Banks join the quest for outside knowledge

Sub-advisory roundtable, June 2009, London, UK. Participants:

• Mario Bortoli, Head of Multi-Manager, Fideuram Investimenti
• Cedric Bucher, Director Investment & Product Office, Barclays Wealth
• Nick Phillips, Head of third-party distribution Emea, Goldman Sachs Asset Management
• Frank Schäfer, Head Sub-advisory Asset Management, Clariden Leu
• Furio Pietribiasi, Managing Director, Mediolanum Asset Management
• Lars Eigen Möller, Head of Asset Management, Danske Capital
• David McFadzean, Head of Manager Research, RBC International Wealth Management

Panel moderator: Elisa Trovato, deputy editor, Professional Wealth Management

Elisa Trovato: Welcome to PWM’s sixth annual sub‑advisory round table. The aim today is to discuss, in particular, drivers to outsourcing the management of assets, the impact of the financial crisis on manager selection and asset classes sub-advised, and new areas of opportunity.

Search for external managers

Elisa Trovato: What drives your decision to use external sub-advisers versus developing internal expertise or buying third-party funds? And what are the benefits of sub-advisory?

Lars Eigen Möller: In 2003 we realised we had spread out into too many types of assets and too many strategies. We aim to be global competitors in our core areas of expertise and it did not make sense to try to be all things to all people. We started to focus on European assets and to look for external managers on those areas where we did not feel we had expertise; we applied more discipline in our product creation process.

Of course, it hurts to stop producing products in areas where you have good performance. For example, taking the decision of not wanting to manage emerging market equities out of Europe made some people unhappy. It takes a lot of explanation in the organisation and changes to adapt to the new order. Most of the resources were reallocated within the organisation and some of them went to strengthen specific areas.

Mario Bortoli: Fideuram Investimenti started sub-advising some years ago in the absolute return or flexible space where we think we do not currently have the right expertise. Our mandates have been described as 130/30 but they are more flexible than that, depending on market opportunity. Most of the assets we have in multi‑manager products also have absolute return targets, with different risk-return profiles.

I am quite optimistic about absolute return products for the next 12 to 18 months. We may see poor quality assets in some funds and negative returns in the future. But overall we expect to be in an environment where hard work, ie analysis and appropriate portfolio construction, pays off.

Cedric Bucher: One benefit of sub-advisory mandates is the ability to define the investment mandate. One can clearly specify the benchmark, alpha targets, tracking error and relevant constraints within a mandate, which allows you to have a very clean asset allocation at the overall portfolio level.

Many active managers, particularly in equities, often generate some of the alpha by going outside their core asset class. That might be a good thing on a single asset class level, but if you construct a portfolio across multiple asset classes, the preference would be for clearly defined mandates to avoid allocation biases. Sub-advisory also gives you the flexibility to create innovative, unique products that otherwise you could not do.

A further benefit of multi managing is that you are accessing institutional managers at institutional rates. So at the total expense ratio level you are competitive. However, it is quicker to select and promote an existing third party fund as opposed to creating a new fund and having it approved by the regulators, which is important when playing tactical investment ideas.

Furio Pietribias: We tend to sub-advise where primarily we do not have the necessary expertise to provide the best product to our clients. In the market many retail clients suffered from very bad advice and they are becoming very selective on what they are buying and who is advising them. Sub-advisory, or buying somebody else’s asset management, for some institutions is an opportunity to reinstate their credibility and trust with their client. It also allows you to mix products together and to give clients a service for which you are paid.

We are managing in house products where the outsourcing would be over priced and with little added value. We recently started running in-house some money market and short term euro fixed income portfolios. We wanted to have more transparency and control on the investments. Generally we always look outside to see what external players can offer to give the best available to our clients.

Elisa Trovato: Is there risk of cannibalisation where sales of sub-delegated funds replace in‑house funds?

David McFadzean: Well above 95 per cent of the new assets that come in to our discretionary business are in our manager of manager programme. Our starting point is: what is the best product for our client? We too manage in‑house primarily high‑grade fixed‑income and money‑market and we use RBC Asset Management for Canadian equities and for assets like natural resources for example but in the majority of cases we found that going outside the bank is the best place to go.

Also, a large number of our clients are actually trusts and there is a kind of expectation from a trustee that you should go outside the organisation to source products, because there is a perception that there could be a conflict of interest if you use in‑house products. RBC is a several hundred billion dollar asset management business and they have numerous distribution channels, not just their internal wealth management business. Around the edges yes of course, there could be cannibalisation, but from a P&L perspective it is pretty much a wash in terms of whether you manufacture or distribute.

