Time for investment houses to accelerate pace of change

Following on from the famous ‘Papa and Nicole’ car advertisement, which ran on UK TV screens for most of the 1990s, Renault was voted most persuasive advertiser across five different European countries. Surveys by two commercially-led TV channels found the series to be the most popular car advert ever made.

Now Douglas Thursby-Pelham, who launched the Renault Clio campaign for the Publicis agency in 1991, is bringing his techniques to the investment management market, where he has teamed up with industry stalwart Nigel Legge, once of Liontrust, in a new venture called Vinculum. And he sees a set of similar cultural forces at play today.

“In those days, we were in the throes of the recession, with a backlash brewing against the excesses of the 1980s,” recalls Mr Thursby-Pelham.

With European leaders such as Margaret Thatcher being rejected by the public, a simple dialogue between a pretty girl and her caring father captured the public mood.

“We were seeing a rejection of materialistic values and a genuine, if grudging admiration for the way the French had safeguarded their quality of life,” he says.

Twenty years on, Europe is experiencing a similar zeitgeist, with the public fundamentally rejecting an apparently corrupt and excessive financial world. “Barclays’ recent manipulation of the Libor rate is just the latest instalment,” says Mr Thursby-Pelham. “The image of financial services has finally reached its nadir.”

With big-brand groups unable to distinguish their product offering in any meaningful way, and two-thirds of active mutual funds under-performing their benchmarks, the time has come for investment houses to dramatically reshape and modernise their business models, he argues. Changes will be forced on them by a combination of regulation and the public’s mounting disaffection with hidden fees and charges. “This is the only market I know where there is fixed pricing for a variable product quality delivery,” says Mr Thursby-Pelham.

These assertions are backed by James Bevan, head of investments at charities fund manager CCLA. “Ours is an industry which traditionally overpays itself,” says Mr Bevan. “Is compensation going to go down? It is something which is inevitably going to happen. Fair compensation in practice is one of the factors which will be at he heart of the business model of the future.”

Cost pressure from consumers and clients is coupled with a squeeze on established asset managers from new competitors entering the market, argues Greg Ehret, head of Emea at State Street Global Advisors, where he oversees assets worth $450bn (€363bn) for European clients. “The pot of revenue dollars has shrunk substantially over the last few years,” he says, with interest rates at all time lows and Treasury Bills guaranteed to lose money over a 10-year cycle.

Succesful strategies of the past often have no place in today’s changed environment, with key clients maximising exposure to cheaper exchange-traded products and ditching pricier active versions.

Manufacturing production lines must be refocused, ventures Mr Ehret, to cater for client demand for high-dividend paying equity funds and those strategies which can leverage growth from developing markets.

He points to a huge disconnect between current allocations and the global economic reality, with just 5 per cent of US pension scheme assets and 3 per cent of Swiss institutional money lodged in emerging markets, while companies in the world’s developing regions account for 35 per cent of global capitalisation.

This focus on seizing opportunities in emerging markets is so strong in some companies that many have lost interest in potential opportunities on their own doorsteps, believes Jervis Smith, global head of client executive, Citi Transaction Services.

“Many of our clients are simply not interested in talking about Europe and what they do here, although there is occasionally some talk about whether US equity product will sell in Europe,” he reveals.

“They want to sell products further afield or invest further afield. Pure European discussion on asset management is currently in a state of suspension. European government bonds are proving very difficult. European large cap stocks are generating good dividends, but flows into large cap equity funds are not what they should be.”

One of the biggest dilemmas for the funds industry, says Mr Smith, is how to cope with the “huge wadge of cash, waiting on the sidelines, looking for a home and losing money every day”.

In the private banking, as well as institutional spheres, the aim is no longer to make money but preserve capital, say industry players. “When I joined this industry 17 years ago, asset allocation was all about making money for clients,” confirms Ann Richards, chief investment officer at Aberdeen Fund Managers, speaking during a panel session at the Fund Forum event in Monaco earlier in the summer. “Today, things have changed, and it’s all about balancing risks.”

Momentum Global Investments’ chief investment officer Mike Allen agrees. “A lot of gatekeepers and wealth managers are presenting products first and foremost to protect themselves rather than to create returns.”

This means a huge shift to big brand names, often to the detriment of clients. While high quality teams of portfolio managers can exist within a big firm, they are more likely to be found in a boutique group, believes Mr Allen, who is happy to move money away from funds very quickly if a problem is detected.

“Nothing scares us off from being the first ones to invest in a small house,” he says. “We like the idea of just buying intellectual capital without all the red tape.”

This is particularly true when Momentum chooses equity and hedge funds, although for passive investments, large groups such as BlackRock are generally chosen on grounds of size and scale.

All good fund houses have a “consistent DNA” in terms of ownership structure and philosophy of investment teams, says Mr Allen. He became very sceptical about the “village of boutiques” structure, where the salesmen of large houses would display a range of semi-independent logos on their business cards. This once ubiquitous structure, which gained popularity before the financial crisis, was a reaction to the huge brain drain from large houses to smaller ones, he believes.

Yet it is now suffering a backlash. “The village of boutiques was usually window dressing by big houses, trying to re-position themselves,” says Mr Allen, often leading to some scepticism among fund selectors.

“We may not have gone with some of these houses. You realise the investment entity is not really a boutique, as it’s not ring-fenced. All of us selectors would have seen through it,” he says.

