The search for specialist partners

The desire for greater transparency, control over investments and bespoke solutions in the hedge fund space drove private bank Investec to sign sub-advisory agreements with two large firms, Goldman Sachs Asset Management and JP Morgan Asset Management, explains Andrew Summers, global head of product and research at Investec private bank in London. The two firms will each run a hedge fund multi-strategy mandate.

“Every aspect of the mandates we set up with Goldman and JP Morgan has been designed specifically for Investec, the risk target, the return target, the concentration, the liquidity and strategy biases,” says Mr Summers. “It is exactly what we want, rather than having to choose an off the shelf solution from a fund of fund, which is not going to completely match all your requirements.”

When sub-advising, there is also greater level of operational comfort regarding the administration, the custody and the oversight of the assets, he says, explaining that assets will sit in a fund vehicle, which has representatives of Investec on the board and the fund administrator, custodian and auditor will be chosen by the bank.

“With sub-advisory there is greater transparency and we will be able to go to JP Morgan and Goldman Sachs’ offices, we will be able to review all their due diligence, all the managers they select, so we can really understand at very great level of detail all the underlying investments.”

Cost reduction

Despite all these benefits, sub-advisory is also a cheaper solution than funds of funds, says Mr Summers. This reduction in cost is passed on to clients, who will get a superior offering at a cheaper price, he claims. “If you have got enough money to open a sub-advisory relationship, you have probably got enough money to negotiate lower fees.”

The two sub-advisers will select underlying managers, construct the portfolio, and will be responsible for risk management and portfolio management. However, Investec will continue to select single manager hedge funds in-house, as overlays to the sub-advisory mandate.

So far, Investec has offered 10 different funds of hedge funds to clients. Different strategies were blended together to create an overall multi-strategy exposure. But one of the problems of this approach is the risk of over-diversifying and just getting the average market return, says Mr Summers. In order to have a diversified portfolio of hedge funds, between 10 and 15 managers are needed, with a total of 30 managers closely monitored for any possible replacement.

This process is very resource intensive, with a large volume of assets needed, in order to apply the right level of due diligence.

Funds of funds have also clearly had problems during the crisis, through lack of transparency and liquidity. And they are generally more expensive and unlikely to match clients’ requirements exactly.

Communicating change

Investec considers the sub-advisory route the optimal solution, outsourcing to benefit from resources which big companies like GSAM or JP Morgan can bring to the process. Rather than 10 funds with 300 underlying managers, it is better to move to two mandates, a higher and lower risk brief, believes Mr Summers. This solution is more concentrated but still sufficiently diversified for risk management purposes, he says.

The biggest problem with the sub-advisory route is that when creating a bespoke portfolio, there is by definition no track record. Also, there is the issue of having to communicate changes to both advisers and clients.

“A lot of our private bankers and clients are comfortable with our funds, they don’t necessarily see the need to change,” says Mr Summers. “Any change can be unsettling for people, so you need to educate them on the benefits of the move.”

Since the crisis there is more focus on liquidity and risk management, when selecting managers.

“In the case of sub-advisers, what you are looking for in addition is somebody who has a substantial sub-advisory business,” he says, as the risk of awarding mandates to companies which have the large majority of assets in flagship funds is that they will spend the large majority of their time on the funds rather than specific mandates.

“We wanted to choose managers who have a long history of running segregated, bespoke mandates, so you know the whole infrastructure and process was set up to run bespoke portfolios.”

Asked whether his past at GSAM had any influence at all on his decision, he says that when he worked at the firm, he did not really know the individuals involved in this area and adds: “When you scour the market for a blue chip organisation with a long track record and good level of AUM, big team, robust infrastructure and long history of running bespoke mandates for private banks, there aren’t many organisations to choose from.

“There are a lot of new entrants into the market, who all run a small level of AUM, and we deliberately try to avoid those. A lot of people say they would like to go to managers that have a small level of AUM, because they are nimble. I am not sure that is true. For us it was more important to go with a manager who was very well established.”

Swiss & Global: pressure to perform

The separation of asset management and distribution has often been cited as the key driver in the decision to sub-advise, as search for alpha becomes even more crucial when the fund house does not enjoy the benefits of distributing through its captive channels.

