Regulation impacts sub-advisory growth

Participants

1. Jaime Arguello
Head of multi-management, Barclays

2. Paolo Biamino
Head of fund selection, Euromobiliare Asset Management

3. Katia Coudray Cornu
Head of Syz Fund Research, Syz & Co

4. Lee Freeman-Shor
Portfolio manager, Old Mutual Global Investors

5. Nathan Gelber
CIO, Stamford Associates

6. Peter Preisler
Director of international investment services, Head of Emea, T. Rowe Price International

7. Gavin Ralston
Head of official institutions and global head of product, Schroders

8. Dirk-Jan Schuiten
Head (Netherlands), ABN Amro Advisors

Moderator: Elisa Trovato
Deputy editor, PWM

Elisa Trovato: Welcome to PWM’s tenth annual sub advisory roundtable. Gavin, do you feel regulation will be a major factor in driving sub-advisory growth?

Gavin Ralston: There is no doubt, from what we have seen already in the UK and are beginning to see in the Netherlands, that the regulatory changes, in particular the ban on retrocessions, are raising the proportion of assets which are managed on a sub-advisory basis relative to traditional branded funds. The driving force is that a lot of distributors are looking for ways to preserve the margin they have lost by no longer having access to rebates. There are different ways of doing that; charging an advisory fee is the most transparent way, but another is taking part of the asset management fee – the annual management charge – that would traditionally have gone entirely to the asset managers. There is a very strong commercial logic behind a growth in interest in sub-advisory.

It will be interesting to see how the providers of branded funds respond to that, because there is no doubt we are beginning to see more differentiation of pricing between higher alpha and lower alpha funds, and the asset managers who are manufacturing branded funds will undoubtedly want to make sure the branded funds remain competitive with the sub advisory alternative.

Elisa Trovato: Is there any evidence that the sub-advisory boom is finally about to happen? 

Peter Preisler: No, I do not see the evidence yet, but I agree with Gavin that people are starting to think about sub-advisory. It is a well-known fact that a number of funds overcharge on the operating and administration costs for their funds. A number of firms charge 20 basis points – and this is a revenue stream for asset management. If you insource those funds, that revenue, if you can maintain it, will go to the distributor instead.

The bigger sub-advisory opportunity lies on the continent, where the asset managers have proprietary distribution. There is a real gain where you have the whole chain in house. There are organisations who will offer only one fund per asset class to their entire network, which is sub-advised. The sub-advised agreement will be on institutional terms, which means distributors will benefit from the scale; they can take a higher margin, they can keep the operating and administration mark-up and can differentiate pricing among their clients, because they are then deciding what share class is selected.

Elisa Trovato: Are regulations forcing banks to reinvent the way they present investment solutions to clients in the Netherlands?

Dirk-Jan Schuiten: The jury is still out; the regulation is to be implemented on 1 January next year in the Netherlands. A lot of banks are looking into how to change their current models. As we introduce advisory fees, we see that clients will become much more critical of the advice received, and the product offering. One of the reasons we go down the sub-advisory route is because we feel we can offer the client more than through third party funds.

Sub-advisory opens up a larger universe of managers. One of the challenges we are seeing, being a big bank like ABN Amro, is that the volumes of assets going into third party funds are increasing. We are running into concentration risks with a lot of our funds, which is forcing us to look at the very big funds, which are not necessarily the best performers. Going down the sub-advisory route also offers a solution to this issue.

Transparency and more insightful reporting for our clients will give us that edge in introducing new concepts.

But I do not believe sub-advisory will be directly a source of extra margin, making up for the loss of rebates. The Dutch regulator has stated very clearly, and that is very much in parallel with RDR, that clients will have to be charged upfront a very transparent advisory fee. I would be very wary of introducing margins at the product level if you cannot offer any clear added value there.

Scale is going to be very important. We believe the sub-advisory route is an interesting one, because it allows us to use our asset base to negotiate lower fees for our clients.

Paolo Biamino: In Italy, the advisory business has developed in the last few years. Most of the companies provide it, but it has proven very difficult to charge clients; it is much easier to charge slightly higher management fees with the direct distribution of mutual funds. In Italy, regulatory issues are not there yet. I do believe the classical model of direct distribution of mutual funds and open architecture will still be leading for the foreseeable future, while sub-advisory will remain a niche business.

Elisa Trovato: Jaime, Barclays has $10bn (€7.5bn) assets in segregated mandates; do you think regulation is really having a significant impact on your decision to sub-advise?

