Hunt for the perfect combination

As the polarisation between those creating investment products and those selling them to the final client solidifies, both parties are searching for the ideal distribution system. The Holy Grail is a streamlined product range and a perfectly honed network linking distributors and manufacturers. Consolidation among fund providers looks likely to result, while banks and insurance companies will merge and cooperate increasingly. And it will be the banks that end up dominating the business of selling funds to the final investor. The future of distribution will be a key issue at the forthcoming Fund Forum conference in Monaco in July.

Insurance companies and major banks are both separating themselves from asset management as they focus on the distribution of products rather than the manufacturing. Witness Spain’s Banco Santander outsourcing most of its asset management capabilities and the decision of its UK banking subsidiary, Abbey, to move all asset management out of house.

The change is being driven by a number of factors. Investors are demanding high performing products, but the market remains tough to beat. They also want specialist fund managers with expertise in particular fields.

Another issue is the increasingly onerous demands regulators are making of those who manufacture investment products.

“Distributors need more products than those being manufactured by their own factories,” says Willem van Someren Gréve, executive senior vice president of Robeco Asset Management. “At first the factories complained but gradually they are accepting it.”

Distributing systems

Looking ahead, banks, shorn of their asset management divisions, will have to find the best systems to distribute products to individual investors in Europe.

Mr van Someren Gréve believes that in five years’ time, banks throughout Europe will have an average market share of 70 to 80 per cent.

Compared to banks, “most independent financial advisers (IFAs) are not very good because they are too focused on distribution margins”, says a belligerent Mr van Someren Gréve. “The bank knows best what an investor can afford. A financial adviser just wants to make a quick product sale because he or she gets paid on a one-off fee basis. The bank makes its money from a customer over the period of a lifetime”.

If he’s right, this will impact hardest in the UK, where the market is dominated by IFAs. “The UK is going to follow the example set by the Continent. Banks, which are better at client retention and financial knowledge, will take over from IFAs. The same has already happened in the US, where the good networks of IFAs have been acquired by the banks.”

In Germany and the Netherlands, Mr van Someren Gréve predicts that IFAs will actually gain market share, although banks will still do significantly more business. “Where banks over-dominate they will lose a bit of market share. Banks cannot make seven million people happy all at one time, so there will always be some customers who go elsewhere, thinking that the grass will be greener, only to find out that it is not after all.”

At the same time, he says, banks will move closer to insurance companies as their distribution channels are merged. “We will see more bancassurance in the future. Why is there a need to have someone different for your investments, mortgage, life assurance and house insurance? They are so closely linked, why should customer go through three different distribution channels?”

It will not necessarily mean corporate mergers, but undoubtedly it will mean bringing together distribution channels. The trend is already taking hold, as shown by Dutch financial services giant Eureko in April. Eureko has merged Interpolis, the insurance operation of its subsidiary Rabobank, with another insurance subsidiary, Achmea.

Gijsbert Swalef, Eureko’s chairman, explains: “Interpolis provides an important complementary distribution channel for Achmea via the local Rabobanks. The Interpolis brand also fits well with the power brand strategy of Achmea.”

A place for manufacturers

So where does this leave product manufacturers? Massimo Tosato, global head of distribution at Schroders, has strong ideas on what the best distribution networks for fund managers should look like. For a wholesaler like Schroders, he believes in selling both branded and white-labeled products through distribution channels, but never selling products direct to the client.

“We are about managing money, not distributing funds to the man in the street. In order to sell to the retail market we would need a salesforce of thousands, different brand positioning and a whole new culture.”

The Schroders approach is to work through two distribution networks:

• First, the wholesale approach, where the counterparty is a private bank, insurer or fund of funds with an institutional approach to selecting funds.

• Second, the retail third party distribution, where a bank offers its customers access to a Schroders product but without advising on that product or conferring preferred provider status on it.

The third possible route would be to market funds directly to retail investors. Although this is shunned by Schroders, asset managers such as Fidelity Investments see this as a valid model. Once a product provider has constructed its distribution network, it needs to ensure it is manufacturing the right products. Mr Tosato advocates an “all-weather product mix”.

“You need to build a set of funds that is able to answer the needs of different customer bases in different countries,” says Mr Tosato. “We began from scratch in 1999/2000 by identifying which markets were most interesting for us. We settled on the UK, Italy, Germany, Switzerland and France, in that order. We also decided to target Asia.”

The next step was to carry out detailed market analysis in these regions in order establish which products sold best and what distribution channels were in place.