But this is not the case at Zurich-based Swiss & Global, previously Julius Baer’ asset management arm, until the separation from the bank in October last year.

Its newly acquired independence has had no impact on the firm’s sub-advisory business, says Stefan Angele, head of investment management at Swiss & Global.

This is because only 10 per cent of the firm’s assets were distributed through the bank’s captive channel, with the vast majority sold through third-party distributors.

“We always had this pressure to perform as we were competing with the rest of the world,” he says, explaining that for many years the firm has relied on external managers to manage asset classes where it does not have internal skills.

A good example of a sub-adviser chosen by Swiss & Global is Macquarie Capital Investment, which manages infrastructure and has a good track record and strong team. It would be very hard for an institution to start its own team in that space, where it is difficult to hire good managers.

It would not make sense to build a team just to manage one product and this applies to other asset classes, such as agriculture or natural resources fund, currently managed by Wellington.

In selecting external managers, what gained importance is the “DNA of the manager, the business model, the incentive structure, the management, how stable the company is,” says Mr Angele.

“It is not just performance, a lot of managers that performed well in the past and were blown away in the last crisis. We really benefit now from being an independent asset manager and therefore we are seeing good inflows in our business,” he explains.

But he is reluctant to say whether the firm will concentrate on strengthening investment capabilities in-house or awarding more mandates to external managers in order to grow assets.

“Those two things go in parallel, we will strengthen our investment capability, when we have a good product in mind and we find talented individuals that fit within our corporate culture, and we will also continue to outsource, if we think it makes sense,” says Mr Angele.

AUM: SF77.9bn (€58.4bn)

Sub-advised assets:

Artio Global Management: JB Global High Yield Bond Fund, JB Dollar Bond Fund, JB Dollar Cash Fund

EMCore: JB Global Convert Bond Fund

GAM International Management: JB Absolute Return Bond Fund, JB Absolute Return Bond Fund Defender, JB Absolute Return Bond Fund Plus, JB Local Emerging Bond Fund

Fayez Sarafim International Management: JB US Leading Stock Fund

Macquarie Capital Investment: JB Infrastructure Fund

Wellington Management Company: JB Agriculture Fund, JB Natural Resources Fund

Russell: value in multi-management

The manager of managers proposition has necessarily evolved with time, believes Pascal Duval, executive managing director at Russell Investments, the multi-manager institution with €114bn of global assets under management, of which €31bn are sourced from Europe.

“If you provide best of breed managers, it is because you are going to deliver excess return, otherwise multi-manager is just another way of getting beta,” he says.

Hiring specialists is essential to be able to offer added value in multi-management, he says. Segregated mandates, which Russell employs to manage its 325 funds worldwide, have a competitive advantage over funds of funds, not only because they provide more transparency, offer higher levels of risk control and enable product customisation, but also because they allow access to specific areas of expertise and teams within selected asset management companies. Another key element in the multi-management proposition is portfolio efficiency, which is often overlooked, says Mr Duval.

“We have worked a lot on the implementation of efficient portfolios, which ensures that when a product is managed by several sub-advisers, they don’t trade against each other. We want to make sure the mandate is implemented in a liquid and efficient way and we want to minimise any leakage cost, in terms of trading, portfolio turnover, and hedging cost.”

The level of growth of the sub-advisory business in Europe depends very much on the market, he believes. Some may offer fewer opportunities, such as France, Italy and Spain, where the top banks control captive distribution with proprietary products. Some other markets, such as UK with its large independent financial advisers’ network, are more open and fragmented. Also, the overall development of the European asset management industry has to be considered.

“The asset management business went through a phase of big expansion from 2000 to 2007, recovering from the recession in 2001-2002. But now it is very clear there is a contraction and looking after costs is the main driver in the mass production of asset management,” says Mr Duval.

Asset managers are contracting, profits are going down and some are experiencing losses, which is very rare in the industry, he says. “This context is not favourable to sub-advisory. At the same time, within each of these markets institutions that do not want to lose market share need to bring some smart solutions.” The emphasis is today on more proactive asset allocation and being more reactive to markets, as is shown by remarkable inflows into “flexible funds” in Europe, adds Mr Duval.

