Sizing up the benefits

As we reach the halfway stage in the first decade of the 21st century, open architecture (OA) – where banks sell a variety of externally manufactured products, in addition to their own funds, to clients who cannot be fully serviced in-house – is being increasingly accepted in Europe.

“Open architecture is being sold as the most efficient distribution model, because it offers economies of scale,” said Sebastian Dovey, partner at Scorpio Partnership, in his chairman’s introduction to the second FT OA Forum held at the end of 2004.

“Profitability has soared as a result of this model. But what are the banks going to do with the savings? Manufacturers are complaining about distributors not re-investing the capital saved in the short term in the quality of distribution.”

There are two connected factors highlighted here by Mr Dovey, which laid the foundations for the day’s debate between our panel of Europe’s major distributors and the 200 delegates who travelled to London from all over Europe to participate:

• What is the nature of the most efficient partnership in terms of profitability for both distributor and manufacturer?

• And when we measure the level of “openness” of the architecture, what is the ideal mix of internal and third-party products in terms of profitability?

During the discussion, some indication of the perfect mix began to emerge.

Institutions choosing to sell external products must weigh up the manufacturing revenue they will lose, against revenue from trailer fees generated by external funds, while factoring in changing sales and manufacturing costs, said Mike Harding, managing director of consultants Mercer Oliver Wyman.

“Very few banks go through the systematic analysis of which funds to outsource and how, let alone who we should outsource them to,” said Mr Harding. “We should be very careful how much revenue we are giving away on the manufacturing side, particularly if customers are not really asking for a wider selection.”

Mercer recommends an optimal profitability mix for banks of two-thirds proprietary and one-third “guest” products. “We say you shouldn’t be fully open and you need to restrict your fund range, acting as a delicatessen rather than a supermarket, and offering guidance to customers around the shelves,” Mr Harding added.

Limited partnerships

This restricted distribution model was adopted in 2003 by Deutsche Bank in Germany, where it is known as “guided” architecture.

Deutsche signed agreements with eight “preferred partners”, Alliance Capital, Fidelity, Franklin Templeton, Invesco, Merrill Lynch, Morgan Stanley, Schroders and UBS, in addition to offering products from its in-house provider DWS.

“We have 13,000 staff and 13m customers across Europe, therefore we have to limit the complexity in order to position ourselves as best adviser,” said Dominic Blum, head of product management for Deutsche’s Private & Business Clients division. The programme has since been rolled out through the bank’s branches in Italy, Spain and Belgium. Poland may be next on the agenda.

The relationship between Deutsche and its manufacturers is based on reciprocity and innovation, said Mr Blum. “We invite partners to share views, to sit frequently and talk about market trends and to listen to the house view of the chief investment officer”, in order to develop products.

‘Open architecture is an inevitable outcome since fund markets have become more segmented’

Mark Raynaud, BNP Paribas

Although the bank describes the move as irreversible, and that there is no danger of returning to the “closed shop,” Mr Blum was cagey about profitability. “Increasing margins is a very tight job, so we concentrate on asset growth. We are looking for performance for the producer and net inflows for the distributor. That’s the strategic partnership on our terms.”

But being only partially open to external funds presents the best potential for new revenues, he believes. “We decided not to fully open up and implemented guided architecture, so we can give the customer guidance through the jungle.”

For Marc Raynaud, global head of mutual funds business development at BNP Paribas, the consolidation of OA across the industry is a direct result of the increased sophistication in investors’ portfolios and the specialisation of the market.

“I think open architecture is an inevitable outcome since fund markets have become more segmented,” he said. He explained how investors now take into account different management styles – growth or value-, and also look at different sizes – small, medium, large caps. “As a result management companies have become more specialised, focusing on a geographical zone, asset class or management style.”

Loyalty procurement

Mentioning research indicating that two-thirds of investors would like to have access to a wider range of mutual funds and that around 79 per cent of high net worth individuals have several mutual funds from different asset management companies, Mr Raynaud noted that OA represents a great way to develop client loyalty, as well as it helps to enhance brand image by giving clients access to the best managers.

For Mr Raynaud the growth potential of third-party distribution in Europe is very attractive, and has been for some time. As an example, he explained BNP PAM’s experience in Italy where it has more than €5bn under management. “In 1996 BNP PAM had only five distributors, and today there are 350 active.”

The company, that now manages €13bn in third-party assets, is getting prepared for further development of OA in Europe by merging its multi-management teams under a centralised structure, CFM, and expects to see its third-party assets grow to €25bn in five years.

Being at the centre of third-party distribution in Spain and having a growing presence in the Italian market, Juan Alcaraz, CEO of Allfunds Bank, is a firm believer in banks opening up doors to third-party providers. Mr Alcaraz used Santander, Spain’s largest asset manager that has recently outsourced the management of US and Asian equities, as an example to illustrate how large firms are going third-party in those areas where their in-house capabilities are limited. “They want to concentrate on what they are good at and now they know it was a good decision and they are happy about it,” he explained. “When you want to compete in areas where you don’t have the expertise the only solution is outsourcing.”

Foot dragging

Despite this fact, Mr Alcaraz pointed out that not everyone is embracing OA, and found it surprising that many small banks, that in theory do not have the resources to manage everything internally, are sometimes more reluctant than large players when it comes to open their distribution networks to third-party providers.

For those considering entering this sector, Mr Alcaraz had some tips to share. “I am totally in favour of open architecture but it is a difficult business and institutions have to have clear ideas about it.” In his opinion people shouldn’t approach OA as a defensive reaction or just because everyone else is doing it. “It requires resources and investment and it takes time, because if you go to fast you can damage your client and your company. It has to be a core strategic decision.”

‘We decided not to fully open up and implemented guided architecture, so we can give the customer guidance through the jungle’

Dominic Blum, Deutsche Bank

Focusing on the retail market he said customers have traditionally had little exposure to investment funds in comparison to other investment assets. “If they have invested at all, it has always been in their own bank’s funds. The concept of “margin versus advisory” has always meant re-channelling towards the bank’s own products, which is more profitable for the bank itself but not necessarily for the customer.”

This situation, that Mr Alcaraz describes as being unsustainable, is changing as customers start demanding more. Distribution networks have first reacted introducing third-party products under wrap strategies and, more recently, guaranteed products with underlying third-party funds.

“This strategy continues to grow because it removes one of the main obstacles to open architecture, namely the lower margin, by wrapping the product and applying a management commission,” he explains.

More recently major European banks have taken a step further by distributing third-party funds directly through their networks. “Although this is a interesting first step and therefore beneficial for investors, in some cases these measures are mostly market-oriented, designed simply to strengthen the banks’ ranges in very specific niches,” said Mr Alcaraz.

“The key will be to ensure that banks add more and more managers to these strategic agreements, triggering competitive processes for the entry and exit of managers based on certain criteria.

“That would make the strategic selection of managers an active process aimed at truly being able to offer the best product,” he added.

Additional reporting by Yuri Bender

European community: PWM’s Open Architecture Forum held in London attracted 200 delegates from retail and private banks all over Europe