The mutual fund sub-advisory business has become more than just the icing on the cake for pure-play asset managers; it is evolving into their bread and butter and their ability to garner - and keep - relationships is the key to remaining viable.

The concept of sub-advising a fund is essentially one fund firm creating a fund and then outsourcing the investment management role. There are brokerages, banks, insurance companies and fund firms that have fully sub-advised fund lineups. "There really isn't a part of the industry that it hasn't touched yet, so the expansion has been dramatic," said John Benvenuto, director of research at Boston's Financial Research Corp. and author of a white paper report on sub-advisory distribution. "More fund firms are embracing these sub-advisors because of the growing acceptance of open architecture," he said.

For example, if a firm wanted to build or repair its reputation for a specific product area such as fixed-income, it could strike a deal with PIMCO, the clear leader in bond offerings. Bill Gross, manager of its $74 billion PIMCO Total Return fund, is the face of PIMCO and would draw plenty of new assets for the primary firm because of his expertise and success in that field.

The alternative to outsourcing is to build from within, which for some firms makes sense, but it often requires a longer time frame to get the right people in place. And in this business, time is money. As a result, a majority of fund complexes are turning to the sub-advisory model in order to remain competitive, particularly amid a prolonged bear market for equities. For many firms, the development of sub-advisory business units has been more reactionary not strategic, FRC noted.

Many managers characterize their sub-advisory outfits as the most lucrative businesses in their entire organization. In fact, profit margins among active portfolio managers range from 20% to 60%, according to the white paper report. But not all fund shops are implementing the same strategy when it comes to third-party advisory agreements. Some groups have up to 20 managers and use sub-advisors across their entire fund lineup, whereas others only need one sub-advisor to manage an area where they lack expertise.

Going the Retail Route

In his report, Benvenuto outlined three specific organizational strategies used to market and distribute sub-advisory services, including the subset of retail, the subset of institutional and a collaboration of both. While each approach has its own merits, the underlying trend that has been developing in recent years is a dramatic shift from an institutional approach to a retail-oriented approach. "Employed by nearly two-thirds of sub-advisory firms, the retail subset approach is the predominant structure in use today," Benvenuto said. That is in stark contrast to its traditional home in institutional, which has dropped to 20% from nearly 100% just a few years back.

A major catalyst for that shift is the increasing need for a sales support team, one that can help market the fund through a wholesaler or advisor representative. A retail-focused firm can provide that support along with business development and client service. They can also help grow the assets by generating sales ideas and positioning the product effectively in some of the fund's distribution relationships.

The firms that have sub-advisory operations housed in an institutional framework are at a disadvantage because they can't provide that retail support. On the flip side, companies that have it housed in the retail side are disadvantaged because they're often not capable of delivering an upfront institutional sales pitch. Still, once that initial sale has been made and a relationship has been formed, even an institutionally sub-advised fund then becomes a very retail-oriented operation. The reason being that sales and marketing support is integral to the success of that relationship.

Some firms choose to have an institutional person head up this business unit but put into a retail subset, Benvenuto said. An example of that would be an insurance company like American Skandia, which packages multiple managers into a product. It uses large mutual fund organizations to get its foot in the door, often with an institutional upfront sale. The next step is to grow the assets of that particular fund with strong support. Striking a balance between the institutional and retail approaches is the key. For most groups, it is going to be defined by the firm, he said.

Pricing in the sub-advisory market will often fall between fees for traditional institutional separate accounts and retail separate accounts, the report revealed. As the size of the account and potential for asset growth rises, pricing falls more closely in line with institutional separate account pricing. Based on that philosophy, one can assume that sub-advised fund accounts have stronger relative growth potential.

The biggest expense borne by fund companies for their sub-advisory unit is compensation, which can run upwards of $350,000 a year for a team of two individuals. A team with 10 to 12 individuals can run as high as $2.25 million on an annual basis. That translates into about 40 basis points in management fees for the firm, as calculated by FRC. In order to cover that hefty price tag, the firm must amass a sizeable amount of assets. The other major expenditure is the cost of marketing.

Despite the robust growth in the sub-advisory market in the last few years, FRC recommends exercising caution in this area. "While revenues are cleanly identified, costs are often spread across an organization, thus artificially inflating the true margins associated with the sub-advisory business." In the end, the key to a successful sub-advisory business is being able to recruit talented money managers and deliver the necessary sales support to grow the business and foster strong relationships with investors.

Copyright 2003 Thomson Media Inc. All Rights Reserved.

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