Impact of the crisis

Elisa Trovato: Frank, have drivers to sub‑advise evolved during the past couple of years?

Frank Schäfer: I think the drivers are more or less the same but their relative importance has changed. It is always about investment performance and credibility. It is about costs, and pricing of capabilities; so do we really have the skills in house to actually manage a certain asset class and do we see the potential to maybe allocate or buy the resources to manage a new capability, or shall we go with an external partner to do so? It is about the innovation cycle and the ambition of further diversification of the product range within asset management companies.

Two or three years ago everyone was talking about more sophisticated strategies. Today, investors are looking to buy easy to understand products. This is not only about fixed income or money market, but also about thematic investments in equity space, which are very tangible. The pace of the product development has slowed down a bit during the crisis. Some asset managers were very aggressive in building or further diversifying their product range.

Now with the asset levels coming down due to the crisis, many are sitting on their high cost base; this could be an opportunity for sub-advisers to step in. What is also helping the sub-advisory market is that more and more investors are implementing a core-satellite strategy, and are looking for higher alpha opportunities on the satellite investments, which are the typical ground for the sub-advisory business.

Elisa Trovato: Has the crisis made available some managers that were not accessible before?

Mario Bortoli: Definitely in the past it was more difficult to hold conversations with firms that were happy of their assets size or in the case of hedge fund space, were closed. Now we are seeing people very much interested not just in raising money, but also in having a more diversified investor base. Asset managers thought they had a very stable investor base, with the foundations and endowments in the US. Had they had more European exposure, also in the retail space, their client base would have not been so affected last year. They are more open to different solutions than they were in the past.

Furio Pietribiasi: I think they can become more accessible. Asset managers look for “sticky money”, which typically comes in from direct retail distribution. In some cases it could also be institutional investments where there are commercial and branding factors, which strengthen the relationship with the asset manager. Therefore on that basis, they are keener to negotiate for their fee structure.

In reality the managers too, who were acting a little bit like prima donnas before and are still performing well, are willing to consider fee negotiations for commercial reasons to cope with the assets volatility generated by net inflows turnover. The crisis has emphasised the gap between top quality asset managers and the rest of the pack.

Nick Phillips: Our experience is that companies who outsource are looking for high quality, reliable managers that offer them good value for money. They are looking to strengthen their own business by building lasting relationships with partners who can enhance their brand and help them win market share.

Elisa Trovato: Market downturn has had a major impact on funds assets; is there a minimum size for a mandate?

David McFadzean: The minimum size tends to be driven by the provider of the investment service in the sub‑advisory business, and I think there are two main strands to that. One, is it commercially viable for them, but hopefully more importantly, is the mandate big enough to actually properly invest? So if it is an asset class, like money market funds, for example, you need a sizeable AUM to run an efficient money market fund. In that case, if the assets either fell below or initially were below a certain level, then maybe that kind of relationship would not work. It is not something that has effected us directly yet, and partially that is because we try and limit the number of sub‑advisors that we use, and we have quite sizeable relationships which helps obviously in that regard.

Elisa Trovato: Do you think this environment is an opportunity to build products to fill more niches or an opportunity to rationalise your range of products?

Lars Eigen Möller: I believe it is about having a simpler and transparent range of products that is easy for the client to understand. We will have probably less products and we will have a more disciplined approach to distribution. For the majority of our clients we will offer simple solutions that are easy to sell. Advanced types of products will be designed for a low number of clients. Many products require a lot of dialogue with the clients; there is more than the pure performance data behind product recommendation.

Elisa Trovato: About 18 months ago it was all about financial engineering, leverage, quantitative models; now it is about transparency, simplicity, flexibility, value. How has this change affected the way you operate and select sub-advisers?

Frank Schäfer: We are looking for client‑centric investment‑driven companies that have the agility of a boutique. Reporting and being able to communicate in a transparent way on the positions held and the impact of those positions on performance is very important, especially in difficult times. We expect our managers to stick to their strategy. We do not want to see any style drifts and that was one very big danger in these times; we saw many managers positioning the portfolio much more defensive, at the bottom of the market, and now they are missing the whole upside in 2009. We want our managers to add alpha in a very specific niche capability. Performance attribution in terms of a risk‑management tool will be more and more important going forward; in many cases, what was sold as being

alpha was just a liquidity premium. I think having a strong partnership with a sub‑adviser is also a marketing instrument for Clariden Leu, we like to have joint road-shows for example. We prefer exclusivity of distribution; this is an important feature for us.