Jaime Arguello: To some extent it is, but we had adopted the sub-advisory model some time ago. As a result, at the first stages of the new RDR implementation, we are seeing shifts from mutual third party funds into manager of manager funds. Broadly speaking, clients have responded positively to the additional transparency of fees as we aim to be very clear on the value our advice brings to clients.

Katia Coudray Cornu: Regulation has changed fund distribution in Switzerland; the retrocession business is over, but this has not affected our business model, as we have conducted sub-advisory for several years. The fund range we offer is targeted to be sold externally, and our philosophy is to pursue only active management, and niche strategies, where it is not possible to insource every capability.

Elisa Trovato: The wealth side of your group, Old Mutual Wealth, ex Skandia fund platform, recently launched a number of sub-advised funds targeting the restricted advised market base. Will fund platforms contribute to the growth of sub-advisory?

Lee Freeman-Shor: The asset management arm of the group, Old Mutual Global Investors, does some of the sub-advisory for Old Mutual Wealth, but they partnered with other asset managers as well to deliver funds they think are best in class, and they are able to deliver those fund solutions at a competitive price. These factors are going to be very attractive going forward in the UK, where advisers under RDR are going to have to go down the fee route; to be able to charge a fee, products should be very competitively priced.

The established large fund platforms that command a lot of assets and have long historic relationships with large investment houses should benefit from the new world.

The more assets you have, the better pricing agreements you can come to with asset management firms, which means the end product should theoretically be able to sell through the platform cheaper. Scale does matter.

Elisa Trovato: Sub-advisers have a desire for increased scale of mandates and distributors need customisation and innovation. How do you find common ground between these conflicting needs?

Gavin Ralston: It is a conflict that has existed in institutional mandates for years. It is helpful if the wealth manager awarding the mandate can be as transparent as possible as to their own growth expectations for the product, how much marketing spend will go behind it, what priority will be given to it. The more transparency there is in that initial discussion, the easier it is for the asset manager to form a judgement as to whether it is something they would like to pursue.

Gavin Ralston, Schroders

Elisa Trovato: How does the business model of your firm impact the manager selection process and the products you sub-advise to third-party managers?

Katia Coudray Cornu: First of all, we look for an asset class or a strategy where we have a long-term conviction. We look for a manager not particularly well-known in Europe, that does not have the same client base we have, and we work on a complementary basis with, which means they are bringing us capabilities we do not have in terms of asset management, and we are bringing them structuring and distribution capabilities they do not have.

For example, the high yield manager we are working with manages $30bn in assets, half of which are in high yield, is very well known in the US, but with no distribution network in Europe.

Effectively we are always working with exclusivity of distribution. We do not need an innovative product, but this approach forces us to be innovative and creative.

We started to in-source and offer hedge fund strategies, in the Ucits format, which are on demand. We often find very good hedge fund managers who are not really familiar with regulation and distribution of Ucits strategies, and we can support them in this.

Also it is important we share the same types of investment philosophy and have aligned size and expectations.

Dirk-Jan Schuiten: The difference in our business model is we are looking more for a building block to add to our portfolios, both on the discretionary and advisory side. That means we can also make a sub-advisory contract with the bigger asset managers in Europe.

We do not necessarily need to customise solutions and currently only the minority of the mandates we have given are customised.

Peter Preisler: We manage standard products on a sub-advisory basis too for some of our clients. Their interest is to gather a lot more volume in their own name so they can drive down price, and they can offer our capability to their client cheaper than we can by going direct, because they decide the pricing that reflects this volume.

Jaime Arguello: We are not initially building these funds to market them externally; we construct bespoke portfolios for our clients through either discretionary or advised services.

Manager-of-managers funds enable us to add value through our proprietary portfolio construction techniques.

Our bankers and investment advisers have two choices: off-the-shelf funds or manager-of-managers solutions. The latter gives greater transparency.

In principle, we do not exclude managers that distribute in Europe, but some managers are only institutional, they do not manage mutual funds, so the only way to get access to these managers is through a segregated mandate. One of the advantages is that these managers are not influenced by retail flows on a regular basis, so they might have a more stable and long-term perspective. A number of those managers, in which we have invested, are closed, because they reached capacity.

In general we give specific guidelines to the managers, but we make our mandates pure, unlike the average retail funds they might manage, or similar to the institutional mandates they manage. We do not tend to restrict the investment process of the manager too much. We let them implement their process – although there may be some small tweaks in terms of investing in off-index positions.

Peter Preisler: Most manager selection, in my experience, is done to identify the skill-set of a manager. The more you box the manager in a different direction from where his natural skill-set lies, the more you risk that the manager cannot express conviction. We run several sub-advisory mandates, and outside the ESG world, where it plays a role, we have not really come across someone who wanted to interfere with the mandate.