Mr Tosato then built a suite of products to fit the risk-return profiles identified by the research. “We chose to be in the middle of the total expense ratio range – not more expensive than others, but not too cheap either. The market is more sensitive to performance than fees. Also, you need a certain amount of money to invest in staff if you want to hire and keep quality people, and at the end of the day you rely on the talent of individuals.”

A further step towards building an optimal distribution system is to streamline operations. This bring benefits of scale and avoids duplication, saving money for both the fund provider and customers. Schroders has centralised all administration in two centres – the UK and Luxembourg.

The UK back office has been outsourced to State Street subsidiary IFDS. Although the Luxembourg branch is run internally, it has to be asked for how long it will remain in-house. Fund management has also been centralised in the financial centres of London, New York, Singapore and Tokyo.

Product delivery, however, must remain local, says Mr Tosato. “In the mutual funds business being local is a key competitive advantage. In sales, marketing and client services, it helps if you speak the language, understand the culture, know the local regulations and are generally interconnected with the financial community.”

But Schroders still has work to do on its distribution network. Currently, 25 per cent of the firm’s assets come from the retail market, through private banks, fund of funds and insurers, with the majority coming from institutions such as pension funds.

Mr Tosato is working to shift the balance between retail and institutional from 25-75 to 50-50 in two to three years. The retail assets represent half of the group’s asset management revenue, but not half of the profits. They are high maintenance, with high marketing and operational costs.

But Mr Tosato believes that the retail segment is highly valuable nonetheless because its investors stay invested for longer periods. The average retail investment lasts between four and nine years, while an institutional investment tends to last just two years. The move may also be driven by Schroders’ less than perfect reputation with its core client base of institutions. As a specialist in growth equities the firm’s performance took a battering during the bear market.

Product build-up

Mr Tosato plans to build the retail segment of the business by bringing out new retail-focused products, beginning with the launch of four funds in autumn offering access to European, euro-denominated, global and UK equities.

Jamie Hammond, sales and marketing director, Northern Europe, Franklin Templeton Investments, agrees that new types of products will be needed in future. “In the next five years across Europe, we will see pension reform and changing demographics. People used to retire at 65 with a life expectancy of 15 years. Now people are retiring earlier with 25-year life expectancies. It’s all driving new product development, including funds designed for defined contribution pension schemes and lifestyle funds, which change as the investor gets older, investing in less risky instruments.”

Mr Hammond adds that investors also want absolute return products. “I’m not talking about hedge funds, I’m talking about products that deliver good returns as opposed to relative returns, which are considered good as long as they are beating the index by a couple of points, even if the index is delivering deeply negative performance.” He anticipates more unconstrained products, particularly multi asset funds, which can switch in and out different asset classes in order to be in the best markets at the right times.

Systems under construction

In line with the development of new products, not only Schroders, but the industry as a whole will have to restructure distribution systems in the next few years, according to Mr Hammond.

“The move to open architecture has been talked about for a long time but it’s actually starting to happen now. And it’s evolving into not fully open architecture but what might be called guided architecture.”

Guided architecture, according to Mr Hammond, is where the distributor, “rather than trying to cope with the administrative challenge of offering the complete universe of funds, chooses select partners to supply funds.”

We are also seeing a growing number of banks offering access to third party products through a fund of funds model. The fund of funds is presented to the client as a model portfolio to match their investment requirements.

In order to make these new methods of distribution work, the right technology is needed. “Electronic trading will be more of a requirement. Already being automated is coming up as a criterion for being selected by a partner. We are looking for more automation all the time. As much as possible with trade through EMX in the UK and similar platforms in Europe,” says Mr Hammond.

He cites the growing use of fund supermarket platforms. While IFAs have been using systems such as Cofunds and Fidelity Funds Network for several years, private banks are now looking at these platforms too.

Those fund managers who can’t keep up in the increasingly competitive environment will be swallowed up in a spate of consolidation, according to Mr Hammond. “As asset managers we are starting to see segmentation between big global cross-border groups and small specialists which are extremely good at certain asset classes. The mid-sized players in-between are being squeezed.”

In order to survive, these medium-sized fund houses will have to scrutinise their business models, decide where their strengths lie and move towards becoming either a small specialist or a larger group. Larger groups will have to work particularly hard to offer a range of products sufficiently diverse to keep distributors interested. Many may find that like the banks they have to draft in funds from third parties.

Mr Hammond confesses: “It’s getting tougher and more competitive for asset managers.” This seems to go for the fund distributors at the opposite pole as well. Both parties need to look at their range of investment products and their relationships with other institutions if they are to find their way to distribution systems that will last.