The search for that perfect subadvisory match

As institutional asset owners demand more outcome-oriented solutions, money managers increasingly are seeking out specialty or niche firms to help them subadvise their assets.

This, along with increased scrutiny from the U.S. Securities and Exchange Commission, chief compliance officers and asset owners, has led to a more intense due diligence process when setting up subadvisory deals, managers on both sides of the table say.

And, they said, money managers looking for — and looking to provide — subadvisory services also are working to create more collaborative relationships.

“There's so much creativity out there and such a sea change in creatively co-designing solutions as opposed to fitting in a style box. It's a big change from before the crisis,” said Barbara A. McKenzie, a senior executive director and chief operating officer of boutique operations at Des Moines-based Principal Global Investors. Principal subadvised $144.7 billion in assets at year-end 2013.

“Things are becoming more complex. Investors are expecting more from managers,” said Davis Walmsley, a consultant at Greenwich Associates, Stamford, Conn.

“Institutional investors are struggling with conflicting needs,” he explained. “On one hand, they're seeking to diversify and take risk off table. On the other hand, many are underfunded and seeking alpha to get these funds back in a funded position.”

So, asset owners are looking for a manager “who can pull together a more holistic solution for them” to provide the diversification and protection against risk that they need, but to also “get them the returns that achieve their funding objectives,” said Mr. Walmsley.

As a result, managers looking to provide these more complete solutions to their clients need a subadviser or subadvisers “to fill in some of the gaps within their products,” said Mr. Walmsley.

Because of an increased need for a more collaborative partner or partners, the due diligence process for selecting a subadviser has gone beyond performance and history. Money managers, Mr. Walmsley said, are “looking at the firm's underlying philosophy and who's in the team.”

Scott Herrick, director of national marketing and client service at money manager Becker Capital Management Inc., Portland, Ore., agrees.

“The due diligence process seems to be a lot longer than it's been in the past,” said Mr. Herrick. Becker Capital, a boutique manager that has a total of $3.2 billion under management, about $290 million of which is as a subadviser.

“The focus has gone from a product level review to include an overall corporate assessment,” Mr. Herrick added. “With what happened with Bernie Madoff, no one wants to look like they're not doing their due diligence.” (Mr. Madoff in 2009 pleaded guilty to fraud charges connected to operating a Ponzi scheme.) Managers seeking third parties to manage some of their assets “are very interested in protecting their clients from any potential conflict.”

“The due diligence process has become more intensive over time as there's greater focus than ever on not only finding great people, but also (looking into the) risk, trading and compliance side of things,” said Dan Newhall, a principal in Malvern, Pa.-based Vanguard Group Inc.'s portfolio review department, which looks into potential subadvisers.

When Vanguard seeks a subadviser, Mr. Newhall said that the firm looks at both the firm and its environment. His team wants to know if the potential subadvising managers' investment philosophy is aligned with the interests in Vanguard's clients, whether it's a firm that's been around a long time and will remain around for a long time, and if it has a high-quality client base and reasonable mix of strategies.

Although extensive due diligence has always taken place, he said, there now is greater scrutiny of trading, risk and compliance considerations as a result of growing requirements from the SEC, chief compliance officers and boards of directors.

Vanguard, which hired other money managers to run about $456 billion in assets as of Dec. 31, is the biggest user of subadvisers, in Pensions & Investments' database.

Scott Ebner, a senior managing director of State Street Global Advisors and global head of product development and research in the global product and marketing group, Boston, said that when looking for a subadviser, SSgA looks both “for skill and reputation.”

Mr. Ebner noted that the recent growth in its subadvisory business has been substantial because clients have been seeking more solutions- and broad-based services from subadvisers.

SSgA, which both provides and seeks subadvisory services, subadvised $178 billion and passed along $5.17 billion in assets to be subadvised at Dec. 31.

Jack O'Connor, head of business development and client service at subadviser DDJ Capital Management LLC, Waltham, Mass., which subadvised $2.99 billion at Dec. 31, said he's noticed “a greater focus on the investment team's background as we go through the due diligence process. Not just past work experience, but really trying to get to know the team on a more personal level.” This includes looking into who their mentors early in their career were and what experiences helped develop their investment style.

Jim Kwok, a managing director at J.P. Morgan Asset Management in Chicago and head of its subadvisory business for the U.S. and Canada, explained that managers that hire JPMAM as a subadviser “are increasingly looking for who has a deep, global platform. It's important that you can do all of the different asset classes in all of the categories. That means you have to have, not necessarily size per se, but scale.”

Mr. Kwok also noted that another “new thing we're seeing this year is that (firms hiring JPMAM) are thinking very hard about how to allocate to fixed income.”

Since achieving high levels of income while also preserving capital is an obvious challenge, Mr. Kwok explained that many firms are looking to hire subadvisers to help them figure out how to do both at once.

Mr. Kwok added that he's also seeing the managers “recognize the need for more emerging market and international representation.”

JPMAM subadvised $81.78 billion at the end of 2013.

Mr. Walmsley also noted that Greenwich has seen a trend where institutional investors are “looking for more managers that have expertise in specialty niches.” This is causing some managers that might not necessarily have certain in-house capabilities to establish subadvisory relationships.

Hiring a subadviser, said Vanguard's Mr. Newhall, “opens up the talent pool for us in contrast to us building it in-house, gives us more access to a greater variety of firms, people, practices and products.”

Mr. Newhall added that it can “improve the diversity of thought” and avoid “"group-think' risk.”