Fund of funds structure triumphs

Views on manager of managers are bifurcating. There’s growing disillusionment with a number of the generalists, who have been notching up a noxious combination of poor performance and high fees. They risk losing institutional clients who understandably feel peeved that they are often getting below index returns with the extra fees that are associated with the asset class. But there is a growing interest in specialised manager of managers who can offer access to the more impenetrable asset classes such as private equity, hedge funds, venture capital and property.

That latter trend is driving growth in the industry. Last year saw net inflows of £680 million or nearly double those of 2004 at £353 million, according to the Investment Management Association. That’s still small beer. Andrew Twells, partner in Barnett Waddingham’s Amersham office, estimated that less than 5% of UK pension fund assets are invested via manager of managers. That could increase to between 10-15%, he predicted in the mid-term, more in line with levels in the US, South Africa and Australia, where the strategy is more established.
That growth is unlikely to come from generalist mandates. Initially, it was small pension funds without the in-house skills to select managers that went down the manager of manager route, according to Ian Burton, senior consultant at Mercer Investment Consulting Business. They were driven into the arms of these managers in part by the Myners Principles, which recommends that only those with sufficient skill and expertise select managers. And compared to using consultants, manager of managers can work out to be cheaper for small funds, pointed out Twells. Typically, consultants charge some £20,000 per full manager review in each asset class with smaller pension funds often needing seven or eight reviews. Manager of managers charge 20-30 basis points of the fund’s assets on a yearly basis.
In theory, using a manager of managers approach should work well for these funds. By selecting best of breed managers across a range of diverse styles, they should offer diversification and above average returns. Furthermore, manager of managers are able to hire and fire managers much more quickly than would be normal for small pension funds and are sophisticated enough to fire managers not just on the basis of performance but for sins such as style drift or seeing a key investment team leave, said Twells.

Keeping Close Tabs
Not only that but manager of managers can keep a beady eye on their selected managers with direct feeds from the custodian to tell them what investment managers have in their portfolios, added Burton. “In one instance, a manager of managers called up a value manager and queried why they had bought a growth stock. That level of attention is not feasible for a pension fund,” said Burton. Pension funds that retain manager selection typically go through the palaver of annual reviews, short-lists and beauty parades before changing managers and are hampered by having few investment experts to make those decisions.
But the bottom line is that recent performance has been mediocre. It has been damaged by weak UK equity performance, still by far the biggest allocation for most UK funds. Many of the small pension funds that chose the manager of manager route are growing disillusioned. Some are reconsidering their allocations to manager of managers, said Burton.
Jane Welsh, senior investment consultant at Watson Wyatt Worldwide, said that some manager of managers use a combination of over-diversification and a roster of only so-so underlying managers that could lead to long-term underperformance. “If the manager line up’s only OK, the extra fees will ensure the returns are mediocre.” Burton agreed and added that mandates that are not sufficiently differentiated. “If you combine fund managers with similar mandates, for example to provide moderate outperformance over the FTSE 100 index, you’re unlikely to produce significantly different returns.”
And there’s another problem. Just as in funds that invest directly in equities, the seeds of disaster are sown with success. Manager of managers that win too much new business have difficulty placing monies with their preferred managers and end up investing it with second class managers, argued Welsh. Add in the extra layer of fees and it’s no wonder that they fail to add alpha. If underperformance is not turned round, smaller pension funds are likely to return to passive investing. If that happens, it may be some time before they are persuaded to believe that any active manager can really achieve sustained outperformance. For now, manager of managers are likely to benefit from the slow speed and reluctance to fire managers that marks pension fund investing, which may give them time to put right the performance issues, but they are unlikely to win much in the way of new monies.

Good Reasons for Specialist Funds
If underperformance is putting a dampener on generalist manager of managers, consultants have considerable enthusiasm for their specialist brethren. They appeal to bigger, more sophisticated funds and typically invest in hedge, private equity, venture capital and property.
The reasons for their popularity are clear. These asset classes are more complex and require a greater sophistication and knowledge. Few pension funds have the resources to research them thoroughly. Even if they can research these esoteric areas, manager of managers have developed deep relationships with the most successful funds and the volume of their business means that they are more able to gain access to them. Finally, the spread of returns from these assets is usually far wider than that generated from equity and bond mandates and justifies the extra layer of fees associated with the asset class, argued Welsh.
Mercer has also seen its mid-sized client base use manager of managers to gain diversification in areas such as the Asia Pacific region, Japan and emerging markets, noted Burton. “The growth in this industry is going to come through managing larger schemes and offering a broader array of products,” he said. Twells believes that these manager of managers will benefit as pension funds increasingly divide their assets into a safer, asset liability-matching pot and an active one.
And there are areas that are ripe for further exploitation. Manager of managers should be offering tactical asset allocation, currency exposure and property. Clients now see these areas as capable of producing additional alpha for portfolios and want to capture that upside. But manager of managers have proved frustratingly slow to meet that challenge, claiming they don’t yet see the demand. “It’s the chicken and egg argument,” said Welsh. “Manager of mangers say that they need to gain sufficient size and need to see investor appetite to offer these new products.” Burton agreed that these strategies have been neglected and predicted that the first successful movers in this area will have a strong advantage.
Despite the potential, there have been relatively few new entrants. One reason is that investment managers fear going into competition with the consultants who direct business their way. The cost of establishing a business and the need for long track records in the institutional space presents a relatively high barrier to entrance, Welsh added. So most of the new manager of managers are boutiques, such as Bramdean Asset Management and MM Asset Management (formerly Attica Asset Management) and Close Finsbury Asset Management (which took over Escher UK Asset Management).
It is becoming clear who the winners and losers are in the manager of managers space. Those offering strong, niche products in areas requiring specialist knowledge are likely to capture an increasing amount of larger funds’ allocations. The generalists that cannot produce consistent returns will have to shape up or ship out.

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