Rising regulation drives growth of sub-advisory

The growth in the sub-advisory model among European distributors is showing no signs of weakening over the near future, despite findings from PWM’s annual sub-advisory research suggesting a slow-down in the uptake of new sub-advisory arrangements over the past 12 months.

The survey, now in its 13th edition, is based on responses from European private banks, wealth managers, asset managers, life insurers and fiduciary managers with combined asset under management of €2.5tn ($2.7tn), of which  €517bn are managed by third parties on a sub-advisory basis. 

Although 86 per cent of respondents believe that more distributors will start using sub-advisers over the next two years, many pointed out that appointments of new sub-advisers in the past year might have been lower than during 2015. A combination of changes in regulation, market and political events and the lengthy process of integrating newly sub-advised investment solutions into existing portfolios are some of the reasons given for this perceived deceleration. 

“A lot people are talking about it but I can’t say I have seen a strong trend towards sub-advising more,” says Didier Chan-Voc-Chun, head of multi-management and fund research at Union Bancaire Privée (UBP) in Geneva.  “However I wouldn’t be surprised to see further development in that area, given the changes in the regulatory environment.” UBP has some €105bn assets under management, of which around €1.5bn is managed on a sub-advisory basis.

Nearly half of interviewees said they have seen evidence that the ban on inducements has lead wealth managers and private banks to sub-advise more. Similarly, 67 per cent said regulatory changes such as the Retail Distribution Review (RDR) in the UK and similar regulations in the Netherlands, and MiFid II are likely to drive more distributors to sub-advise (see Fig 1 and 2).

At Lombard Odier in Geneva, head of open architecture Philippe Baumann agrees that regulatory change is pushing more distributors away from off-the-shelf funds and into the sub-advisory model. “Sub-advisory allows us to provide our clients with access to managers who don’t have a presence in Europe – no Ucits funds offered – and also to partner with managers on differentiated strategies that we believe better fit our client portfolios than the existing funds available from this manager,” he comments. 

The private bank launched its first fund managed by a third-party manager back in 1998. In 2014, it launched a dedicated Luxemburg Sicav called ‘PrivilEdge’, with a view to grow that part of the business. 

According to Andy Brown, investment director at Prudential Portfolio Management Group in London, there has been a move towards a more vertically integrated wealth management business, driven by the need to differentiate the client offering. 

“This has been accelerated by regulatory changes which have meant more accountability remains with the adviser, so the adviser is building a distribution model within which they can control their risks.”

Acknowledging the challenges faced by the sector, with dry humour, he adds: “In London, the change to inducement rules has led to an increase in business for tailors, due to weight loss of people within our industry, and a decrease in business for restaurateurs.” 

Others comment that the new inducement rules and requirement for increased transparency on costs, as a result of MiFiD II, should lead to use of more wrapper products, relying on low cost external solutions such as passive funds, ETFs, and smart beta products. 

Responses to the survey show the most important factor driving more distributors down the sub-advisory route is the wish to enhance their product offering to their clients, followed by search for higher alpha, and the need to free up capacity to focus on core competencies. 

At Mercer in London, senior fiduciary consultant Tim Banks mentions two key industry trends that are driving demand for sub-advisory and fiduciary management services: the retail and institutional investment worlds coming together and a renewed focus on outcomes-based investing. As a result, wealth managers and life insurers are aligning their products with the achievement of investment goals, and working with outsourcing partners to be able to include institutional-type investment solutions in their offering to clients.

“Continental Europe has been slightly ahead of the curve in harnessing these opportunities,” Mr Banks explains. “In the UK, things slowed down a bit during the first half of the year – Brexit, regulation and the consolidation in the market, all played a big part. But over the last quarter we have seen a renewed focus on thinking about solutions for the future.”

He adds: “In a world where we have increasing regulation, margin pressure and distribution model disturbance, a growing number of businesses are now reviewing which parts of the value chain they provide themselves and which they don’t.”

When choosing a sub-adviser, niche managers are still the preferred choice for respondents, with 78 per cent saying they favour specialist managers now, and 83 per cent saying they will continue to do so in the future.  Preference for global investment management firms has increased considerably from last year, from 33 per cent to 50 per cent. On the other hand, interest in multi-boutique asset managers decreased, from 43 per cent to 28 per cent (see Fig 3).

“Over the last three to five years we have invested heavily to develop our own internal investment capabilities but we are very conscious that we cannot do everything ourselves,” says UBP’s Mr Chan-Voc-Chun. “The industry is really overcrowded and we are trying to be creative by partnering with niche investment managers to offer different investment solutions to our clients, such as private debt products.” 

The largest proportion of sub-advisory mandates are now bespoke, with 43 per cent of respondents saying this applies to more than 90 per cent of their mandates (see Fig 4).

Just over half of respondents said traditional asset classes, like equity and fixed income, are more suitable to sub-advisory, versus 24 per cent finding alternatives such as hedge funds, real estate and commodities, more suitable. However, when asked which asset classes show stronger potential for sub-advisory growth in the future, 62 per cent of participants chose alternatives (see Fig 5).

On average, each firm in the sample delegates fund management to 20 different third-party managers. The most frequently used asset managers are Aberdeen Asset Management and BlackRock, followed by Goldman Sachs AM, Invesco and JP Morgan AM (see Fig 6). Invesco is the best-rated sub-adviser in our sample, with 44 per cent of respondents rating it as very good (see Fig 7).

US equity remains the most sub-advised asset class, followed by European equity and high yield (see Fig 8). Two thirds of participants reported that 50-70 per cent of their sub-advised assets outperformed their benchmark over the past 12 months. 

Investment performance continues to be key when selecting sub-advisory partners. The majority of respondents said long long-term consistent fund performance, track record, investment style and risk management are their top selection criteria.

Despite the different approaches to manager selection, respondents agree on the need for analysing all the factors that can drive the performance of a particular manager.

“If you are looking at a global equity product, you need to know which kind of regions and sectors and which kind of FX have driven the returns,” says Anders Bertramsen, head of fixed income at Nordea Investment Management in Copenhagen. 

“You need to separate between what is structural and what is manager skill. If you don’t do that, you are not a good manager selector.”

Bad performance, personnel changes and fees, are some of the key reasons that drove respondents to replace a sub-adviser in the past.

The debate about costs has intensified over recent years. The fee environment has become more competitive, due to passive and factor-based strategies gaining more support, resulting in fee reductions across the board. The majority of respondents said they expect to see fee levels across asset classes to either decrease or stay the same. 

Looking ahead into 2017, around two thirds of respondents indicate their exposure to the sub-advisory model will grow over the next 12 months, both in terms of the number of mandates given to third-party managers, and the size of the assets sub-advised.

“All the macro factors in Europe, the US and emerging markets are strengthening the case for more tailored solutions for clients, both active and passive,” says Cord Hinrichs, head of asset allocation at Corestone Investment Managers in Zug, Switzerland, explaining how he sees more opportunities for active and more specialised strategies going forward.