“When we visit fund houses, we don’t mind if they don’t have a swanky meeting room to accommodate us, if the guy is a bit left field or wears trainers to work,” says Mr Allen. “The key thing is that he is concentrating on the client’s portfolio and has his own money invested. If you went to a BMW showroom, you would feel very twitchy indeed if you found out the salesman was not driving a BMW.”

In fact this multi-brand structure did not find favour with many selectors, because they could not see a real desire amongst the fund managers to run portfolios to the best of their abilities. Instead, the managers wanted the comfort of working for a big bank.

“We want to choose firms which have a real philosophy and alignment of interests. Are they waking up each morning and looking after their clients’ portfolios? Often, we don’t see that. If you are a fund manager setting up you own boutique, why would you go to a bigger bank?”

Some fund selectors wrongly seek the comfort of big brand funds, believes Mr Allen. “The whole market has gone risk averse. Because people are so worried about the outcome, they feel it is a much safer option to revert to a company they have heard of. But just look at the funds which blew up in 2008: they were all managed by big firms.”

Muddled thinking

This confusion about preferred business models often stems from the inability of matching up needs of the investment and distribution functions of large houses, believe commentators.

“Economies of scale in distribution means it makes good sense to be large, while diseconomies of scale in active management kick in at a fairly low level,” says Jim McCaughan, CEO at Principal Global Investors. “But distribution is also about seeking the ability to communicate two ways with clients, not just thrusting the products down their necks.”

Most large groups got themselves geared up for open architecture over the last 10 years, but a consumer-led trend for a huge choice of products led to many disasters in practice, says Mr McCaughan.

“Open architecture may have been all the rage, but it led to inadequate due diligence, selection of funds such as those managed by the Madoff group, high costs and complexity of products.”

The invesment industry is crying out for a system of guided architecture, argues Mr McCaughan, where clients and consumers are presented with a limited range of high quality products in each asset class. Regulations such as Mifid at European level and local legislation including the UK’s RDR (retail distribution review) are working towards such as system. But there is an inbuilt problem, says Mr McCaughan.

Guided architecture requires implementation of the controversial multi-boutique model, so that groups can present a variety of products on distribution platforms, he says. But this system has not always been correctly implemented and is currently distrusted by most chief operating officers, worried about the creation of fiefdoms within their fund houses.

“We badly need sensitivity to talent management and retention to avoid expensive bureaucracy and to give people a sense of ownership,” says Mr McCaughan. He believes fund houses can be successful for long periods without even deploying the most efficient business models available to them.

“People routinely get these things wrong, but they still make a lot of money in the short-term. But in the long-term, you need to keep your talent.” he says. “Industrialisation has led to mediocrity in active management.”

Banks, many of whom are almost technically insolvent in Europe, are very poor owners of asset management groups, says Mr McCaughan. He believes they should recognise this fact, sell up and concentrate on banking.

“This will hugely change the business model over the next five years. Being part of a bank, going through a period of recapitalisation will be a painful experience for asset management companies.”

There are nevertheless huge opportunities for asset managers, which many may not be able to exploit due to the restrictive nature of their ownership, reckons Mr McCaughan. “A lot of former industry leaders are keeping their heads in the sand and not paying attention to these changes,” he says.

Most practitioners agree it was easy to make money five years ago, charging 50 basis points for products targeting returns of 2 per cent above the S&P500 index. But changes in economic conditions, regulations and a move to passive and liability-driven investments could lead to permanent changes in industry dynamics.

Asset managers need to respond to these changes with a different product range, embracing high yield, emerging markets and real estate speciality products, says Mr McCaughan. “If you give me $100m to invest in US equities, it’s easy to go to the stock exchange. But if you ask me to invest it in high yield bonds or real estate, it’s not so easy. You need selectivity and expertise. This all leads us back to the multi-boutique model.”

Asset managers who expect equity appetite to one day miraculously return are “in denial,” he adds. “Many managers still have nostalgia for 2005. They say clients are not buying their equities, but they soon will again. However, the world has moved on.”

Managers need to be more self-critical, listen to their clients and offer them much more diversified portfolios, constructed from elements, which probably did not exist 20 years ago.

Fund management has been much quicker than most older industries, such as automobiles, to internationalise and move into new geographies. But it is this fast progress and an increasing, factory-led manufacturing mentality which has led to a lack of innovation and flexibility, believes Amin Rajan, CEO of Create, who conducts annual research into evolving business models. Fund houses, still a relatively new breed, are experiencing birth pangs while they find the correct model, he says.

“The industry has become highly commoditised and mechanical and cannot establish the level of trust necessary to deal with clients, while at the same time failing to capitalise on opportunities.”

Hard to see through regulatory haze

While most fund groups are grappling with economics when pondering on new models, the industry’s interest groups are more absorbed by regulatory issues.

“There are 35 pieces of regulation currently being implemented, which makes it difficult for any CEO to make the right decision about future strategy,” says Peter De Proft, director general of the European Fund and Asset Managers’ Association. “I am surprised that anybody can have a clear view of what their business model will look like.”

But he does not see any problem with an evolving industry, where active management of equities is no longer at the core of a successful business strategy, as was the case for two decades leading up to the financial crisis of 2008.

“Equities are no longer on the list of favourites, but we are in a process of evolution,” confirms Mr De Proft. “Equities are still part of investing culture, but it is balanced funds which are prospering. The world is changing and today people are afraid of sovereign bonds, temporarily, but all that will be eventually resolved.

“Funds will always have an important role to play in the financing of the European economy, but that can be fixed income, equities or alternative funds.”