Risk management gains even more prominence

Risk management is by far the factor that has gained the most importance for institutions scouting the market for external expertise. Seventy per cent of the respondents – which included asset managers, life insurance companies and private banks – believe systems used to control and manage risk to be one of the three criteria that has acquired more prominence since the crisis. The transparency of the investment process, consistency of long-term performance and quality of the management team are the factors that carry the most weight when making the decision of which sub-adviser to appoint (see figure 4).

More emphasis than ever is now placed on understanding how the manager generates alpha or excess return. “We need to understand where the returns come from and what we can expect in different market environments moving forward,” says Ralf Ferner, head of multi-management at SEB Wealth Management, the Nordic asset manager that has €5bn of its €126bn total assets in segregated, sub-advised mandates.

“The investment process and the thinking of the management team, the key man risk, the remuneration and retention policy are the most important factors and have always been so in the past. But other factors have gained even more prominence such as risk management, operational risk and liquidity.”

However, performance is still the main driver in manager selection, with around three quarters of respondents stating long-term consistent returns head the top three selection criteria, followed by management team and investment style (see figure 3).

The financial crisis has proved to be an excellent benchmark to test the consistency of the investment process. “Some managers did not hold their nerves very well during the crisis and changed their portfolio without following their investment process,” says Jaime Arguello, head of multi-manager and third-party funds at Barclays Wealth, the UK-based institution which has one of the largest multi-manager platforms in Europe, overseeing around £8bn (€9.8bn) in assets.

“The years of 2008 and 2009 provided us with a very interesting opportunity to analyse how the managers navigated the financial crisis.”

Mr Arguello, an experienced and influential figure in the manager selection space, is adamant that managers who drifted away from their mandate should not be given a second chance.

“Arguably, in 2006 and 2007, a lot of the returns that were generated were very much beta. But beta hurt you seriously in 2008,” says Luke Reeves, head of retail and institutional business development for asset management at Matrix Group, a privately owned financial services businesses in the UK.

“The crisis has definitely enabled allocators to be able to identify managers that operate a solid risk and investment management systems,” he says. “However, we are not saying that if you had a good 2008 and 2009, you are a fantastic manager and will only ever do good. But if they did poorly in 2008-2009, then you have to ask what changes were made on an ongoing basis and you can then have your analysis on that and see whether or not you agree or disagree.”

The intense turnover of key managers in the asset management industry over the last five years has led to a boom-time for new boutiques, often founded by talented managers with the support of strong financial organisations. These smaller, high conviction firms, have increasingly become the preferred choice for some institutions looking to delegate.

“In the last three to five years, more than 50 per cent of the firms we hired were boutique managers,” says Pascal Duval, executive managing director and 15- year veteran at Russell Investments. “We don’t have a preconceived idea that boutiques are better, but the boutique organisational framework has been much more available recently than it was in the past.”

There are an increasing number of talented managers that leave large organisations and set up their own boutiques. Frequently, if that manager or team were the main reasons why the firm was employed as sub-adviser, then Russell will continue hiring them in their new company and seed their products.

“Fundamentally, asset management is a people business, it is about people making decisions on investing money,” comments Mr Duval. “We have numerous examples where we have seeded new products in newly created companies, because we know the manager or the team.”

When giving out mandates, a three or five year track record on the product is not needed to appoint a sub-adviser, unlike with a fund of funds. “The track record of the product is irrelevant, it is all about the track record of the manager,” says Mr Duval. “What is important is to invest in those new boutiques from the start, because then the team really focuses on delivering the performance; they start from zero and they have to grow, so they know performance is absolutely key.”

An appropriate remuneration system which rewards managers’ success is crucial, as it can help ensure low staff turnover.

“We make sure there is a strong organisation backing the team,” says Mr Duval. “Strong does not mean large necessarily, but it needs to be ready to pay and compensate well the team for performance success. This could happen in a large organisation too, but in a boutique this is generally the case.”

According to our research findings, however, the most used sub-advisers are still large organisations such as Goldman Sachs, AllianceBernstein and BlackRock (see figure 1). The best rated sub-advisers are Pimco, Schroders and Blackrock. Being reactive, flexible and able to meet client needs earned Pimco the title.