Nathan Gelber: When you consider the sub-advisory platforms with which we are involved, the managers selected are typically lesser-known names managing non-market like portfolios. What we are really interested in is the quality of  human capital within an investment firm, which has realistic potential to generate added value over time. It is difficult enough to identify and capture superior talent; if we start to constrain ourselves to those who have or do not have distribution, I do not believe we have a good chance of succeeding.

To us, brand recognition is irrelevant. Our sub-advisory clients established their own brands, construct a wrapper, and the managers’ portfolios are positioned within their own wrapper. The investors are essentially buying a distinct manager selection, monitoring and packaging process, primarily, and the managers, secondarily.

We notice, however, as we transport manager ideas from the institutional to the retail space, that there can be certain hurdles.

Retail investors tend to be absolute return orientated, while many of our institutional clients still adhere, particularly in the long-only space, to relative benchmark related mandates; to bring the two together can be a challenge.

To the extent we position long-only mandates on a retail platform, we are trying to ensure there is – to a degree – an absolute return orientation embedded in the investment proposition, although it is difficult to eliminate the impact of beta.

We found considerable interest in absolute return oriented strategies in the long/short space, whether it relates to equities long/short or fixed income long/short strategies and we observe strong demand for those, in particular as building blocks for multi-strategy portfolios.

Elisa Trovato: What types of asset classes are most suited to sub-advisory, core or niche?

Jaime Arguello: We prefer to sub-advise more established asset classes which we know will be in our strategic asset allocation over the longer term. We offer them as third party funds too, but obviously the end result of the manager of managers fund is quite different.

With more niche asset classes that could be a tactical or shorter-term allocation, we prefer to use either ETFs or third party funds. We wouldn’t structure a manager-of-managers fund for a very niche asset, because our asset allocation might not allocate too much to these asset classes.

Elisa Trovato: Is it important to award customised mandates?

Lee Freeman-Shor: It is, in the way we manage our portfolios.

The team I am in heavily uses customised mandates. If you are not doing the offering whereby you bring in a new manager to a different market, the other angle you can do with sub-advisory is to take an existing manager’s capabilities and offer something new and unique to the market in terms of a solution you create, which is what effectively we do.

For example, my portfolios are run by a team of managers at external asset management houses, and each manager just invests in 10 stocks.

One of the beauties of sub-advised mandates is that if you identify a manager that is an alpha generator, and you realise the majority of his alpha comes from just a handful of names, you do not have to buy his whole fund, 70 or 50 stocks; you can do what I do and just say, ‘How about I give you a mandate within my funds and you just invest in those 10 stocks, because what I want is just the alpha, I do not want the padding’.

If I look at the multi manager team I sit on, the bulk of our assets are in risk-weighted solutions, which is going to be a very big movement in the UK post RDR in the advisory channel. We are seeing a lot of demand in that space. The best ideas products are aimed at advisors that still bring portfolios together, and are interested in high alpha. The way we see the market going is that, if people do not go for solutions and they are building their own products, they will either go for cheap beta, or they will pay up, where you have got to have alpha.

Elisa Trovato: Does a sub-advisory relationship contribute to bring innovative solutions to end clients?

Paolo Biamino: Yes, sub-advisory was the path to innovation for us. First of all, we start with a specific investment idea, an investment solution that we want to bring to our distribution network and to our clients. Then we ask ourselves whether we are able to manage this specific solution internally or we need to find an external manager. At that stage, one of the important elements in deciding to assign the mandate is the willingness of the counterparty to be proactive with us, to collaborate on specifying the investment solutions.

Through all of our mandates we launched products not available within the standard product range of the third party asset manager, and in a few cases these were very innovative for them as well.

Katia Coudray Cornu, Banque Syz & Co

Katia Coudray Cornu: Where we can give several new mandates and where it is interesting to bring innovation through sub-advisory is in the absolute return space. As the longest and biggest fixed income bull market is coming to an end, the appetite for absolute return strategies – call them what you want, flexible, alternative, or non directional – is huge. It is quite difficult to have just internal capabilities and proven talents to manage these strategies.

To find a partner on the hedge fund side we have to be very selective and we need to be sure that flexible strategy is fully replicable in the Ucits format. Also it is important to find a hedge fund manager with a solid risk management infrastructure, able to sustain the management of a Ucits platform.

