he says. “But if you are outsourcing a fund of hedge funds you need to outsource to a company which has got a very thorough and well-resourced research team.”

The role of the sub-adviser in the hedge fund of fund space involves selecting single hedge fund managers and strategies, allocating between these assets in line with mandate guidelines and carrying out continuous due diligence and monitoring of underlying funds. Essentially a bank looking for a sub-adviser in this area can outsource the whole manager of managers role, explains Mr Phillips, whose GSAM hedge fund strategy group manages around $21bn (€16.5bn).

There is some demand for Ucits III compliant hedge funds. But in that space too investors need to fully understand whether the strategy is conducive to the Ucits III format. This means being aware of any possible discrepancy between the regulated strategy and its offshore version, and monitoring any liquidity mismatch between Ucits regulation requirements – two weekly liquidity minimum – and the actual liquidity of the underlying strategy.

“Ucits III hedge funds is definitely a growing segment of the market with more and more companies entering that space,” observes Mr Phillips. “But it is vital people understand what they are buying, the portfolio risk and how it is managed.”

Firms that seek third-party providers’ expertise to fulfil their product range are today continuously searching for different sources of alpha, which they blend to create the appropriate model portfolio.

“There is very specific demand for emerging market debt, dollar based or local currency,” he says, as there are fewer managers having the necessary expertise to build a product in this area. “We have also seen an increase in people searching for global high yield. Part of that is due to market conditions and the attractiveness of global high yield. But also because the majority of issues are from the US, people may not have that expertise locally.”

There is also growing interest in absolute return products, which can include multi-asset fixed income, for example. Another reason why sub-advisory is popular and growing is because private banks, and not only asset managers, want to create multi-manager solutions, which they use as core building blocks in clients’ portfolios, states Mr Phillips. In US equity, for example, they can blend growth, value, small or mid caps and S&P 500 into their portfolios. Each of the sectors are outsourced to the managers they think are best in the market, who run the assets on a segregated basis.

Sub-advisory, or managed accounts, enables banks to tailor investment solutions to their client needs, control their risk and alpha targets and the asset allocation within the product. It also gives more control on costs, as they know how that cost fits into the overall pricing of the product and they can negotiate the price with the asset manager.

This is in contrast with an off-the-shelf fund, which comes with a set price and has already pre-established risk and asset allocation guidelines, claims Mr Phillips.

“Private banks are looking for consistency in the approach they have with their clients globally, so they build a portfolio depending on their view on asset allocation and client risk profiles. They typically pay an institutional separate account price for the underlying portfolio management skills. They may want to give the manager more freedom or put on more constraints, and they are able to build a bespoke, tailor-made products for their clients, which they think is making the most out of the manager’s skills.”

GSAM has many strategies – managed for individual clients – which are not made available in a mutual fund format. This key characteristic of sub-advisory also overcomes some banks’ reluctance to sub-advise to a manager who distributes funds in their same jurisdiction, he says.

In reality, GSAM also runs many mandates that are the same as off-the-shelf funds distributed in the same markets. But the key difference is that the end clients have a strong relationship with the brand and the people of the company that gives the mandate, and not with the sub-adviser, notes Mr Phillips.

Value added services

The relationship between key firms involved in running funds on a sub-advisory basis and their institutional clients in the wealth/asset management space is now entering a new phase, following the establishment of a long-standing track record, believes Mr Phillips.

At part of GSAM’s third-party distribution expansion in the Emea region, which has seen Mr Phillips’ sales force grow to 60 people, the firm has laid out plans to improve the practice management and portfolio construction support to its strategic partners. These added valued services, which go beyond the simple portfolio management traditionally associated with sub-advisory, will make the relationship stronger, he says.

“We are now approaching sub-advisory in a slightly different, evolved way,” says Mr Phillips. “We are trying to build our added value services, or what we call internally ‘wealth management services’. There are two ways we could be helping our clients’ sales force: firstly, we can give them training and help in prospecting, in order to help them increase assets from existing clients. Secondly, we can help them construct portfolios, to ensure their end clients get the right products. It is a partnership, and both sides of the equations are completely aligned.

“The more successful we are at managing the product, the more successful they are at marketing it. If we can help them become better sales forces or to have better portfolio construction and expectation in client management, they are going to be very interested.”

The idea is to recruit specialists in Europe, in the area of practice management and portfolio construction, replicating the model the firm has already been running in the US. The European sales teams has already been able to leverage on the expertise of US colleagues, who have been working with distributors to help them become more efficient in their sales process.

“Working more closely with the distributors has really evolved over the last 12 months and it is all part of our sub-advisory goal,” says Mr Phillips. “When somebody outsources to us they should feel as if they haven’t outsourced, but as if they have another in-house provider.”

This approach clearly limits the number of key relationships the firm can establish. “We are very selective, and we are in the process of talking to a number of organisations in Southern Europe and the Middle East to raise strategic partnerships on a sub-advisory basis,” he adds.

These services are not something that all clients seek from their sub-advisers. Some banks such as Deka in Germany have always been guarded against allowing their preferred fund partners to speak to branch staff.

“In some cases it is a very institutional relationship. They may simply want a quarterly review with their portfolio management to understand performance. In other cases, they would like to work very closely with us, because we are embedded in their distribution process,” explains Mr Phillips.

Many wealth managers are now reviewing the validity of their asset allocation offering, he says. “Asset allocation has always been important but there is more of a focus to it, to make sure clients have the correct portfolio to suit their needs. The days of a client owning a hot product because it has gone up the year before are gone.”