Sub-advisors facing increased competition

(April 2006) The drive toward lower MERs and overall costs may be benefiting investors, but it has ravaged the third party sub-advisory industry, according to the latest research from Investor Economics.

Between December 2001 and December 2005, the number of fund companies using sub-advisors dropped 34%, from 94 to 62. The number of long-term funds employing these advisors also declined, from 704 to 524, or 25%. Over the same period, the number of companies offering such services declined from 183 to 160, a decline of just 12.5%. Clearly, the market is becoming more competitive.

That increased level of competition has resulted in a game of take-away, according to Investor Economics Insight. Since the bear market ended in 2003, between 11% and 13% of funds have seen changes in management each year.

Fortunately for the sub-advisory industry, transfers to in-house management have accounted for only 2-3% of the 13% that changed. About 5% of funds switched from in-house to external, while another 5% switched from one external manager to another.

“Commitment to external management does not mean commitment to a particular external manager,” the report says. “The greatest number of changes last year — 114, or 40% of the total — involved a shift from one sub-advisor to another.

“Not only are there fewer mandates to manage, but also most if not all long-term inflows have gone into in-house managed funds,” Insight notes. The reason is simple: investors have been increasingly opting for mutual fund offerings from the banks, which generally prefer in-house management to rein in costs.

The poor sales performance of the core equity fund groups — Canadian, international and U.S. — has also cut into the sub-advisors’ business, according to Insight, as nearly three-quarters of externally managed funds belong to these categories.

Since 2001, in-house managed funds have posted positive net flows, with annual sales exploding to $24.5 billion by the end of 2005. Externally managed funds have lagged for the past four years, with net redemptions in 2003 and 2004.

Net sales from 2001 through 2005 totaled just over $5.8 billion for sub-advised funds, compared to nearly $61.3 billion for in-house managed funds.

While external sub-advisors have matched in-house management over a one-year period, with a cumulative annual growth rate (CAGR) of 17.8% (compared to 17.9% among in-house funds), their longer term performance has lagged. The three-year CAGR for external managers falls to 11.5% — which isn’t shabby, but falls well short of the 17.3% return posted by in-house managers.

“In-house funds have dwarfed externally managed in terms of development,” says Insight. “Two-thirds of the funds launched last year are managed in-house. Only 20% have sub-advisors.”

Still, external managers have done well in the area of specialty funds. Among high yield bond funds, sub-advisors outperformed in-house managers, with three-year returns of 13.3%, compared to 7.2%. U.S. multi-cap funds also benefited from external managers, presumably U.S.-based, with average three year returns of 7.1%, compared to 4.4%.

The authors of Insight point out that contracting management out to a sub-advisor is most common among smaller fund companies, allowing them to concentrate their efforts on distribution.

At the end of 2005, there were five fund companies that relied entirely on external management, although with Industrial Alliance’s takeover and restructuring of Clarington Funds, the list has fallen to four. The largest of the remaining four is Northwest, with $1.8 billion in assets (again, as of December 2005).

Of the larger fund companies, AGF ranks the highest in its use of external managers, with 39% of the assets out-sourced, followed by Desjardins at 33% and IA Mutual Funds at 32%. The largest dollar value allocated to external managers comes from CI Investments, which has outsourced management of $13.7 billion, while RBC uses sub-advisors for $10.2 billion in assets.

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(04/01/06)