Regulation set to make its mark on sub-advisory

The wave of regulations hitting the asset and wealth management industry is expected to have a significant affect on the sub-advisory business, according to the results of the eighth annual survey conducted by PWM.

Although there is still quite a lot of uncertainty on its real impact, increased regulation in the financial industry will lead firms to look for third-party fund managers, believe 44 per cent of the research respondents, which include asset and wealth management firms, private banks and life insurers (Fig 1).

Greater costs to comply with new legislation will force smaller houses to focus their product range on a limited number of in-house capabilities and complement those with external expertise. The value of economies of scale will increase and regulatory know-how will no longer considered a commodity. Only those companies with a strong regulatory ability are expected to succeed.

The cost of staying in the investment management space will be too high for players with no critical mass, especially in the alternative space, as the new Directive on Alternative Investment Fund Managers (AIFM) regulation is anticipated to especially affect firms that so far have been able to operate with light regulatory constraints.

The need to comply with regulation will increase firms’ internal costs and thus may lead to higher outsourcing in order to improve profitability, argues Wolfram Gerlof, head of product strategy & client service at Vontobel Asset Management.

However, higher risk-management requirements will make it harder to sub-advise, he says. The effect on the total business is still uncertain. Using funded solutions would be an easier way to deal with regulation, some suggest.

It is worth noting that since the PWM survey started seven years ago, regulation has always floundered at the bottom of the list of drivers to sub-advisory. At the top are the desires to search for higher alpha, while focusing on core competency, to enhance product offering to clients, and to tailor the funds specifically to client needs (Click to view Figs 2 and 3). The continued financial crisis and market turbulence has not significantly affected the business model of the firms doing the outsourcing, which emphasises the concept that appointing external managers to run segregated mandates is a long-term strategic decision.

“The drivers for sub-advisory are not regulatory, but investment driven,” says Christophe Girondel, managing director at Nordea Investment Funds. “The exception would be Ucits IV considering the feeder structure ‘sub-advisory’. Here we could see many smaller funds using this option to disband investment teams but retain their product range.”

Whereas it is still too early to assess the true implications of Ucits IV for the sub-advisory business, the impact of the trend towards the separation between investment management and distribution and the end of the retrocession-based business model is much clearer. The retail distribution review in the UK, which is increasingly under observation from European authorities and wealth managers, is an illustrative example quoted by a number of respondents, who predict the new regulation will drive distributors (and consequently managers) to focus much more on the investment performance, rather than on rebates. The result will be a higher level of sub-advisory activity aimed at getting higher performing products.

Indeed, according to the survey, sub-advised assets do perform better than equivalent off-the-shelf products, with around 72 per cent of the respondents estimating that 50 per cent or more of their sub-advised products generate higher returns ( Click to view Fig 4).

MANAGER SELECTION

Once the decision to sub-advise is made, the issue is finding the right manager.

Consistent with past years’ results, long-term performance heads the top criteria in selecting sub-advisers, according to 80 per cent of people, followed by management team and investment style. However, when asked to identify the biggest mistakes made in the selection process, around 65 per cent, unprompted, admit they are too much focus on historical performance or on short-term returns and profits.

It is important to evaluate managers over multiple market cycles and truly understand their process, and assess the stability of the team moving forward, say respondents. A few of them believe that the biggest challenge when selecting sub-advisers is to analyse correctly the managers’ track record and separate real alpha from hidden beta.

“Not doing your homework on the track record and not employing enough resources to get under the skin of the management are some of the biggest mistakes when selecting managers,” explains Mattian Hagen, head of manager research at SEB Wealth Management.

It is imperative to “slice and dice” the track record and understand, for example whether the fund performance refers to a segregated mandate, which is easier to get, or to an open ended fund, where the manager has to deal with inflows and outflows, says Mr Hagen.

The 2008 financial crisis proved to be a good benchmark to test the consistency of managers’ investment process, believe 78 per cent of the participants to the survey.

“Any kind of crisis helps separate the skilful from the lucky,” says Ryan Hughes, senior fund manager at Skandia Investment Group. “High quality managers who have a robust process have demonstrated this throughout the crisis.”

Managers with a good investment process were able to take advantage of the financial crisis, points out Furio Pietribiasi, managing director at Mediolanum Asset Management, as they tend to invest in companies where they understand their business and the way revenues are generated.

“We have been sceptical about managers that changed their investment process as a result of short-term negative results,” says Mr Pietribiasi.

Although a few mentioned that the financial crisis cannot be considered a good discriminator, as all markets were so badly and temporarily affected, around 70 per cent of respondents stated they have not given a second chance to managers who drifted away from their investment process during that time.