Mandates awarded in the year ending June 2010: 226. Half of them (113) were in the EMEA region

Flexibility is key for private banks

Most private banks embrace open architecture and offer third-party funds to clients to enhance their product offering, improve performance and diversification in portfolios. Often, purchasing funds, rather than appointing managers to run managed accounts, is the preferred choice, as it is seen as more flexible than setting mandates.

“We have a strong internal asset management unit which has a quantitative approach to management, but we have an open architecture approach in the private bank. We use external funds but we do not sub-advise,” says Dr Magne Orgland, managing partner and head of portfolio management at Wegelin & Co. “We also use many indexed products, such as ETFs and low cost indexed funds. The choice is broader in terms of funds, it is easy to find the track record and to do the quantitative analysis. This is the main reason why we have not gone into segregated mandates.”

Bank Julius Baer also prefers to adopt an open architecture approach and currently has 180 funds sourced from 60 providers in its recommended list. The bank’s intention, revealed after separation from its asset management arm last year, to adopt a managed open architecture where the number of partners would be reduced to 20 providers, seems to have been toned down.

The risk of fixing a reduced number of providers may restrict the universe offering, says Lorenz Altwegg, head of fund solutions and open architecture at Bank Julius Baer. However the preferred partner concept, he believes, is a normal development of a business partnership and the bank is looking at a closer, mutually beneficial cooperation with its partners.

The bank does not use managed accounts or sub-advisers. However, there might be the possibility in the future to work together with a specialised partner, possibly in the hedge fund space. The selection team focuses only on funds of funds, offering clients 25 different funds of hedge funds in its recommendation list.

Currently, Julius Baer does not offer advisory on single hedge funds. This is something a private bank should consider and is one of Mr Altwegg’s tasks over coming months. Sophisticated clients are interested in single manager hedge funds, and this is an area he would like to cover.

UBS: increasing third-party usage

The minimum amount of assets sub-advisers demand to accept a segregated mandate, generally estimated at $50m (€40m), is a barrier to entry to small private banking institutions in Europe. This is certainly not the case for UBS Wealth Management in Switzerland, which is able to appoint a variety of managers to run client’s assets through managed accounts.

These segregated mandates, each handled by a different manager, are combined and wrapped into a UBS white-labelled multi-manager product umbrella.

Selection of the managers is carried out centrally in Switzerland. Most of the managers that run segregated mandates also run off-the-shelf funds, which UBS private bankers can access from the bank’s recommended list.

The multi-manager funds are mainly in mainstream asset classes, where scale is sufficient to award a mandate. For exotic asset classes, there are fewer managers and funds would be preferred instead.

Increased access to third-party managers has been a fairly recent development within UBS, as historically the bank preferred to use in-house solutions, according to a source within the bank.

Although these multi-manager solutions are manufactured at the bank’s Zurich headquarters, and are potentially accessible to all UBS clients, they would need to satisfy certain conditions to be employed in different European jurisdictions.

For example, these multi-manager funds are not generally used in UK clients’ portfolios due to tax issues with offshore funds.

Because of its smaller size, UBS Wealth Management UK, estimated to run between $2bn and $3bn in total assets, does not appoint managers on a segregated basis, as the efficiency gains for the bank of trying to negotiate managed accounts are not so large as they are in Switzerland, although this is a solution the firm may eventually explore.

However, UBS’ high net worth individual clients get the same advantages offered by a segregated mandate – tailor made solutions and control on the liquidity terms – through buying bespoke funds built by UBS Asset Management. These funds generally sit in the core of portfolios.

They are not designed to be generally available to the public, and therefore remain restricted to discretionary solutions within UBS Wealth Management.

Matrix: Ucits funds in the pipeline

Matrix Group, a UK-based privately owned financial services business with L3.5bn (€2.9bn) under management, has launched a Ucits III multi-strategy credit fund in partnership with Lazard Asset Management, which will be running the mandate.

This new collaboration adds to two existing sub-advisory relationships. Winton Capital, the futures and hedge fund manager, was appointed in 2008 to run a managed futures fund. Earlier in 2010, Sudeep Singh, founding partner of Redux Research, and previously senior emerging market portfolio manager at hedge fund Caxton Associates, was awarded a mandate to run an emerging market hedge fund, the Matrix Redux hedge fund.

