Should One Size Fit All Managers?

Barclays Global Investors. Citigroup Asset Management. FRM. Ignis. Remember them?

Once mainstays in the global asset management industry, these names have been merged into or acquired by larger companies. The thirst for consolidation in this industry seems unquenchable—and there is no end of targets.

A report from Moody’s in December said 2015 was destined to be a bumper year for mergers and acquisitions in global asset management. Regulation, fee pressure, and a move towards passive investing were supposedly forcing smaller managers to take shelter in the arms of their larger brethren.

Yet similar reports were written in 2013, 2011, and 2009, and the number of managers remains largely the same. Why?

“It is a very fragmented industry,” says Stefan Dunatov, CIO of the UK’s Coal Pension Trustees. From the dozen or so asset managers with more than €1 trillion under management—only a handful of which are based in Europe—there is a quick drop off to the mid-tier companies.

“In spite of the talk of impending consolidation, it never actually happens,” Dunatov continues. “As soon as one asset manager is bought by a competitor, another springs up in its place.”

“People like to own what they do, so they create new firms. Investors are sure they can find alpha and skill, so they go looking for them.”
—Stefan DunatovFor every acquisition—BNY Mellon buying Cutwater Asset Management, Schroders buying Cazenove Capital, Natixis buying DNCA—there are new boutiques springing up. Somerset Capital, Ardevora Asset Management, Woodford Investment Management, and TwentyFour Asset Management have all launched successfully in the UK in recent years. (Having an imaginative name is evidently not a priority when starting out on your own.)

The companies being acquired tend to be more established firms with multiple asset classes in their product range (think Aberdeen’s acquisition of Scottish Widows Investment Partnership, or Standard Life’s purchase of Ignis Asset Management), while the new boutiques specialise in a narrow field of expertise, usually because they are launched by fund managers moving out of the behemoths.

“People like to own what they do, so they create new firms,” Dunatov says. “Investors are sure they can find alpha and skill, so they go looking for them. It’s both supply and demand-driven.”

Art by Bill Mayer

In his view, “the market structure of fund management is evolving.” In the years ahead we may see an industry dominated by a “Big Four” or “Big Six” as is the case in other financial services sectors, Dunatov argues, “with a lot of companies in the middle and a very long tail of very small companies, with large amounts of turnover.”

What it might mean for institutional investors? Given the choice, what would you prefer: Behemoth or boutique?

Size isn’t everything. Investment process, track record, manager conviction, and several other factors will come into the mix before investors consider a company’s scale. But far from being irrelevant, the size of a potential asset management partner is definitely part of an asset owner’s assessment and due diligence work.

For Stefan Ros, CIO of SPK, Sweden’s pension fund for the banking sector, having a larger entity running a mandate has several benefits.

Firstly, there is the obvious advantage of greater support for the individual fund managers. “It is important they have internal resources so they can achieve what they want to,” explains Ros. “For example, a global equity manager requires more resources: you wouldn’t want just one person sitting in an office doing all the analysis from his desk—it wouldn’t be credible. But for a smaller regional manager, it could be.”

The benefits of scale are not just limited to a pension’s existing mandate, however.

“We are quite a small organisation, so our relationships with fund managers are very important to us,” Ros says. “If we have a large fund manager running a specific mandate, then we are also interested in other areas: other asset classes, capabilities, and services—for example, producing analysis or asset-liability matching.”

Tolu Osekita agrees. The former CIO of the Northamptonshire and Cambridgeshire pension funds also believes making the most of relationships with big asset managers is important, particularly to smaller pensions.

“We ran a small in-house investment team, which meant we had to leverage our external relationships to get research done—you can only do that with big firms,” he recalls. “We were looking at smart beta a couple of years ago: we didn’t want something off the shelf; we wanted to build our own. We couldn’t have that conversation with small boutique managers, but with our large firms we could sit down to ask them to run an analysis and build a report.”

Scale can be important for particular asset classes or investment strategies, Osekita adds. For passive management, a large firm like Vanguard with more than $3 trillion (€2.7 trillion) in assets can bring efficiencies to its index-tracking funds as well as participating in stock lending as a trusted provider. The benefits are then passed on to clients in the form of ultra-low fees.

The same goes for illiquid asset classes, Osekita argues, where “size is an advantage because you get better deals, which often lead to better returns”.

“With liability-driven investing it’s a similar story,” he adds. “Size matters because you’re buying an off-the-shelf product, and it needs scale.”

There is also the IBM factor: “You don’t get fired for buying IBM”, as the saying goes (even if the tech giant’s stock is down 17% in the past 12 months).

“With a large manager, there is more certainty that the company you’re employing will still be there in five or ten years,” says Jeff Levi, partner at consulting firm Casey Quirk. “If you have a strategy reliant on large managers you can get access to a lot of resources, and create tailored mandates.”

However, not everyone buys the resources argument. Chetan Ghosh, CIO of the Centrica Pension Schemes, claims the expansive compliance, IT, and legal teams of the biggest groups are “a luxury.”

“Compared to what you want from your manager—returns—the company infrastructure can’t be a driver of your selection,” he says. “Even when you’re selecting a manager to just get beta exposure, the same argument applies: you wouldn’t just pick a large manager for the scale. You can look for better beta than that.”

Dunatov flips that argument around, agreeing that larger companies have greater compliance and legal resources, “but they often don’t have the best people managing the funds. But how much does that actually matter?”