When asked to rank the most important criteria that have gained importance when selecting a sub-adviser today compared to before the crisis, unprompted, around 76 per cent of the respondents, up from 70 per cent last year, mentioned risk management as one of the top three, followed by reputation/track record and investment process/style (Click to view Fig 5).

BEST SUB-ADVISERS

The best rated sub-advisers, according to the survey, are BlackRock, Pimco – who also got to the top two positions last year – and JP Morgan Asset Management. The most appreciated qualities in a good sub-adviser are the ability to act and behave as a business partner, providing transparency and access to managers, rather than just to product specialists or sales representatives.

It is also equally crucial to have a reliable investment strategy, long term consistent performance and give quick access to key information. This is even more valuable in very active strategies during very volatile markets.

Large companies, such as GSAM, JP Morgan, Pimco and Shroders, continue to be the most used sub-advisers (Click to view Fig 6). Asked to comment on the advantages of using large sub-advisers, respondents mentioned they can benefit from economies of scale and have centralised back office and middle office functions. These can allow investment teams to be more focused. Other key advantages are greater resources and a global presence, financial robustness, strong risk management and solid operations support, as well as a wide range of product offering, good client service and marketing support.

However, the large majority of respondents view the increasing number of investment boutiques available on the market as a positive development for the sub-advisory business, as they can increase competition and potentially take market share from existing sub-advisers. Around 76 per cent of them use boutiques, and 10 per cent are looking to employ them in the future.

“Investment boutiques can potentially generate more alpha, as they tend to be more nimble and better incentivised to deliver performance,” says Meike Bliebenicht, senior product specialist at HSBC Global Asset Management, adding they can often be less constrained by capacity limits or investment/ benchmark restrictions.

“Including boutiques also enables clients to get access to investment managers they normally would not be able to invest with,” he says.

Other appealing characteristics are their ability to bring innovation, specialisation, conviction and passion. They are also thought to offer better access to portfolio management teams. Also, portfolio managers owning stakes in the company means a better alignment of interests with the clients.

However, the risk is for some of these “boutiques” to grow too fast, and to broaden their product range in order to increase their assets under management. This may reduce their focus on core products, and consequently affect performance.

FUTURE DEVELOPMENTS

Around 56 per cent of the respondents are planning to award new mandates in the next 12 months. Like last year, global equity and emerging market equity are at the top of people’s agendas ( Click to view Fig 7). Emerging markets, bonds and equities – as well as absolute return, asset allocation/multi-asset, alternatives and frontier markets – are expected to be the areas with the biggest potential for sub-advisory growth (Clic to view Fig 8).

But these also are the areas where finding sub-advisers proves more difficult, according to respondents. Given the strong inflows seen in global emerging market equity recently, many strategies are today closed or half closed. Equally, finding a local sub-adviser in emerging market strategies suited to client needs, able to share views and aligned in terms of infrastructure, people, culture and other aspects is not easy.

If the majority of those who sub-advise see no major barriers to the growth of their sub-advisory activity, around a third of respondents are concerned about profitability. They see high fees and the high cost of setting up agreements as the main barriers to their decision to appoint external managers.

The flexibility of third-party distribution is also mentioned. “Through funds we can offer a better product range, keep funds in our recommendation list, where we have no investments,” says Antti Vesa, head of research at Aktia Invest. “And if a (large) client is the only one invested in a certain fund and wants to redeem all the shares, it is easier with funds rather than segregated accounts. Funds are much more flexible. You can easily compare them, buy/sell them and switch recommendations. You can also have a better variety of different fund profiles in your recommendation list.”

However, people are overall positive about the growth of the sub-advisory business in Europe (Click to view Fig 9).

“We see many investment managers have added resources to their manager and fund selection teams and this will increase the amount of sub-advisory agreements,” says Ari Mäkinen, head of economic analysis and fund research at Pohjola Asset Management.

Building up in-house selection capabilities was driven by the need to respond to retail client demand for more diversification in client portfolios, he says, adding it is easier and more cost efficient to outsource the management of certain funds, such as emerging markets, to third parties.

“Moreover, increasing competition will lead firms to focus on core competencies,” says Mr Mäkinen.

The growth of sub-advisory is also fuelled by the increasing number of cheap passive investments available on the market. The result is that, increasingly, investors are looking for alpha-generating investment specialists.

Mediolanum’s Mr Pietribiasi predicts in the next few years high demand for sub-advisory will be driven by growing merger and acquisition activities between asset managers, which will lead to product restructuring. In addition, many of the middle size players that remain on their own will try to reposition themselves to retain existing investors. This will drive them to set-up partnerships with other managers through sub-advised white labelled products.

76 per cent of respondents use boutiques, with a further 10 per cent looking to in the future

Around 56 per cent of respondents are planning to award new mandates in the next 12 months

78 per cent of respondents believe that the financial crisis acted as a good benchmark to test the consistency of managers’ investment processes