Cedric Bucher: We continue to follow a very rigorous investment process. Our fund or sub-adviser selection process continues to focus on investment philosophy, people, processes and performance. On all of these factors we want transparency and clear visibility from the manager. Over the last few years we had to pay more attention to the stability of the organisation. A few managers have lost a lot of assets and had senior management turnover.

Nick Phillips: Long-only managers are now employing the rigorous operational due diligence techniques that have long been established when researching hedge funds. It is no longer enough to just ask about the investment philosophy and some risk management, now it is important to understand and feel confident in the strength of the operations which stand behind the portfolio management teams such as risk management systems and trading techniques.

Mario Bortoli: When you employ sub‑advisers, you have the advantage of knowing exactly what is going on in the portfolio, but what do you do with that? Do you check that the sub‑adviser does what he is supposed to do? If that is the case, then you have got to have risk managers that have a very good understanding of the asset classes that are being managed on your behalf. That is why we have chosen to sub‑advise to managers that have skills that we do not have, but in asset classes that we understand. They are very active, they do what they are supposed to do, but we can monitor what they are doing. You cannot outsource everything; we have to keep responsibility for our clients.

Lars Eigen Möller: We are more concerned about stability and we focus more on companies’ financial figures and monitor any changes in the organisation that might indicate a change in their strategy. Sub-advisers are replaced if they do not meet our expectations, if there are any major changes in the team, performance, risk management or investment style.

We are very much looking into how they have generated the performance, and the more fragile it looks, then the more difficult it seems that they can repeat it in the future. We believe what has worked in the past is also an indication that it will work in the future. In general, we are concerned if only one manager is responsible for the performance but regardless whether it is a small team or star manager that drives performance, we have to believe that stability will continue.

Furio Pietribiasi: After this crisis the risk is that the industry tends to over research, or to over do in their due diligence; that is excluding some very good managers that can generate significant alpha. Because of the bad example of very few Ucits funds exposed to the Madoff scandal, now many are concentrating on utmost operations due diligence more than on the investment management process itself.

That is constraining the decision and sometimes drives the decision to pick the big players, which have big platforms and big client support and which they tend to work on very structured and constrained frameworks and operating models. I hope that this is going to be just a temporary trend because we will be just levelling and averaging the returns for the final clients. I think that we should apply the key selection criteria. I think that we should go back to the fundamentals.

Mario Bortoli: It also depends on how much control you have on the final diversification of the fund. There is always the risk that if your sub-advised fund is distributed to the end client, the financial advisor does not do his job properly and has a very big concentration on that fund. If something wrong happens to that fund, the customer is badly affected. We probably should be more careful with products that are distributed directly to the end investors; you can be happy with a little bit less of alpha, but with a lot of stability and controls. If the fund is included in a fund of funds that we manage ourselves, then it is quicker to get out. It is possible that the end client does not even know he holds that fund.

Elisa Trovato: David, why are looking to bring back in-house funds of hedge funds?

David McFadzean: I would say we are just changing the mix a little bit; fund of hedge funds is one area where we do make more use of third party funds, but we do have a fund of hedge funds that we manage in house and it is sub‑advised. As Mario said, we get a great deal of transparency, but then we have to have a team of people that does something with that transparency. So we have people that will actually accompany that sub‑advisor to their visits to the underlying hedge fund managers, so it is very much a partnership relationship.

That is the reason we are doing it, it actually just gives us more control on things like liquidity, if there is a gate. One of the benefits we have been able to show our clients is that we have not imposed gates over the last 18 months because we have been able to control the fund structure.

Elisa Trovato: Do you think that Ucits III products perhaps will eventually substitute hedge funds?

Frank Schäfer: We believe that the lines between long-only and alternatives are increasingly blurring. We see long-only managers, using the framework of Ucits III, implementing derivative overlays, long short strategies. This is clearly typical hedge fund territory. On the other hand, we see hedge fund managers looking for new sources of money. They are more willing now to accept restrictions, and to offer certain strategies in long-only format for example.

In a couple of years it might ultimately result in the complete abolishment of this increasingly artificial separation. We already see many sophisticated institutional investors who have beta and alpha teams, and they do not differentiate within the alpha bucket, whether it is a traditional or a so called alternative strategy.

Nick Phillips: There are some strategies, such as tactical trading, macro, equity long-short, where you can put hedge funds into Ucits III format, but there are some others where because of liquidity constraints, that is not possible. If you are going to put a hedge fund into a Ucits III format and you are going to sell it into the retail marketplace, it has to be understandable. If it is too complicated, then it is not going to be successful.