“The best sub-adviser is the one that acts and behaves as a partner in business, which provides high quality returns, strong operations, support to the business development and access to key internal decision makers and vision leaders,” says Furio Pietribiasi, managing director at Mediolanum Asset Management.

The majority of mandates that have been awarded are in equities, which is also the dominant asset class amongst mandates that are likely to be awarded in the future (see figure 2).

Emerging market, global and European equity are the sub-asset classes most in demand. A high number of respondents also mentioned emerging market debt as one of the asset classes they will sub-advise in the future, which clearly shows the increasingly important role developing markets play in clients’ portfolios. It also clearly indicates what sub-advisory is about, ie seeking third-party’s expertise in asset classes where there is no or little in-house competence. European institutions are unlikely to be able to offer a solid, credible actively managed solution sitting in their offices in the continent and will need to rely on local specialists or global firms that have widespread research and analysis resource.

There is also some indication that the asset classes that are sub-advised today are not just niche asset classes but core investment solutions).

“I believe clients’ expectations have been increasing. In the past, distributors and managers were using sub-advisers mainly for products for which they did not have experience and skills, which tended to be the more innovative ones, and retained internally the core strategies,” says Mr Pietribiasi. “Now they realised that they have to outsource even those core strategies to achieve better results and retain existing assets.”

But Frank Schaefer, head of sub-advisory relationships at Clariden Leu disagrees and believes plain vanilla core asset classes are typically managed in-house, while sub-advisory is still about identifying specialist alpha managers, who typically cover more niche asset classes.

While focus on core competence, search for higher alpha and enhanced offering to clients remain top drivers for sub-advisory, all the interviewees award mandates for products that, to some extent, are tailored to their clients requirements as opposed to existing flagship products (see figure 8).

Bespoke solutions, in terms of risk or asset allocation, tend to be more in demand in single mandates, while in the multi-management approach the main focus is on blending the managers.

Either way, there is reason to be happy with the performance of sub-advised products. The large majority of interviewees stated that more than 50 per cent of their sub-advised products outperformed equivalent funds available on the market.

The hedge fund space is also seen as an area of growing opportunities for sub-advisory, as due diligence, manager selection and asset allocation between strategies is seen an increasingly important skill (see figure 6).

The majority of the respondents stated they do use Ucits III solutions which embed hedge fund characteristics, often to be able to use absolute return type of strategies.

However, they are quite divided over the impact of the growth of regulated hedge funds on the demand for sub-advisory solutions. For some, the convergence of long only and hedge funds will allow them to leverage on their in-house capabilities.

“The standardisation of Ucits III rules and protection level, as well as the limited current investment universe allows to capitalise on in-house resources to manage fund of hedge funds,” believes Mr Schaefer at Clariden Leu.

Overall, sub-advisory in the retail space is seen as a growing trend in Europe. Around 60 per cent of the respondents forecast the practice of delegating the management of all or part of their assets to third-party fund managers will grow by 5 to 10 per cent over the next five years in Europe.

“We see the trend for specialist capabilities increasing further. More and more established players will seek to identify niche providers with specialist skills,” says Adrian Doswald, investment advisor at LGT Capital Management, the Swiss asset manager which has delegated the management of around €2bn of assets in multi-management. “In fact, most specialists only thrive in their own structures, larger structures may not be able to offer the adequate environment to express themselves fully.”

The growth of sub-advisory will be particularly linked to the growth of multi-manager funds, which enable investors to reduce risk by investing in a diversified portfolio and gain access to less known, often high conviction managers. “Multi-manager products can compete well with traditional single-manager funds and can offer promoters an opportunity to cover markets in which they have limited capabilities of their own,” claims Mr Doswald.

HSBC Global Asset Management’s investment director, Alasdair Prescott, expects the trend in sub-advising to be driven by two main factors.

“For those organisations for whom had a negative experience of running non-core activities in-house during the crisis, there is likely to be a trend to outsource these non-core activities by way of sub-advising,” he says. “By contrast there will have been some organisations that had a bad experience of sub-advised product during the crisis. For such organisations, there will likely be a trend towards consolidating such products and bringing them in house.”