Multi-managers may not have lived up to their hype over the past three years but smaller boutique funds are promising to come to the rescue
Multi-manager offerings have become a major product fad of the financial industry over the past three years, yet their record of performance generation and asset gathering has been relatively poor to date.
Launched into the vacuum created by the death of with-profit funds, the multi-manager product was, by conventional wisdom, the must-have accessory for any self-respecting fund management house. It was believed that IFAs would no longer wish to be held accountable for investment choice and, at the time, there was an unprecedented proliferation of fund choice and a wayward stock market.
To maximise perceptions of the products as being relatively safe, funds invested in by these products have principally been the larger brand name funds.
However, expectations of success for the sector have been disappointing. Its performance record is lacklustre and assets have been difficult to gather. The trumpeted success of some of the better known offerings have been achieved through in-house seed funding, outright buying of assets or covert purchase of assets through loss leader terms of business.
The orthodox view on this sector is less optimistic and providers console themselves with the thought that while new investment flows may be hard to generate, the investment stays forever. The product is thought to have a high valuation because of the durability of the revenue stream, and the expectation is that the next stage will involve consolidation and cannibalisation for the sector.
But this sector can and should have a vibrant future. Its lack of current success stems from the negative criteria that have dominated product design. Funds have been designed as a marketing concept, rather than as added-value investment tools. Reliance on big brand names has resulted in no real added value to the client or to their adviser.
Multi-managers have a bright future by realigning their portfolios as high performance vehicles with meaningful exposure to boutique funds or in providing specialist high performance portfolios. Their expert knowledge and due diligence can then add value to their product proposition. Total expense ratios (TERs) can be reduced for the core of the portfolio by exposure to low-cost trackers or ETFs. In specialist high performance portfolios, TERs are not an issue.
Multi-manager products suffer from high TERs when performance is modest. Most funds have bought large household name funds, diversifying to around 15 funds and relative performance has been lacklustre. As a result, multi-managers have applied brutal discount policies to buying funds.
This has locked many fund of funds (Fofs) providers into dealing only with the houses able to accept such terms. These are either larger houses or funds where performance potential is of an index plus nature. The smaller funds and firms that offer demonstrably greater performance are not usually accessible to the multi-manager as they are generally unable to operate at such reduced terms.
Incorporating exchange traded funds (ETFs) or low-cost trackers into a generalist multi-manager offering reduces the TER, maintains current performance potential for that element and allows managers to select high performance funds to add value to the portfolio.
In specialist multi-manager offerings where high performance mandates are sought, such as Credit Suisse's offering, TERs are not an issue. Diversifying through large funds all too often results in what can be described as "diworsification" to index-matching performance. Multi-managers have been locked into diversifying away performance potential such that their funds achieve index characteristics.
A portfolio of 30 non-correlated stocks theoretically eliminates stock-specific risk. Most of the boutique managers favour portfolios of around 50 stocks.
Because of limits on stock holdings within funds and investment houses, larger funds are forced to proliferate their stockholdings or move up the size scale of companies. As a result, the larger the fund, the more it takes on index characteristics or greater risk of the manager having to generate performance.
Multi-managers generally hold 15 such sub-funds and often attempt to use non-correlating sub-funds to reduce risk. With a portfolio of boutique funds, the multi-manager would theoretically have exposure to 750-1,000 stocks. Within that, there are likely to be significant weightings in small- to medium-sized companies, if these are driving market returns.
With a portfolio of large household name funds, the multi-manager theoretically has exposure to about 3,000 stocks, with minimal weightings to the small-and mid-cap market. Although there will inevitably be some overlap of shares held in the overall portfolio, the problem is exaggerated when dealing with the larger funds.
Smaller funds have greater performance potential than their larger competitors. They are able to gain access to the universe of stocks in the hunt for performance. But this is not the case with bigger funds, where performance, if generated at all, comes from significant sector bets within a more restricted universe of the larger firms.
Where larger firms operate small funds, the dynamics of marketing budgets and business momentum leads to the fund becoming too big to handle efficiently. To maintain their performance reputation, larger fund houses find themselves forced to launch funds operating in areas not favoured by the bulk of their existing funds. As a result, their high performance funds tend to operate on highly restrictive mandates or are reliant upon a single cyclical event. Focus funds and style funds are a clear example of this trend.
Conversely, the smaller firms, or boutiques, are able to offer funds with a wider investment remit that allows them to take advantage of the stock market's changing fortune.
The FSA's ruling on advertising will result in making it more difficult for investors to gather details of relative performance. Enforced discrete period analysis in advertising favours managers able to move rapidly between sectors and stocks.
As freedom to manage efficiently is a factor of liquidity, smaller funds will enjoy a better liquidity profile, even with significant individual stock weightings within the portfolio. As high new net inflows compared with existing asset bases can be useful to counteract absolute losses and enhance lucrative positions, boutiques hold considerable advantages over big funds.
Additionally, as investors become starved of relative performance information, absolute performance will become of increasing importance. In this area, index funds and closet index large funds will operate at a competitive disadvantage to boutique funds. As a result, intermediaries will be more mindful of future performance potential in bought funds, again strengthening the appeal of boutique funds.
Jamie Campbell, Fund Partnerships