Matrix distributes predominantly to retail and small institutions in the UK, Channel Islands and Europe. “Winton and Lazard are very strong international renowned investments firms, and our distribution and structure is important to them,” says Luke Reeves, director at the firm. This also explains co-branding the recent fund with Lazard, which distributes through large funds of hedge funds or global banks.

“Matrix and Lazard felt it was good in order to be able to leverage off both our brands, from our distribution perspective,” he says.

This is different to the relationship with Redux, which is an independent company but sits in Matrix’s offices. “There are managers who are very strong, they need an infrastructure but they don’t necessarily want to be an employee, and we offer that flexibility, where they can leverage off our infrastructure, risk management and compliance,” says Mr Reeves.

The company also has the launch of more Ucits funds, and more sub-advisory mandates, possibly to hedge fund managers, in its product pipeline.

“We are seeing a big trend of hedge fund managers who are now reviewing or wanting to have Ucits structures around their Cayman fund. That is only likely to increase,” predicts Mr Reeves.

“But these managers need to make sure not only that they have got all the operations and infrastructure in place, but that they have diversification of distribution channels.”

Hedge fund strategies must also be conducive towards Ucits fund structures. In particular, they must be highly liquid, he says. Two of the new Ucits III funds are likely to be on a sub-advised model, while the other two are likely to be managed in-house. Matrix already manages a Ucits long-short Asian fund in-house.

Sub-advised assets:

Winton Capital: managed futures fund - Matrix Ascension fund – more than L100m in assets

Lazard Asset Management: Ucits III multi-strategy long-short credit fund - Matrix Lazard Opportunities fund ( just launched)

Redux; Emerging market hedge fund, more than L30m in assets (Matrix Redux hedge fund)

Barclays Wealth: blending for success

Achieving the correct mix of managers in portfolios is one of the key aspects of a multi-manager operation. “One of the things we look at very closely when blending managers is investment process diversification,” says Jaime Arguello, head of multi-manager and third-party funds at Barclays Wealth.

The full transparency offered by segregates mandates, which Barclays Wealth uses for its manager of managers platform, enables analysis of risk positions of the multi-manager fund in each asset class. This enables full control of portfolio construction, says Mr Arguello.

“By using different risk tools, we can analyse the overall exposure of the fund, and we really need to ensure the fund is not having a significant bias where we don’t want to have it,” he says.

“For example, if our view is that, at some point, large caps will outperform smalls caps, and the managers of a fund have a very strong bias to small caps, then we might just change the weight between the managers to correct that bias.”

Monitoring of the portfolios is then done on a continuous basis. The consistency of investment process, the management of liquidity, and transparency in communication are some of the factors that have gained more importance since the crisis when selecting managers.

“The speed with which the manager communicates any radical changes in his portfolio is very important,” he says. “Also now that volatility in the market is very high, we want to know quicker than before what the manager’s view is.”

Amongst asset classes of future interest, Mr Arguello points to emerging market debt in local currencies as a structural growing trend. In the past 12 months, Barclays Wealth has awarded mandates in global inflation bonds and the UK equity space. The mandates were not necessarily in new asset classes, but as they had different characteristics from the past it was necessary to appoint new managers replacing existing sub-advisers.

In general, the main reasons for replacing managers are linked to key personnel changes. “When the lead manager leaves, we need to act immediately,” says Mr Arguello. Underperformance is also a reason for termination, although generally the decision can take a bit longer, as it is the consistency of the investment process which is paramount, says Mr Arguello.

Barclays Wealth manager of manager platform: around L8bn

Number of managers used: 30

Total AUM worldwide: L153.5bn

SEB: filling in the knowledge gaps

SEB Wealth Management, the Nordic Fund house, is developing internal expertise in a number of core areas with a view to expanding its European and international distribution, which today is mainly focused in the Scandinavian countries. The firm is strenghtening and broadening its global equity offering, and it is setting up two teams to manage a quantitative strategy and an active stock picking strategy.

In the alternatives arena, and particularly in the hedge fund space, thanks to the acquisition in 2008 of London-based hedge fund provider Key Asset Management, which had been SEB’s sub-adviser for the past four years, the firm is further developing its expertise and launching its first Ucits III fund of hedge funds.

