Boutique investment firms are outperforming larger investment managers in nine out of 11 product categories, a recent study shows
• Institutional investors are losing trust in managers
• Management-owned boutiques can take more business and investment risk
• Boutiques are more common in the US than in Europe
• The future challenge will be for mid-sized, multi-strategy firms that are not competing in the index and smart-beta markets
Boutique active investment managers have outperformed non-boutique peers and indices over two decades or more, according to research from Affiliated Managers Group (AMG) using the MercerInsight global database. However, Nathan Gelber, CIO of Stamford Associates points out that a boutique in itself does not make a better investor – it is all to do with the quality of employees and the investment process. Traditional active management is facing many challenges in a variety of areas including performance, value for money and alignment of interests.
Institutional investors are losing trust in managers, wrote Roger Urwin in a 2015 report by Willis Towers Watson (WTW). That loss of trust is leading asset owners to reconsider the value chain, causing more assets to be allocated to passive mandates, in-house teams and smart-beta approaches where the role of third-party asset managers is diminished. Are boutiques better placed to regain and maintain the trust of institutional investors in active management?
AMG defines boutiques as investment-focused firms with less than $100bn (€85bn) in assets under management. Its study, originally conducted in 2014 and updated this year, shows that over the past 20 years the average boutique strategy outperformed the average non-boutique strategy in nine out of 11 product categories examined. Boutique outperformance was most significant in emerging-market equities, global equities and US small-cap strategies.
That may be one reason why, says Stephen Miles, global head of equities at WTW, his firm has a bias towards boutiques for traditional equity stock-picking strategies: “In terms of alignment, boutiques provide a better business model through equity ownership and independence. They allow a more niche business model where people can focus on doing one thing really well.”
The criticism of large fund managers is that due to their corporate structure managers are focused on maximising short-term earnings. As a result, underperformance against an index or against a peer group represents a significant business risk for a firm. It can be the driver behind rapid growth or indeed rapid decline over short periods of time – the timeframe that an ambitious executive needs to show success or at least avoid being bottom of the class to ensure the next rung up of the career ladder is reached. This means managers end up closely following an arbitrary index that has little relationship to pension scheme liabilities and they invest in stocks they do not like on the grounds of risk management. “The way to guarantee a bad outcome is to start with the index and then apply transactions costs and high fees,” says Hugh Cutler, head of global distribution at AMG.
In contrast, management-owned boutiques can take more business and investment risk. They are not subject, as Gelber describes, to “tracking error police”.
Indeed, says Miles, it is unusual to find boutiques whose core strategy is just to beat a benchmark by a small amount. The barriers to entry to run high-conviction portfolios over the long term are not that high and do not require vast resources, which benefits boutiques. More benchmark-oriented active approaches often require a bigger team of analysts to cover the universe, which necessitates larger-sized businesses to cover the costs.
If it is ‘culture’ that differentiates boutiques from larger fund managers, is it possible to define what that means? “Culture is the glue that holds individuals together,” says Miles. He adds that culture is underappreciated as something that is important, even though it is hard to measure. It is critical and can be assessed.
Urwin lists two critical factors that can define culture: ‘purpose and drive’, which is often reflective of ownership and incentive structures – Urwin sees client-centricity versus self-centricity as critical; and ‘people ethos’, where respecting personal development wishes, encouraging maximum creativity and facilitating collaboration opportunities is critical.
AMG considers itself a leading provider of boutique strategies, having majority stakes in about 30 such firms. It sees five critical cultural components in its affiliates: principals should have significant direct-equity ownership, ensuring alignment of interests with clients; there should be a multi-generational management team, fully engaged across the business; there needs to be an entrepreneurial culture with partnership orientation, which attracts talented investors; there should be an investment-centric organisational alignment, including careful management of capacity; and finally, principals should be committed to building an enduring franchise, embedding an appropriately long-term orientation.
“Given their meaningful retained-equity ownership in their own firms, our affiliates have an exceedingly long-term perspective – they care more deeply about their legacies and reputation with clients than maximising AUM and [the current] year’s income,” says Cutler. This contrasts with captive asset managers who are more focused on the next quarter’s earnings, and hence incentivised by the current year’s asset gathering.
Boutiques are more common in the US than in the UK and continental Europe. The US ‘end market’, in terms of institutional and private investors, has a higher propensity to work with lesser known names, says Gelber. In the UK there is a tendency to favour established brands. Institutional investors appear to have a limited appetite for boutiques, although name recognition in itself is not necessarily an indication of quality.
The UK market is dominated by the three largest investment consultants and Gelber believes investment consultants are not generally keen on boutiques recommending them as too risky for their own businesses. “We have seen many outstanding boutiques trying to get a foothold in the UK market and not succeeding. Our best-performing manager in the last 20 years has not had a single investment consultant client other than us,” he says. Others may disagree with Gelber, but the UK regulatory authority, the FCA, has referred the consultancy market to the Competition and Markets Authority.
How will the boutique marketplace evolve over the next few years? In a low-return environment it is unlikely that equities will deliver double-digit returns over the next decade, so therefore investors do need excess returns, argues Cutler. “Our observation is that managers who deliver a differentiated return stream that has been and is expected to be more than the index over the long term are attractive and growing. Who produces excess returns? It is the boutiques and firms with differentiated approaches,” Cutler says.
But he says the large index providers, liability-driven investment and corporate fixed-income managers will also prosper because they are providing low-cost, risk-management-oriented investment which is also required for client portfolios.
The challenge in the future will be for mid-sized, multi-strategy firms that are not competing in the index and smart-beta markets. The solution here may be to ‘run with the hare and hunt with the hounds’ – that is, take on board the cultural characteristics of boutiques within a larger firm.
Robeco is a good example of a firm that has adopted this approach. It has €152bn in assets under management and multiple investment capabilities. But as Robeco CIO Peter Ferket explains, the firm is organised in a boutique structure with 10 dedicated investment teams focused on specific areas. “It is more the norm now to have boutiques,” he says. “You don’t see an integrated approach too often.”
Employee remuneration depends on the performance of Robeco and individual teams. Staff do not have equity ownership, but there are incentive schemes to reward top professionals well, says Ferket, designed to encourage the stability of the teams.
Ferket sees advantages in having a multi-boutique approach within a single firm. The individual teams are on the same floor, enabling collaboration. “Knowledge sharing is an advantage of firms of our size compared with boutiques,” he says. It also enables interactions between credit teams and equity analysts looking at the same companies.
“Equity managers are optimists as they always look at the upside, whereas credit analysts are pessimists as they are always aware the upside is limited while the downside is unlimited. Sharing knowledge with equity managers therefore gives a valuable alternative perspective,” says Ferket. It also gives enhanced capabilities to develop new strategies.
In China, for example, Robeco is looking to launch a China A share quant fund. “We would not have attempted to do this until we had a strong understanding of the fundamentals. We have an office in Shanghai with fundamental analysts looking at A shares who can advise our quant team,” Ferket.
For Gelber, having more resources can mean sharing mediocrity. “It is inconceivable that one manager will be excellent across all asset classes.” But he admits that multi-boutique managers could make a difference. “We can identify very talented individuals within large integrated houses and we often ring fence them and use them,” he says.
Perhaps the lesson for institutional investors when it comes to deciding between boutiques and large, integrated managers is that generalisations can never replace due diligence.