Asset managers should recognise fiduciary managers as less of a threat and more of an opportunity, says Nigel Birch
Fiduciary management is a great opportunity for investment managers. It offers a new distribution channel for third party investment offerings in the European institutional investment industry. But fiduciary management is often met with confusion, misinterpretation and general mistrust from investment managers. This may be due to a number of reasons but we generally hear of three main areas of concern: first, that fiduciary managers use their own in house investment products; second, that fiduciary assets are less ‘sticky' than traditional institutional investment; and third, that fiduciary managers negotiate ‘unfavourable' fee terms with their managers.
The long and short of it is that investment managers view fiduciary managers as a threat, and they might well be right to do so. In this article, however, I hope to outline some of the opportunities that exist in supplying funds to fiduciary managers, as well as validating some of these threats. Throughout 2011 we have explored and researched the buying criteria of the fiduciary management market in a research project we called Fiduciary Management Market Intelligence. This article draws on some of the themes and findings of that work.
What is fiduciary management and how much of it is there?
It is first important to set some boundaries around the term ‘fiduciary management'. In our analysis of the market, we adopt a consciously ‘broad church' definition - describing a fiduciary management appointment as existing when:
• The provider is a primary source of strategic investment advice for the fund (or scheme);
• The provider monitors and reports on the majority of the fund's (or scheme's) assets;
• The provider is given a degree of delegated discretion to (re)allocate assets;
• The provider has a degree of delegated discretion to make investments (whether directly as fund manager or indirectly by appointing and terminating fund managers) for at least part of the assets;
• The provider services clients external to their own organisation or ‘parent' company.
At the beginning of this year, the European fiduciary management market surpassed the €760bn mark. We have been tracking growth rates in the industry, and we can confirm that there was significant growth throughout 2010. In figure 1 we show how growth has accelerated post the financial crisis.
What are the challenges?
As already mentioned, we tend to hear about three challenges in particular:
• Fiduciary managers use their own in house investment products.
Fiduciary managers will often decide which external fund managers to use based upon their heritage. Figure 2 describes how fiduciary management assets are distributed across the three most common heritages of fiduciary managers: consultant, asset manager and pension scheme.
Fiduciary managers from a consulting heritage and asset managers from a multi-manager background tend to use 100% externally managed investment products, although often through their own manager of manager products. The small percentage of internal products that some consultants invest in tends to be matching strategies.
Providers from a pensions heritage use slightly fewer externally managed investment products, about 70% on average. Their internally managed funds tend to focus on passive strategies and other ‘non-specialist' asset classes and strategies.
The group that uses the lowest proportion of external asset managers is providers from a asset management heritage - as low a 30% in some instances. The products they tend to use external providers for are more specialist areas focused on high alpha such as alternatives, emerging market strategies and real estate. More traditional asset classes and plain vanilla strategies, developed market fixed income and index linked strategies, for example, tend to be managed in-house.
• Investments from fiduciary managers are less ‘sticky' than traditional institutional investment.
When pension fund assets behave more like a fund of funds, this creates significant business risk for all but the very largest of investment managers. We are able, however, to segment the fiduciary management market into managers that invest through pooled funds using more dynamic or rotating strategies, and managers that focus on longer-term strategies, generally investing through segregated mandates. Our research found that the average manager relationship was 3.7 years, and that the majority of fiduciary managers today focus on long-term relationships through segregated mandates.
Although fiduciary managers place a great deal of emphasis on portfolio liquidity, our research found that fund liquidity was not a key criterion of fund selection. Fiduciary management fund researchers accepted that certain asset classes simply could not provide the levels of liquidity others could and explained that a reasonable lock-up period were often a desirable trait to reduce the operational risk of the firms they were investing with.
• Fiduciary managers negotiate unfavorable fee terms with their managers.
While our research found that fees were generally negotiated down, the scale of assets under management may be the driver rather than the commercial imperative to secure a better deal. Great emphasis was also placed on fee structure. Many of the fiduciary managers we spoke to had moved, or were moving towards, a ‘fixed fee' weighted structure for the matching part of the portfolio. Conversely, for high alpha vehicles, namely alternatives, fiduciary managers strongly preferred performance fees, as they: allow interests to be aligned; incentivise manager outperformance; and can limit unrewarded costs should the manager underperform. The fiduciary managers were divided, however, on the fee structure preferences for more traditional return seeking assets. Roughly half favoured a weighting towards performance fees - to minimise risks and incentivise external managers - while the other half favoured a weighting towards fixed management fees and reduced performance fees, with the aim of retaining more of the investment upside.
Despite existing challenges, the fiduciary management market offers a significant opportunity for fund suppliers. Fiduciary managers have the scale and sophistication to engage with their suppliers in a more meaningful way, often investing through more sophisticated strategies and in more innovative asset classes.
The critical success factor in supplying funds to this market is to spend time in understanding the variety of styles and strategies that can be accommodated under the umbrella of fiduciary management. Segmenting the market allows us to understand the very specific and different demands of each fiduciary manager, targeting tailored products and services to meet their specific needs. If this can be done successfully, then supplying funds to fiduciary managers not only presents a sizeable opportunity, but also a desirable one due to the advantages of dealing directly with sophisticated and innovative clients.
Nigel Birch is a director at Spence Johnson