However, the house is not shy of working with external partners, with a belief that no company is good at managing all asset classes.

The institution has established sub-advisory relationships in a number of areas, and it typically has white-labelled the products, which are SEB funds.

”We do use external partners where we do not have in-house competence, typically in niche or regional markets, where we feel that it would be very difficult to maintain a team that could have credible ambitions in such geographies,” says Ralf Ferner, head of multi-management at the firm.

Covering costs

It is also important to decide whether the level of assets under management back the case for maintaining an in-house team. ”There is no point in running a fund that does not cover its costs. But outsourcing is a business that is less attractive commercially the bigger the assets under management are, unless it is a very specialised strategy, which you can’t develop yourself.

“If an off-the-shelf product is exactly what you are looking for, then there are good reasons to buy it. If you do not find what you are looking for, we will have to negotiate a segregated account. These are often used as building blocks for bigger portfolios,” he says. ”We will review our sub-advisory cases probably more frequently, our scrutinity for existing sub-advisers is probably higher now, whether that will result in more or less outsourcing I am not sure.”

Total Aum for SEB wealth Management: €126bn

Total AUM in segregated mandates: €5bn

Sub-advisers:

Asia ex Japan/ Asia ex Japan Small Caps - Schroders

Emerging Markets Equities - Schroders, Mondrian

Emerging Markets Bonds - Ashmore

European Value - AllianceBernstein

Japan - Goldman Sachs, DIAM

Japan Hybrid - DIAM

Latin America - Schroders

North America - Wellington, SGAM/TCW

North America Mid Caps - Turner Investment Partners

North America Small Caps - Pier Capital

Global High Yield - Muzinich

US High Yield - RiverSource

Global Value - AllianceBernstein

Global Equities Long/Short - ABS

Emerging Market Equities Long/Short – ABS

Lombard Odier: access to excellence

In addition to selecting external funds in an open architecture approach, the Geneva-based private bank Lombard Odier also employs sub-advisers in its manager of manager funds product and in a few single-managed funds.

“The key driver to sub-advisory is access to excellent asset managers,” says Laurent Auchlin, head of open architecture and external fund selection at Lombard Odier. And if these managers can provide exclusivity of distribution in Europe, that is an added bonus.

“We always try to find a good combination between internal and external managers, and exclusivity of distribution is important to us,” he says. The firm is currently in discussion with several “good managers” who do not distribute in Europe, with a view of sub-advising other products in the future.

“The main benefit of sub-advisory is that you build a partnership for the long term, it is not a selection for the short run or a market call,” he says.

Mysteries of the unexplained

The most usual reason for managers being replaced is a performance pattern which cannot be explained, rather than just poor performance. “If a value manager is performing well during a growth type of market, we have to understand why,” says Mr Auchlin. “If a value manager is performing in line with the value index but underperforming the market over the year, we will not penalise him, because we trust the way he is running the money.”

The bank applies the same criteria to select funds and sub-advisers, which are all sourced from the same masterlist. “We have very low fund and manager turnover, between 10 and 15 per cent a year,” he says.

“Fund management delegation is a company’s strength, because you combine the best of both worlds, and I think it will be a growing business,” explains Mr Auchlin.

“However there are two types of barriers to sub-advisory: you have to have enough wealth to invest and the minimum amounts of assets which enable you to award a mandate are fixed by the external managers,” he says. These are estimated to be between €25m and €50m on equity, and €100m for bonds.

“The other barrier is that you need to have competence in selection,” says Mr Auchlin. “You have to have a well equipped team, which is able to find good managers and keep in contact with them on a regular basis.”

AUM - (Lombard Odier Group) €99bn

Sub-advised assets:

Manager of Managers

World Gold Expertise:

Van Eck investments from NY (Joe Foster) US

Tocqueville Asset Management NY (John Hathaway)

Konwave Zuerich (W. Wehrli, R. Werthmüller, M. Gugerli)

Single Manager

Global Equities:

Pzena Investment Management, Inc., NY (value)

William Blair & Company, L.L.C., Chicago (growth)

US Growth Equities:

Baron Asset Management Capital, (R. Haase) NY

Japan Equities:

Alpha Japan Asset Advisors (Hidekazu Kishimoto), Tokyo

Standard Life: increasing distribution

The recent strategic alliance Standard Life Investments (SLI) – the UK based manager with L146bn under management (€178bn) – has entered with Japanese fund management Chuo Mitsui Asset Trust is a clear example of a how a sub-advisory arrangement can be motivated by purposes other than generating higher alpha or enhancing a firm’s product range.

