Gaining access to US funds
On the face of it, Table 1 seems to subvert the widely held belief that local investors understand their own markets better than outsiders, and therefore should always outperform them. Not only have offshore funds managed to surpass domestic general equity funds in the US, but they also have trounced domestic small cap funds by a remarkable margin (47.16% against 37.11% in 1999).
Closer examination of these statistics paints a somewhat different picture. Although by no means exclusively so, offshore funds investing in US equities have a strong bias towards a growth style, whereas there are a considerable number of value funds available to US investors. If we remove these value funds from the equation, we see quite clearly that the domestic US funds have the upper hand for both the large-cap and general equity funds, and also in the small-cap segment.
The removal of the value funds from the US figures is of crucial importance. Not only does it allow us a more like-with-like comparison but also reflects the fact that US domestic equity funds tend to adhere to a stated style (as expressed by market capitalisation and growth, blend or value) more than offshore funds investing in the US.
Moreover, if we extract from our list of offshore funds, those that are managed by familiar US fund brands (Fidelity et al), we can see that the overall performance of the offshore funds is largely driven by the performance of these funds. For example, US-brand offshore funds investing in small companies returned an overall 50.73% last year, ahead of both the remaining offshore funds and of the overall domestic investment funds. It is also noticeable that the US-brand funds also generally are able to attract far greater assets than European or other fund companies.
Nevertheless, given the US fund industry’s domination (it accounts for about 60% of all assets under management in investment funds), these US brand funds represent only a small proportion of the total US-invested products available to offshore and European investors. At first glance, it seems surprising that in an increasingly global marketplace more US funds are not available to non-US investors. The truth is that a great many are.
Whereas most domestic and offshore funds are made more widely available through registering the funds for sale into a certain country with the local regulator, few US mutual funds have been registered for overseas sale.
The majority of US-brand funds available to offshore and European investors are clones or near-clones of their US counterparts. Cloning is popular primarily because it offers a low-cost solution to the asset manager and it is much easier to take a fund to market once there is a proven track record. Given that an increasing number of entrants into the fund business originate from the US separate account industry, the concept of ‘cloning’ and product replication is also second nature to many of the fund companies.
As with the creation of separate account products, the offshore versions of the funds are not always perfectly identical to their US ‘twins’. The reasons behind this are manifold, but ultimately relate to the slight regulatory differences and the different legal structures of US and European fund products. Just as two large-cap growth accounts created by the same asset manager may have slight differences due to the varying needs of their clients, so too the offshore product may have slight variations to the US fund it is based upon due to slight differences in the make-up of the proposed client bases.
Also, the performance of the clone and its original may not match perfectly, even if the portfolios are identical. One key reason for this is that the European and offshore markets are not nearly as cost-conscious as US investors, and therefore there is less downward pressure on fees. In addition, the assets under management in the offshore products tend to be less than those of the US product, so the extra economies of scale are lower, and this too is reflected in the fees.
The epitomy of cloning is the hub and spoke structure put forward by Signature Financial, although this has not yet proven to be the success that it had hoped for. Noteworthy hub and spoke fund managers include Eaton Vance, which offers a number of offshore products ‘spoked’ from their US hubs, as shown in Table 2. There have been a number of reasons for the slow uptake of the hub and spoke structure. One common criticism is that it offers little benefit to companies over the existing near-replication methodologies. Its endeavours to become fully recognised throughout Europe also took far longer than hoped.
Not all US companies have been so aggressive in their pursuit of product replication, and the obvious example here is Fidelity. Historically, Fidelity’s house-style has been to allow fund managers to create their own portfolios based upon the analysts’ recommendations. As a result, Fidelity has been in the position of offering ostensibly very similar products to different investors with massively variant performance.
It is worth noting at this juncture that there are a number of trends under way in the US fund industry that further the cause of cloning. Fidelity’s ‘star manager’ system is increasingly rare.
The key change has been in the substantial increase in ‘quantitative fund management’ techniques. Increasingly, plan sponsors are demanding that funds they invest in utilise extensive quantitative techniques either in investment selection or risk-modelling, if not both. As a result, our perceptions of what is ‘active management’ are changing. Increasingly, mutual funds are coming to resemble quasi-index tracking product or ‘enhanced’ index funds.
There are a number of factors behind this trend. Firstly, until the second half of last year, it has become increasingly difficult for US fund managers to outperform the market, and the narrowness of the market (ie, the fact that the performance of the S&P 500 has been the result of surprisingly few of its components) has exacerbated this. By moving to a quant process, which tends to be more ‘market relative’ than dependent upon absolute values, managers have been able to able to better match the market.
There have also been a number of incidences in recent years whereas successful fund managers in the early part of the US bull market took in substantial amounts of new money only to decide that the market was at a top and to move into cash, thereby missing out on the substantial returns available, and necessitating that the investors and plan sponsors exit the funds in order to avoid further losses.
There is also the perception amongst many that by using a quant process, the fund will be more style adherent – and there is some logic to this. Since ‘style’ is quantified by using the current market benchmarks, a quant process that uses these benchmarks as part of its process will generally appear to stick to its style more closely.
Theoretically at least, such mechanical processes should lend themselves easily to fund cloning. Whether or not this current trend retains its prevalence in the wake of a substantial turnaround in the market and a possible return to favour of a more ‘value-oriented’ approach remains to be seen, but it does seem to be a logical step for the fund industry to take. As cost-containment becomes an increasingly important factor to fund companies and the back-office and marketing functions become ever more influential, it does seem that the ‘star manager’ system (which is far more prevalent in Europe) will become less and less common.
It should also be pointed out that such product and idea replication is not purely a one-way process. Through a tie-in with Munder Asset management, Framlington have recently launched a version of their celebrated healthcare unit trust for US investors. The fund targets predominantly US biotech and health companies, but is managed from the UK.
Overall, with increasing consolidation of the fund industry and the increased preference among large companies for the replication of portfolios, more and more US mutual funds are becoming available to non-US investors. As a result, management techniques across the world are likely to become far more quantitatively driven.
David Masters is with Standard & Poor’s Fund Services in New York