The reputational risk which a private bank or insurance company attracts when deciding to outsource specific mandates to an external asset manager is not to be underestimated and was one of the key topics of the discussion at PWM’s recent summit in Paris, where many leading thinkers and pioneers of the sub-advisory model gathered to discuss changes and developments.
“We always have to very cognisant of the reputational risk that the individual firm who is outsourcing is taking, and work very closely with them to understand their goals,” says Nick Phillips, head of third party distribution for Emea at Goldman Sachs Asset Management and one of the keynote speakers at the Paris event, pointing to the increase in sophistication of monitoring and tracking sub-advisers’ performance over the past decade.
“In a partnership context, the more you understand each other, the more value you will extract from each other, the more powerful the partnership and your alignment of interests will be fulfilled.”
The evaluation of managers is being conducted in a more and more professional manner and it has driven sub-advisers to become increasingly transparent about what they do, believes Mr Phillips. Operational due diligence has grown in the long-only world on the back of the very high degree of operational due diligence employed in the hedge fund market, especially over the past three years.
“Developing tail-risk hedging strategies in the sub-advisory spectrum is something that has really come to the fore in the last couple of years,” he says.
The menu of services an institution can acquire from the sub-adviser has evolved significantly, leading to an unbundling of services. This development also meets the growing demand for cost efficiency, adds Mr Phillips.
An example of this is in the hedge fund space, where increasingly private banks have recognised they can have the ability to both construct portfolios and assess risk within them, but they may not have the resources to do operational due diligence, which is outsourced.
Investment innovation is driven by the desire of an institution to deliver products in areas where they do not have expertise, such as emerging market debt, high yield, or alternatives including hedge funds and private equity. Regulatory changes, such as Ucits III, which offered the flexibility to use more sophisticated instruments in the mutual fund space, have driven product innovation, says Mr Phillips.
Often, the desire to innovate is driven by the intermediaries’ need to enhance the product range for end clients that don’t have the ability to manufacture in-house. However, solutions such as currency hedging or tail-risk hedging are definitely a push from the asset manager, he says.
Another recent development in sub-advisory is knowledge transfer, where the institution sub-advises an asset class with the aim to develop its own capability in it. From experience, adds Mr Phillips, in these cases “the cord is never cut” with the partnership continuing to develop in other areas.
Moving on
The sub-advisory relationship is also moving beyond traditional portfolio management. Added value services, such as training and advising the clients’ sales force to make them more efficient, have become far more important, and denote the concept of alignment of interests between the end clients who want better products, the intermediaries who want to sell more and the sub-advisers, whose success depends on that of their clients, explains Mr Phillips.
Whether an alignment of interests between sub-adviser and client can be achieved was a hot topic at the conference. According to Peter Sartogo, managing partner at GWM Group, in practice in the industry there is little alignment. Sub-advisers are interested in getting a percentage of the assets they manage, and they are quite reluctant to change their fee structure, given that 90 per cent of the managers underperform a given mandate.
The alignment of interest does not just exhaust itself on performance fees but is a broader concept.
“In constructing a portfolio we will use a fund for specific reasons – we need to share these reasons. I think it is important that if the manager achieves that goal, he is allowed to be paid extensively and if he does not, he should share the pain and underlying subscribers should benefit from a reduction in fees. This is how we try to build the portfolio,” says Mr Sartogo.
Claudia Itschner, head of manager selection, investment management at Zurich Insurance Company – who stressed the importance for a sub-adviser to be able to manage risk, especially for an insurance company where asset managers are trading directly on its balance sheet – questioned whether there is real alignment of interests with performance-based fees.
“If you believe markets are efficient and risk and return are related, then the performance-based fee would only increase risk,” she says. “The asset manager would have an implicit incentive to increase the return, which would mean increasing risk too. I am wondering whether performance-based fees really generate an alignment of interests. Perhaps they are a good thing for the asset manager but perhaps not for the client, who carries the risk.”