“The relationship we have just announced with Chuo Mitsui is driven primarily by the desire to increase our distribution, rather than an investment based driver around getting better alpha. This arrangement with a partner opens the door into a new market place that we wouldn’t otherwise be able to get into,” says Colin Walkin, chief operating officer at Standard Life Investments.

Under the terms of the alliance, Chuo Mitsui will manage and sub-advise $1bn of SLI’s Japanese equity fund and SLI will sub-advise $1.2bn of Chuo Mitsui’s global equity funds.

“The straight exchange of sub-advisory mandates is financially pretty neutral for the companies, but the real trust of this relationship is reciprocal distribution. We will distribute their Japanese equity products to our clients and consultants with whom we have relationship in the UK and Europe, and they will distribute our global equity products to their clients in the Japanese market,” says Mr Walkin. “An important principle of the relationship is to make sure both sides feel it is worth their while to distribute the product, even if they are not manufacturing it, and similarly to manufacture it, if they are not distributing,” he says.

Standard Life Investments manages captive funds for its pension company Standard Life and also enjoys a sizeable third-party business – 65 per cent of the firm’s revenue is now generated from third-party activities.

The decision to sub-advise will have minimal impact on the small in-house team which has managed Japanese equities for a long time. The team will join the global equities team and there will be no redundancies.

Staff will also be travelling frequently to Tokyo to support sales efforts there, adds Mr Walkin. Two individuals from the Japanese firm will move to SLI’s Edinburgh headquarters to join the global equity team.

“This is the first time we have gone into a reciprocal distribution arrangement, and personally I hope it is not the last,” he says. “Like most fund managers, we have a strong domestic franchise but a smaller international one, which we are thinking to grow. Our business model is to seek to manufacture consistent alpha and we cover pretty well all asset classes.

“We would not normally seek to sub-advise, but we are constantly looking around the world for opportunities to increase our distribution. Chuo Mitsui people were simultaneously looking to gain distribution in the UK market and so we were able to come together with a mutual benefit,” he says.

That the companies have approximately the same size, similar cultural heritages, similar aspirations and even investment philosophy certainly helps, he says.

SEI: understanding excess returns

SEI has launched a range of multi-asset portfolios in the UK, with a view to distribute them mainly to independent financial advisers, which are being driven by regulation to outsource asset allocation and investment management and increasingly focus on advice, relationship management and financial planning, as well as to private banks.

Depending on their risk profile, each of the seven strategic portfolios is managed by up to 72 different asset managers on a segregated basis, invests in up to four asset classes – equity, fixed income, liquidity, and property – and up to 16 different sub-asset classes.

The top criterion to select and blend managers is to understand sources of alpha, or excess return, says Cedric Bucher, newly appointed director of client investment

strategy at SEI’s Global Wealth Services, the London-based subsidiary of US investment and technology firm SEI, who joined from Barclays Wealth. It is also important that each manager contributes equally to the relative risk of the fund and managers are monitored to ensure none of them dominates in terms of risk contribution over time. SEI has developed a proprietary methodology aimed at ensuring this.

“The third element about blending is that we tactically tilt away from those targets over time and through the economic cycle, so when we see that certain managers and certain alpha sources and styles are more beneficial in one economic market than another, we would tactically tilt the managers within the portfolio,” explains Mr Bucher.

“Currently it is quite a challenging environment for many managers and we would be slight overweight managers with a kind of quality growth and stock selection focus, so managers who look for companies with solid balance sheet and solid cash flows, in a bottom up fundamental approach. We will favour them currently over managers with a momentum approach.”

Total AUM: L98bn (€119.7bn)

Total AUM in segregated mandates: L98bn

As of December 2009, SEI’s manager turnover rate was 21.5 over a three year period

Recent manager changes in the Strategic Portfolios include:

Jupiter Asset Management replaced AXA Framlington Investment Management in the UK Equity Fund

Neuberger and Lazard were added in the Emerging Markets Equity Fund