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Sub-Advisory, the new Eldorado?

04/06/2020

In a world where inhouse asset management offers tend to dominate, sub-advisory is a way for clients to access open architecture at a competitive price. Indeed, they can thus benefit from the operational expertise of their distributor and enhanced risk management thanks, in particular, to an access to the transparency of sub-advised portfolios.

Barely a week goes by without another third-party fund management agreement being announced. English-speaking countries call it “sub-advisory”. Their popularity is such that this issue has been a part of the Brexit negotiations. Indeed, the FCA (the UK’s Financial Conduct Authority), ESMA (the EU’s European Securities and Markets Authority) and all national authorities have reached an agreement should there be a Hard Brexit. Europeans will be able to continue delegating some of their fund management activities to the UK. It is therefore a clear trend that is not expected to end any time soon.

A sub-advised fund is an investment fund, managed by a third-party asset manager. The model is illustrated by the graph on the opposite page. A sub-advised fund is essentially used by distributors in Europe to give access to open architecture. The sub-advisory model is a mix of historical fund distribution and institutional mandates. This requires a strong ability to select managers with a proven track-record and monitor them on an ongoing basis, combined with an efficient operational model for the distributor to set up the delegation.

The sub-advisory market is in full expansion and is the fastest-growing open architecture segment in Europe1 according to INDEFI, with an AUM compound annual growth rate of 18%. This represents 10 to15% of the open architecture market share in Europe, according to the same source.

But who benefits?
Investors?

In a world where inhouse asset management offers tend to dominate, sub-advisory is a way for clients to access open architecture at a competitive price. Indeed, they can thus benefit from the operational expertise of their distributor and enhanced risk management thanks, in particular, to an access to the transparency of sub-advised portfolios.

The next generation of clients are waiting for something different. They want to give sense to their money, investing in new asset classes for example, with ESG and impact prerogatives. Some of these strategies can be complicated to achieve internally, and sub-advisory can definitely help with that.

All this allows the end-client to obtain a better and broader product offer controlled by intermediaries, thus ultimately enabling better advice to be provided.

Asset Managers?

Control of the value chain is definitely shifting from manufacturers to intermediaries. Indeed, sub-advisory mandates drive asset management prices down, with headline fees that can be discounted by 50% on average climbing to more than 70% for the biggest distributors, according to our estimates. Ultimately, asset management is one of the few industries in which ready-made is more expensive than made-to-measure.

There is such an appetite for sub-advisory that asset managers, despite the squeeze on prices they are the victim of, have had no choice but to step into the breach and ensure they are able to provide their sub-advisory expertise, incorporating the constraints these intermediaries want.

The sub-advisory model does have some major advantages for asset managers, such as holding a product for a much longer period of time (you can’t just join or leave a sub-advisory in the blink of an eye). If we add to that the substantially higher volumes – as they are distributed on a broader scale – and the brand projection within distribution networks (co-branding), the deal becomes much more balanced despite the price squeeze policy.

This squeeze on prices combined with greater monitoring requirements benefit asset managers of a significant size to the detriment of smaller ones, enabling distributors to leverage a potentially recognised asset management brand.

Distributors?

Fund distributors are facing new challenges in terms of investment, regulation and competition.

In a negative interest rate context, low investment returns make fees proportionally larger. Cheaper products such as passive investments are one solution, high alpha products or investments in non-traditional strategies (via sub-advisory for example) are others.

Sub-advisory enables a customisation of the product for a distributor with its own constraints (Risk guidelines or specific exclusions on stocks or sectors to meet ESG requirements). This drives strong commercial interests and greater purchasing power.

MiFID II, which bans the possibility of receiving third party inducements in case of portfolio management and independent advice, was also a game changer for the asset management and distribution industry. Management delegation is definitely a way for distributors to neutralise, or at least offset, the disappearance of these trailer fees, because it allows intermediaries to keep a distribution margin that is roughly the difference between the management fees of the product and the price paid to the third-party asset manager.

Management delegation allows value creation compared to competitors, in open architecture, for end clients (which is also under scrutiny by regulators), one of the key differentiators in the distribution offer.

A triple-win deal despite challenges

The sub-advisory model seems to be a win-win-win deal for clients, third-party asset managers and distributors, despite some challenges for distributors and third-party asset managers.

Indeed, the sub-advisory model requires scale and operational lead time. Even if replicating some existing processes may appear simple, customised strategies involve more costs and operations (portfolio and risk management, communication and marketing, etc.) Furthermore, when the distributor is not satisfied with the sub-advisory, it can take a long time to modify or change it.

Scalability, dedicated reporting or performance attribution are elements that make the relationship very demanding for the asset manager, which must find the resources.

As a consequence, the success of this model depends in large part on the manager’s selection, of course, but also on each sides’ operational capabilities.

The sub-advisory model looks set to continue growing for some time to come. Even if bargaining power is largely with distributors, we can talk about a real partnership being established between the manufacturer and the distributor. In addition, this form of outsourcing makes it possible to incorporate expertise in new asset classes, as well as extended geographical coverage.

The quality of the end product definitely matters. And it’s not only a question of business relationship, but also of trust.

(1) INDEFI: the sub-advisory market in Europe: key features and trends, 2019.

NICOLAS MOUSSAVI
Head of  Mutual Fund Selection
Lyxor Asset Management

Nicolas Moussavi has 15 years of experience in the financial industry. Since September 2009, Nicolas has been working as portfolio manager of mandates and dedicated funds advised by external investment advisors, on all asset classes in the Multi-management Team. In 2014, Nicolas has been appointed Head of Fund research (Mutual funds and Alt Ucits) at Lyxor Asset Management, where he is responsible for fund selection for various entities of SG Group. Before that, he worked for SGAM Alternative Investments in the Structured Asset Management Department where he was in charge of selecting and analysing underlying funds for structured products. Prior to joining SGAM AI, Nicolas was assistant portfolio manager at Montpensier Finance. Prior to that, he began his career at Societe Generale Corporate & Investment Banking as an assistant of the Long/Short Equity Desk in the Hedge Funds Relations & Risk Analysis Team at Lyxor Asset Management. Nicolas holds a Master degree in Econometrics & Mathematics from Aix-Marseille School of Economics. Nicolas holds also an Advanced Master in Financial Techniques from ESSEC Business School & is a CAIA charterholder.

 

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