On the flip side, we have seen funds of hedge funds, who would like to buy equity long short in a Ucits III format because it is easier than buying a hedge fund, because it is more regulated, more transparent and it is more liquid. In our view, there is going to continue to be, strong demand for hedge funds from institutions and high net worth individuals. At the same time, in the Ucits III format, there are going to be certain strategies that do translate and will apply to both retail and to the hedge fund of fund market. We continue to see bursts of innovation as institutional techniques are made available to a broader audience through funds.

Elisa Trovato: It is all well and good to discuss products, but how do we convince investors of the inefficiency of an entirely risk-free allocation?

Cedric Bucher: With current interest rate levels, I think there is a strong case for having exposure to markets. The performance of passive and actively managed portfolios over the past few months speaks for themselves. Also, we have looked at some long term performance and if you miss the best fifteen to thirty days over a long investment cycle, your average annual performance does drop significantly. Not being in the market on some of the critical days can impact your long term performance and could reduce it by 30-50 per cent. So, it is important to be in the markets and not try to time the markets if you are targeting long-term returns.

Elisa Trovato: Are there new areas that offer opportunities in sub-advisory?

Cedric Bucher: We have always had a fully diversified range of funds. We have an in house range which focuses on European Equities, money markets and fixed income, but then in terms of multi management we cover most asset classes globally, and we will continue to do so.

The market environment has opened up some strategies that were previously closed, so it is certainly a good opportunity to review some of the mandates and get some very exciting strategies into multi-management. For instance, we just added some new managers into our emerging markets mandates. Also, for active managers in corporate bonds it has been a very good year. Going forward, with increasing inflation expectations, new opportunities to develop interesting fixed income products arise.

Future outlook for sub-advisory

Elisa Trovato: What are the barriers to sub-advisory and what is your outlook for the future?

Nick Phillips: I think sub-advisory, seen as both manager of managers and single fund management delegation, is still a growing trend. It depends on the business model of the asset manager or the private bank and what they feel is right for their business and their client proposition. We have definitely seen this year, and I expect it to continue, a rise in the opportunities on the alternatives side, moving from traditional assets to blended Ucits III assets, as well as a rise in fund of hedge fund demand, on the back of what has happened over the last 12 months.

Where we have had an equity mandate in a particular asset class or country, one trend that we have seen this year is increasing demand to do currency hedging because of the volatility of the currency market, which on the equity side, we had never really seen before.

Lars Eigen Möller: In terms of barriers, we cover small markets and finding a sub-supplier has been a challenge in some areas. I look forward to Ucits IV, to see whether that will make access to managers easier. On the distribution side, I can see there has been a little bit of a shift from distributing existing funds, which was the preferred option a year ago because of marketing visibility, to distributing sub-advised products, because of transparency.

David McFadzean: In the recent events, where we are talking to our clients more than ever because they are more anxious about things, sub‑advisory is a good solution because you have a much closer relationship with the investment manager.

Mario Bortoli: Sub-advisory is part of our long-term strategy and we shape an individual sub-advised fund into the format we like, so it is not really a clone of somebody else’s strategy. We may also change the mandate a little bit, if we believe that the strategy has lost some commercial appeal. We really try to take into account what the requirements of our clients are in terms of risk return, volatility or draw-down potential.

Cedric Bucher: I think the transparency argument, as you have a direct view of all the holdings at any point in time, is certainly favouring in house and sub advisory products over third party products, in the current environment in particular. For multi-managers the added value is the blending particularly in the equity space. Sub-advisory has been growing for years now. I think it will continue to do so, but I think it is not the one and only solution. That is why we are offering a broad choice of products to our clients, which includes active and passively managed funds, but it also includes structured products, absolute return products and innovative cash solutions. I think it is really one solution amongst others.

Furio Pietribiasi: I see that there are three types of sub advisory, as single fund management delegation, in the market. A firm may use the sub-advised product as a component of its own strategy within a certain fund, like in some cases Mediolanum does. We define the commercial characteristics of the product to make it suitable to our retail clients and we make sure that the investment strategy is consistent with it. This is going to grow.

The second type opens up retail distribution channels setting up a dedicated fund to small players offering exclusivity. The third one, which I believe has not been that successful, is when institutional distributors, to broaden their fund range, sub-delegate to managers, which could be directly accessible by any big institutional investor.

With multi-management, even in the institutional world there is a reason to have an intermediary, because you are blending together the managers. But in single fund management, does it make sense that a product is a pure and simple clone of an existing fund, which sometimes performs even better than the sub-advised fund?

Sub advisory is valid when it does not become just a vehicle to generate more fee crunching and more confusion in the market. If wrappers that include the sub-advised product are mis-sold to retail clients, even the reputation of big investment house can be at risk.