Running a fund comes with plenty of challenges, not least the management of its investment strategy – arguably the central pillar of its raison d’être. While it is understandable that many fund managers would want to keep decisions related to a fund’s holdings and future direction completely in-house, there are compelling reasons to outsource this function in advance of Mifid 2’s arrival – one potential avenue being sub-advisory mandates.
Of course, the use of sub-advisory arrangements is nothing new. For years, those groups wishing to offer a product menu with broad-based appeal have opted to use external specialists for strategies that go beyond their core competencies. The use of sub-advisers allows groups to hunt for best-in-class alpha-generating skills across geographies and sectors rather than developing their own internal capabilities at even higher cost. It also enables growing mid-size groups to overcome the natural scepticism of fund selectors that they cannot possibly be experts in all the sectors and categories on offer. The use of sub-advisers not only allows a group to provide as fully rounded a product range as possible – it can also allow them greater flexibility in tailoring products more specifically to the needs of their client. The latter use has tended to prevail among funds serving the more sophisticated side of the industry’s client base and is unlimited in terms of the range of requirements that may be expressed, whether exposure to a niche asset class or the need to construct a portfolio targeting a specific risk profile, a particular degree of absolute returns, a certain amount of regular income etc. Opportunities abound here for groups large and small, be they industry giants assisting smaller firms with exposure to core asset classes, or boutiques with the right skills to help an industry giant implement a highly specialised strategy.
These days, the advent of Mifid 2 is shining a bright spotlight on the subject of asset-manager remuneration, and we have been increasingly hearing from our clients and industry contacts of a concurrent growth in activity in sub-advisory – but why? The reason seems to be the link between control of a fund and preservation of profit margins. Mifid 2 makes a distinction between independent and non-independent advice. Essentially, kickbacks will only be outlawed where a distributor organisation describes itself as an independent entity offering an unbiased palette of products from across the market. Under the new regime, independent distributors will have to charge fees and this is placing them under huge pressure to rethink their business models in such a way as to preserve and develop their margins. One way of doing this, particularly for the larger entities, is to consider moving into fund management themselves, setting up own-branded funds that are sub-advised by external specialists in order to circumvent the financial impact of the commissions ban.
It’s not just about margins. There are some potential advantages to the client. For a start, the distributor gains greater control over the products it is supplying to its customers, making it easier to understand and match them to client needs. By working directly with their funds’ investment advisers, these selectors-cum-fund managers and their products ought to benefit from greater transparency of investment process, broader scope to customise the investment strategy and better marketing communications. Furthermore, it is conceivable that by placing sizeable chunks of money in the hands of their sub-advisers, they could negotiate lower institutional-level advice charges, thus passing on a saving to investors via lower overall costs while replacing retrocession income with management fees – a win-win situation.
This is clearly more straightforward in bank-dominated distribution landscapes, where providers and distributors are more closely tied than say in the IFA-dominated UK, where the home-grown retrocessions ban stemming from the Retail Distribution Review has led to the appearance of a so-called advice gap. That gap is arguably less likely to rear its head in the rest of Europe given that banks will find it easier to vertically integrate their operations and remain non-independent. The Netherlands, where a commission ban is already in place, is a good case in point. Here, ABN Amro has opted to launch its own sub-advised funds for its client base, resulting in huge inflows for its partner companies, Northern Trust being one clear example.
Sub-advisory arrangements can be costly to set up and therefore difficult, and time consuming, to disentangle when performance drops off. In Europe, though, there has been a long tradition of establishing sub-advisory deals that operate purely at the advice level and do not require the sub-adviser to trade. In such arrangements the investment adviser listed in the prospectus is generally a competent individual within the fund sponsor company. In this way sub-advisers can be switched quite easily.
The sub-advisory route is not the only option for groups looking for more profitable operating models in the post-Mifid-2 world. Some distributors will opt merely to avoid the label of independence and, as long as they can prove that they are offering services that justify the commissions paid, they can arguably continue to sell third-party funds alongside their own products. Funds of funds are another option that allows distributors to offer exposure to third-party specialists under the umbrella of an internally managed product. Sales of funds of funds have been very robust over the past few years and there are signs of real growth driven by regulation alongside the obvious commercial benefits. Net monthly third-party fund of funds subscriptions hit a record €14bn in April 2015, with Spain, Italy, Germany and Belgium among the top markets contributing to this asset class last year, according to data from Broadridge FundFile.
In contrast, comprehensive data on the sub-advisory landscape – such as the asset classes, sectors and funds where such arrangements are thriving – remain less readily available. Given this opacity and the signs of demand for related information, MackayWilliams is delving deeper into this topic to produce our own research on it later in 2016. Watch this space for more!