Stability, reduced costs, access to intellectual capital—the big boys certainly have their distinct advantages. So why are there still so many boutiques?

The answer may be as simple as alpha generation. While scale is certainly an advantage for a passive manager, the bigger an active fund gets, the harder it becomes for the manager to outperform.

“Managers of smaller firms have the hunger to do well, and their interests are seen as being more aligned with those of the firm as it is their own neck on the line.”
—Dunatov“All things being equal, for active mainstream assets a smaller manager with focus and conviction tends to outperform over time,” says Osekita. “At Northamptonshire and Cambridgeshire, our best performing manager was one we seeded from scratch, and it outperformed every other manager in the portfolio consistently for 10 years. There is definitely a lot of evidence pointing to an inverse correlation between size and performance.”

Another important correlation at boutique managers is between their own success and the success of the client. Centrica’s Ghosh prefers to use boutiques and smaller managers for this reason.

“We have found that, for continuity, it is better to stick with boutiques,” Ghosh says. “A lot of the larger firms don’t have the remuneration or packages that are sticky enough to make the good managers stay. I thought these firms would find a way to keep the managers that they considered to be crucially important, but a recent case at one of our managers proved it wasn’t the case.”

There are reasons other than remuneration why managers flee behemoth groups for something smaller, of course—Bill Gross being case in point. But for the most part, emerging and boutique firms’ compensation schemes work to asset owners’ advantage.

“Often these smaller firms are run by managers who have left larger firms,” Dunatov adds. “They have the hunger to do well, and their interests are seen as being more aligned with those of the firm—and by extension, the clients’—as it is their own neck on the line.”

Casey Quirk’s Levi believes alignment of objectives forms part of an asset manager’s overall credibility, along with investment strategy and the communication of its process. “This is where size comes in,” he says. “When you talk to large firms you might be really far away from the centres of thought and research. At smaller firms, there is often a sense that you have access to the entirety of the business. The mandates often mean more as well, so they will do more for the client.”

However, small firms—and in particular startups—cannot always cope with sizeable mandates from larger asset owners. Splitting a big equity allocation between several small managers is an option, but as Dunatov queries, what would a large number of small mandates do to an overall portfolio, even if they do outperform? “Do they move the needle? That is certainly a factor for consideration,” he says.

Scalability was one of the factors cited by Ted Eliopoulos, CIO of the California Public Employees’ Retirement System (CalPERS), when announcing his intention to wind down its hedge fund allocation. Few European funds can match CalPERS’ $300 billion (€272 billion) of assets, but at any size, asset owners would hope that their managers can at least keep pace with the growth of their overall portfolio.

“The decision is not necessarily between the behemoth and the boutique—you want a blend in your portfolio,” says Osekita. In general, he says, smaller managers are better placed for mainstream alpha-chasing active mandates, while larger managers tend to be preferable for passive strategies, smart beta, or illiquid alternatives.

There is, of course, a third way. Centrica’s Ghosh speaks positively of the “multi-boutique” structure favoured by the likes of BNY Mellon, Hermes, Natixis, Affiliated Managers Group (AMG), and BNP Paribas. Often in this model, specialist groups are allowed to operate autonomously but with the back office support of a larger firm. AMG in particular keeps a low profile despite its stakes (sometimes minority ones) in smaller, top performing operations such as AQR, Veritas, and Pantheon.

“The decision is not necessarily between
the behemoth and the boutique—you want a
blend in your portfolio.”
—Tolu Osekita“There is an increasing trend of skilled managers heading towards multi-boutique set-ups,” Ghosh says. “That way they are direct owners, but with a certain security. In these set-ups, we feel it is less likely the firm will suffer a ‘corporate event’ and have a key manager leave. Happy fund managers—with a stake in the direction of the company—are more likely to stay.”

It is becoming “more important to have a minimum size” for asset managers, particularly in the alternatives space, according to Casey Quirk’s Levi. He points out that some of the largest operators in alternatives are the big global firms such as BlackRock, PIMCO, and Goldman Sachs, which are not necessarily well known for those capabilities. As a result of the growing resources of these companies, “traditional players in the middle ground are getting squeezed out”, Levi says—echoing Stefan Dunatov’s prediction of the future shape of the asset management landscape.

Evidence is mounting that the biggest managers are getting bigger. Aberdeen’s acquisition of Scottish Widows Investment Partnership has created an £84 billion group (€114 billion), the biggest in the UK, according to data gathered by the Investment Association, an asset management trade group.

Separate data from Preqin on private equity, hedge funds, and unlisted real estate has shown that funds in these areas are on average getting larger. The bigger, more established names are raising ever more capital at the expense of smaller or mid-tier players. Blackstone’s Real Estate Partners VIII fund closed in the first quarter of 2015 having raised a record $14.5 billion. The previous record of $13.3 billion was also held by Blackstone.

This dominance by larger groups may be a reflection of the IBM effect, but whatever the cause it is most certainly not the whole story.

As SPK’s CEO Peter Hansson explains, “there is an art” to selecting fund managers—“it’s not a machine that can output who to invest with.” There are multiple factors to consider, not least the context of the individual asset owner, and choosing the right fit can take months of work and hours of meetings.

“The point not to forget is that this industry is built on greed,” says Dunatov. “People think they should be looking for alpha and others think they can provide it.”

“People are always chasing skill, whether it is there or not,” he concludes—and this can apply to any fund manager, boutique or behemoth.

—Nick Reeve & Elizabeth Pfeuti