Search for alpha drives rise of sub-advisory relationships

The sub-advised investment model, where a bank or distributor asks a third party investment provider to manage a segregated fund for their client base, has an established place in European financial services, but it is set to spread its tentacles into some new areas.

PWM’s eleventh annual survey into sub-advisory trends canvassed 30 private banks, wealth managers and fund houses, who represent €658.25bn in assets managed by third-party managers on a sub-advisory basis. On average, each firm in the survey delegates fund management to 27 different third-party players, managing an average of 10 asset classes. But with new financial institutions adopting the model, the average number of sub-adviser relationships in our survey ranges from as many as 250 at the old stalwarts to just two or three for some newcomers.

Newer entrants  have a bias to multi-manager funds, and are using the model to deliver a few highly targeted and complex solutions, in comparison  with the core group of respondents, which have always focused on providing an extensive range of individual funds. Alliance Bernstein, for example,  intends to outsource the management of a range of multi-asset target date retail pension funds later in the year.

The cohort have differing views about the advantages of bespoke mandates. Historically the consensus view has been that tailoring gives the distributor greater control and daily transparency into the underlying portfolio, plus the facility to tailor to their clients’ requirements and  no need to concern themselves with the activities of other investors in the pool. In the past in particular, value was attributed to having a consultant-based relationship with the manager, as an  expert in an asset class where the firm lacks internal expertise.

However, while 47 per cent said that more than 90 per cent of their mandates were bespoke (see Figure 1), around a quarter said that less than half of their mandates were made to measure. Some firms prefer to structure funds as a mirror of the pre-existing funds, and some will only use sub-advised mandates as a last resort.

For example, at private bank Kempen, the house style is to look for flagship fund offerings.  Sub-advisory relationships are only used where the desired exposures cannot be purchased off the shelf, such as its fundamental European equity tracker, where clients required an SRI screen prohibiting 25 names.

 “Today, we can get a lot of transparency  in funds and can negotiate separate share classes. But first we look at the fund offerings to see what is possible,” says Theo Nijssen, director of multi-management at Kempen.

“Also, the reality is that flagship funds often outperform segregated accounts. With segregated funds, there is a tendency to come up with restrictions when you have the power to do so and I have noticed this creates less freedom for the fund manager to try to generate alpha, less freedom in fact than the flagship fund. After a few years, there is often a new team who does not even know any more why those restrictions had been applied.”

Different clients will make different demands, he explains, such as not liking the use of credit default swaps, so the temptation is always to go with the most limiting common denominator.

“There is also the hassle,” says Mr Nijssen. “We may have lower fees but the arrangement requires a governance structure with a board, and NAV (net asset value) calculations.” This all adds costs, leaving more asset managers against the concept.

For certain asset classes such as emerging market debt, it can take at least six months to set up the trading and custody accounts, while with an off the shelf fund you can invest immediately.

Vanguard is planning to expand in the UK with active funds on a sub-advised basis, and Dan Newhall,  a partner in the US firm’s Portfolio Review Group, cites fund capacity as a prime driver for using the sub-advisory model.

Vanguard is better known as a champion of indexing, but is the fourth-largest US sponsor of actively managed equity funds, he says.

“One reason we went outside Vanguard was that one fund with a single investment strategy can only take so much money, so we spread the inflows between multiple managers  to avoid pushing up against this problem,” says Mr Newhall.

“The multi-manager model also works because a single strategy can be quite risky. Even the best managers run hot and cold and can move from producing exceptional returns one year to disappearing returns the next, so the multi-manager model mitigates that risk.”

In the US, Vanguard has up to eight managers running each fund which improves investor outcomes by diversifying risk, says Mr Newhall. M&G already runs a commodities and mining stocks fund for the group in the UK.

The most popular individual asset classes for sub-advised funds are the basic building bricks of European, US and global equity (see Figure 3). More than 25 per cent of respondents sub-advise domestic equity portfolios, as their strategy is to delegate investment management in its entirety. In these days of low yields, 27 per cent  now sub-advise  income generating equity mandates.

Surprisingly, relatively few have signed up real estate managers although it is a specialist area of expertise and therefore intuitively more likely to be outsourced. Russian equity is also currently sub-advised by only 4 per cent of the sample but real estate, Russian equity and also global bonds top the list of asset classes distributors plan to sub-advise in future.

Nearly three quarters of our respondents think their sub-advisory assets will increase (see Figure 4), while more than half said the number of sub-advised mandates they give to managers would grow (see Figure 5). This marks an improvement in confidence over last year when just over half thought their sub-advised assets would expand.

Looking ahead, respondents indicated they would make greater use of managers with  global equity or global fixed income expertise than specialists – in fact twice as many predicted greater use of  global managers in future than today.

But while traditional asset classes such as equities and bonds are more suitable for use in sub-advised mandates today, alternatives such as hedge funds, commodities and  real estate will be growth areas in the future (see Figure 6).

“On past experience, we can argue that selecting third part managers can improve portfolio efficiency,” says Gian Maria Mossa, joint general manager at Banca Generali. “That is notably true when considering specific asset classes such as emerging bonds, real estate, commodities or particular market themes like natural resources, or portfolio strategies, where a dedicated manager can provide better results thanks to its expertise.”

We asked the respondents to rank the qualities they paid most attention to in selecting sub-advisers. The top three answers were conclusive and concurred with last year’s results – a consistent long-term performance; the management team and the investment style. Risk management and fees were deemed slightly more important this year than last.

BlackRock was the most used sub-adviser followed by Aberdeen Asset management (see Figure 8). JPMorgan and Investec were also prominent and well regarded.