Gavin Ralston: From the manager’s perspective, if we have a great new idea for an investment strategy – and typically oportunitstic ideas will have linited capacity – it is in our interest to sell it at the highest possible price, which is almost always not sub-advisory. Unlike the smaller firms for whom using sub-advisory mandates is a great way to access the European market, we have our own distribution capability, and we will typically reserve new ideas for our own distribution throughout branded funds.

Our experience has certainly been that there is demand for absolute return, but it is much more often delivered through third party funds where we can create the maximum flexibility to use all the strategies, particularly very heavy derivative strategies, sometimes with leverage, which may not be palatable within a sub-advised mandate.

Elisa Trovato: Greater transparency is one of the key benefits of sub-advisory. How do you make the most of it?

Nathan Gelber: Transparency at portfolio level represents a critical requirement if one’s overall investment analysis is predicated on portfolio evidence. It is not only transparency on underlying investments and transactions, but also the costs and expenses the managers incur, the trading volume, all kinds of other considerations that enter the equation, which one is simply unable to see if you buy a fund.

In hedge funds we tried to obtain transparency and, frankly, are struggling with how to best use it, mainly due to the overwhelming amount of information available. Inevitably the question arising is ‘Can you see the wood for the trees?’.

Paolo Biamino: Transparency is an opportunity which you need to be able to exploit, but also a threat. When you have a pre-agreed set of guidelines, the portfolio manager should be able to manage as freely as possible in order to deliver the expected results, but what happens if he wants to buy a specific asset class, single credits or stocks, you are not confident with?

An example may be buying PIIGS sovereigns or credits at the end of 2011, beginning of 2012. You have a full visibility and transparency of the portfolio, regular conference calls, and you are free to tell them you do not feel confident with these positions, but at the very end you have an influence on their capability to manage the portfolio.

If the managers are finally proved right, you cannot blame them for not delivering the expected results. This is becoming a key issue we would probably have not thought about when we started, just because we are living in very uncertain times.

Lee Freeman-Shor: Transparency allows you to get better control of risks. When the credit crunch happened, when Bear Stearns and Lehmann’s went, it was ‘Which domino is next – Goldman Sachs, Morgan Stanley?’ Our team were able to look at the portfolios line by line, look at the exposure of the managers, and if we were concerned there was a potential risk, we were in a position to ring them up and get confidence ourselves in the counterparty risks, not just the sub-adviser we had appointed.

Elisa Trovato: How do clients and advisers perceive sub-advised funds? If private banks really establish strategic partnerships with a smaller number of selected asset managers, is that bad news for private clients? Does this mean closing the architecture?

Dirk-Jan Schuiten, ABN Amro

Dirk-Jan Schuiten: I do not think it means closing the architecture; it means focusing your product offering. Clearly, it depends a lot on your branding strategy, but sub-advisory could be perceived as a step back in open architecture in that you are offering your own vehicles again; even if you communicate it as open architecture and there is an external manager involved, clients sees more of the same name in their portfolios. That is a challenge you have to face when communicating with clients the benefits of sub-advisory. It is true there may be a higher concentration of counterparty risk, but my gut feeling would be it is not the issue clients are most worried about.

Elisa Trovato: Are there any key areas of negotiation or battlegrounds between managers and firms that sub-advise?

Nathan Gelber: Fees are one of them, but not the only one.

There is the wider area of transparency, beyond portfolio transparency. There is a huge effort to be undertaken to obtain a fairly solid appreciation on what makes a manager tick, how he is tied into the firm, and an ex-ante commitment towards an ‘early warning’ system, should there be any material changes in the manager’s own situation.

When news is favourable, managers typically divulge it as quickly as they can. However we are keen for managers to promptly disclose bad news as well.

Peter Preisler: From my experience the difficulties are often not between the sub-adviser and the asset manager; the difficulties are between the people in the organisation that sub-advises and the different distribution channels within that organisation, where there is not perfect alignment internally or sufficient communication with client facing managers.

Elisa Trovato: What is the key difference between selecting a sub-adviser and selecting a fund?

Paolo Biamino: The difference probably comes later, and that has to do with the fact that you have to make sure you are a key client to your sub-adviser. If I feel the potential size of the mandate is going to be relatively small, I may naturally exclude certain managers knowing their capacity or size.

Dirk-Jan Schuiten: Maybe through sub-advisory you can dive a bit more into the real alpha sources, because you are able to isolate them more easily, but the main difference is especially on the operational and legal side. This is where we bring our separate team to the table.

Peter Preisler: When a distributor is putting a fund out for someone else to manage, they are literally taking their own brand and putting it out there, and they need to do their homework in terms of finding the right manager. In my experience the risk management part of the due diligence is much deeper when selecting a sub-adviser than when selecting a fund.