The wave of regulations hitting the asset and wealth management industry is expected to have a significant affect on the sub-advisory business, according to the results of the eighth annual survey conducted by PWM.
Although there is still quite a lot of uncertainty on its real impact, increased regulation in the financial industry will lead firms to look for third-party fund managers, believe 44 per cent of the research respondents, which include asset and wealth management firms, private banks and life insurers (Fig 1).
Greater costs to comply with new legislation will force smaller houses to focus their product range on a limited number of in-house capabilities and complement those with external expertise. The value of economies of scale will increase and regulatory know-how will no longer considered a commodity. Only those companies with a strong regulatory ability are expected to succeed.
The cost of staying in the investment management space will be too high for players with no critical mass, especially in the alternative space, as the new Directive on Alternative Investment Fund Managers (AIFM) regulation is anticipated to especially affect firms that so far have been able to operate with light regulatory constraints.
The need to comply with regulation will increase firms’ internal costs and thus may lead to higher outsourcing in order to improve profitability, argues Wolfram Gerlof, head of product strategy & client service at Vontobel Asset Management.
However, higher risk-management requirements will make it harder to sub-advise, he says. The effect on the total business is still uncertain. Using funded solutions would be an easier way to deal with regulation, some suggest.
It is worth noting that since the PWM survey started seven years ago, regulation has always floundered at the bottom of the list of drivers to sub-advisory. At the top are the desires to search for higher alpha, while focusing on core competency, to enhance product offering to clients, and to tailor the funds specifically to client needs (Click to view Figs 2 and 3). The continued financial crisis and market turbulence has not significantly affected the business model of the firms doing the outsourcing, which emphasises the concept that appointing external managers to run segregated mandates is a long-term strategic decision.
“The drivers for sub-advisory are not regulatory, but investment driven,” says Christophe Girondel, managing director at Nordea Investment Funds. “The exception would be Ucits IV considering the feeder structure ‘sub-advisory’. Here we could see many smaller funds using this option to disband investment teams but retain their product range.”
Whereas it is still too early to assess the true implications of Ucits IV for the sub-advisory business, the impact of the trend towards the separation between investment management and distribution and the end of the retrocession-based business model is much clearer. The retail distribution review in the UK, which is increasingly under observation from European authorities and wealth managers, is an illustrative example quoted by a number of respondents, who predict the new regulation will drive distributors (and consequently managers) to focus much more on the investment performance, rather than on rebates. The result will be a higher level of sub-advisory activity aimed at getting higher performing products.
Indeed, according to the survey, sub-advised assets do perform better than equivalent off-the-shelf products, with around 72 per cent of the respondents estimating that 50 per cent or more of their sub-advised products generate higher returns ( Click to view Fig 4).
MANAGER SELECTION
Once the decision to sub-advise is made, the issue is finding the right manager.
Consistent with past years’ results, long-term performance heads the top criteria in selecting sub-advisers, according to 80 per cent of people, followed by management team and investment style. However, when asked to identify the biggest mistakes made in the selection process, around 65 per cent, unprompted, admit they are too much focus on historical performance or on short-term returns and profits.
It is important to evaluate managers over multiple market cycles and truly understand their process, and assess the stability of the team moving forward, say respondents. A few of them believe that the biggest challenge when selecting sub-advisers is to analyse correctly the managers’ track record and separate real alpha from hidden beta.
“Not doing your homework on the track record and not employing enough resources to get under the skin of the management are some of the biggest mistakes when selecting managers,” explains Mattian Hagen, head of manager research at SEB Wealth Management.
It is imperative to “slice and dice” the track record and understand, for example whether the fund performance refers to a segregated mandate, which is easier to get, or to an open ended fund, where the manager has to deal with inflows and outflows, says Mr Hagen.
The 2008 financial crisis proved to be a good benchmark to test the consistency of managers’ investment process, believe 78 per cent of the participants to the survey.