“The risk in selecting a manager is to focus too much on performance and not enough on your own needs,” says Paolo Biamino, Euromobiliare’s fund selection head. “First you really need to scrutinise yourself and ask what client requirements  you want to satisfy, what specific solution you are having this manager for and what your expectations are,” he explains.

Most of the managers Euromobiliare has are in the fixed income arena, specifically mandates with core investments in corporate credit, both investment grade and high yield, with satellites in emerging market debt. “We are looking for process-driven features more than style-driven, and a performance that is not dependent on the view of a single manager but team–based,” says Mr Biamino. It also helps if there are quant skills in the team for portfolio construction, he adds.

Managers said that typically their sub-advised equity funds carry a fee of 0.2-0.9 per cent while bonds funds are charged at 0.5-1 per cent. “In terms of trends, equity fees are relatively stable, but fixed income  costs are increasing as the better alpha managers are more in demand given beta return is so low,” says Conor Owens, senior product manager at Mediolanum.

“For flexible and multi-asset managers, demand has grown rapidly and the better managers have more pricing power.”

Turning to investment performance, 22 per cent said more than 90 per cent of their sub-advised funds outperformed  benchmarks and 28 per cent said between 70 and 90 per cent of their funds had outperformed (see Figure 9).

Crucially 11 per cent said that only between 10 and 30 per cent of their sub-advised funds outperformed benchmarks, which does nothing to answer criticism about the value of the model’s additional layers of governance and fees.

Poor performance and personnel turnover were the key reasons given for changing manager. One third also pulled the plug after a bout of bad publicity. A quarter cited structural changes at the organisation, and 17 per cent mentioned style drift, falling service levels and brand awareness.

The reason our respondents are opting for sub-advised relationships is predominately the search for alpha, followed by the ability to tailor funds to their clients’ needs (see Fugure 11). The desire to concentrate on core competencies and to find competitive differentiation also ranked highly.

“We expect sub-advisory growth to be driven by investment solutions suitable for the current market environment,” says Will Pompa, senior vice president at Pimco.

“We call this  ‘The New Neutral’ which we expect to be characterised by low but stable global growth, low central bank policy rates and modest return potential for equities and bonds. In such an environment, investors need to be smart about how they obtain beta, active and flexible in seeking alpha, and focused on delivering outcomes, like income.”

Different firms focus on different attributes, largely driven by whether they are looking to bring a best-in-breed manager to their own fund platform, or whether they are looking for a specific risk exposure to play a role in a broader portfolio, says Mr Pompa. “On occasion, we see an emphasis on costs relative to other factors, but we think this is short-sighted. We expect that in The New Neutral market returns will be relatively muted, which makes after-fee alpha as important as ever.”

The impact of regulation seems to have faded in importance as an argument supporting the sub-advisory model with just 46 per cent saying regulations such as the retail distribution review (RDR) in the UK or Netherlands or Mifid in Europe will drive private banks and wealth managers to sub-advise more in the future (see Figure 13).

Most respondents thought growth in the sub-advisory model would be strongest in the UK (89 per cent), followed by Italy and Scandinavia, with most growth in demand coming from life insurance companies.   

Case Study: LGT Capital Partners

The sub-advisory structure has advantages in that a segregated account affords a one to one relationship, says Michael Simmeth who heads the long-only multi-manager business at LGT Capital Partners. “It is us and the manager and there is nobody else in the pool,” he says. “When we invest in frontier markets we have to go into a fund. But we need to examine the other clients in the fund to make sure they are like-thinkers. We don’t want to be in a high turnover environment or we will end up taking the costs of the additional turnover as retail investors move out.”

He likes smaller organisations which are focused on a small number of asset classes. “If they are gathering assets too quickly, this has negative potential,” he says.

The guidelines are tailor-made. “Typically our slant is to give the manager as much freedom as he needs to achieve alpha, not to do anything that ties his hands,” says Mr Simmeth.  “In fixed interest, primarily in sovereign bonds, we may also specify duration against certain risk guidelines.”

LGT uses 60-70 names on the long only side and turns over around 10-20 per cent of its managers per year. One of many causes of termination is performance, but this needs to slip for a prolonged period of around a year minimum before action is taken. “It is important to understand what caused it,” says Mr Simmeth. “If it is in line with style then we will be less concerned, but if the manager is doing something different than he told us, then that will be a cause for worry.”

Another common problem is a change of ownership, typically if a boutique sells out to a large organisation.

“It can also be because we lose our trust, perhaps if an important piece of news is not communicated.” 

Case study: Amundi

For French asset manager Amundi, the use of  sub-advised mandates typically occurs only when a client requests it, but the firm has experience in sub-advisory strategies dating back to 2001 and a team of 18 working in the fund selection department.

“Often delegation to external managers will be at the client’s request rather than something we actively want to put forward,”  says Mai-Khanh Vo, head of fund selection and advisory. “We may for example have a client who wants to use Amundi for asset allocation  and external managers for underlying mandates.”  Some believe the best way to go is to split responsibilities, but another client may be very large and so may want to diversify holdings in one asset class across multiple managers to manage risk.  Of the firm’s €22bn in advisory, some €14bn is in sub-advised mandates.

While most clients are 100 per cent invested in Amundi’s own funds, Ms Vo says the firm’s sub-advised AUM is growing owing to a mandate it won for fiduciary management from a big insurance client, and also because its distribution partnership with First Eagle Investment Management has been very successful.

Across the market, she says that   tightening regulatory burdens are driving greater use of delegated management, and believes the sub-advisory model could also be more widely adopted if Retail Distribution Review-style legislation is introduced in France.

Manager selection is based on a three stage process of quant screening, qualitative screening and operational due diligence. Managers are terminated if they do not comply with guidelines, or fail to deliver, but it is much rarer than leaving a mutual fund.