Fund management - flying the flag for the UK

It may not be one of those “see it, feel it, smell it,” industries upon which much of the UK’s economic well-being depends. But, in terms of good, honest wealth-creation, fund management is still a positive gold mine, ranking alongside the textiles or the drinks industries in terms of its importance to the economy.

According to a recent report by British Invisibles, the private sector body concerned with the City’s contribution to invisible earnings, fund management bolsters the UK’s national income by some #2.7bn each year (equivalent to 0.4% of GDP) with #425m generated in overseas earnings.

Unfortunately, like many of the UK’s traditional industries, the backdrop is one of declining profitability with managers straddling a see-saw of threats and opportunities. Strike the right balance and the sector will ride high into the next millennium. Pitched the wrong way, it could hit the deck with a bump.

Although a so-called “invisible” earner, UK fund management has had more than its fair share of visibility of late. First it was hit by the scandal surrounding Peter Young’s alleged mishandling of a Morgan Grenfell Asset Management (MGAM) fund. Then came the brouhaha which attached itself to Nicola Horlick’s untimely and acrimonious departure from MGAM.

With a welter of new challenges set to emerge over the next few years, it is unlikely the industry will ever return to the quiet anonymity it so enjoyed in the past.

A recent survey of the industry by Price Waterhouse revealed that during 1996 UK investment managers suffered their first fall in profitability for five years. Market conditions were strong yet losses were reported for the first time since 1992.

Despite the possibilities for growth – particularly in mainland Europe, fund management is essentially a mature industry with tremendous price competition and fee sensitivity. “Over the last few years investors and agents have realised that they have been paying premium rates for a commodity service,” says Graham Wright a senior manager in Price Waterhouse’s investment management consulting practice.

Fund owners typically pay a pro-rata amount to fund managers – a percentage per u1m in their portfolio. If the market goes up and the value of the fund increases, the fee automatically gets bigger for no more work for the manager. “Fund owners have woken up to this and are now becoming more demanding,” Wright explains.

In these conditions, tight cost controls are vital. Over the last four years costs in the sector have risen faster than inflation. Price Waterhouse found that although some of the cost increases may have been down to improvements in product and service quality, the difference between expected and actual cost was considerable.

This would not matter, perhaps, if revenues were rising even faster than costs. In the short-term, at least, the industry would remain profitable – as it did in 1995. However, Price Waterhouse believes the industry is leaving itself open to competition from new entrants to the market and hostile takeovers.

“The industry appears to be complacent about costs because revenues are rising too. But current profitability is built on shaky ground – it is too dependent on the vagaries of the stockmarket. High cost firms are at risk from European banks and insurance firms eager to buy into the UK’s fund management competence,” notes Andrew Duncan, a partner in Price Waterhouse’s European investment management practice.

Germany’s big banks in particular have been flexing their muscles in the UK arena. Dresdner Bank, the German commercial bank which owns the UK investment bank Kleinwort Benson, recently announced it is looking to buy another UK fund management group. Last year Dresdner paid $300m for RCM Capital Management in San Francisco.

Bayerische Hypotheken und Wechsel Bank (Hypo-Bank) recently lifted its stake in Britain’s Hypo Foreign and Colonial Management from 50% to 65% in a #60m deal while Commerzbank paid #169m to acquire the UK’s Jupiter Tyndall.

Other cross-border deals recently have included Allied Irish Banks’ #101m acquisition of John Govett & Co, CIN Management’s #50m sale to the US investment bank Goldman Sachs and Munder Capital Management of the US’s #33m acquisition of a 49% stake in Framlington.

Overseas acquirors seek size and expertise and such moves are generally seen as a vote of confidence in the strength of the UK as an asset management centre. And it is a two-way street. In 1995, for example, Barclays bought Wells Fargo Nikko Investment Advisors in the US for $440m which brought substantial US passive funds under Barclays’ control.

There has also been some significant domestic reshaping in the sector led by the #800m acquisition of Clerical Medical Investment Group by Halifax Building Society and NatWest’s #340m acquisition of Indosuez UK Asset Management which owns Banque Indosuez’s 75% holding in Gartmore. NatWest then acquired the outstanding 25% stake in Gartmore for #125m. Fleming Investment Trust Management was recently looking to take over the funds of Ivory & Sime.

A few years hence the issue of ultimate ownership will be blurred but there is no room for xenophobia – fund managers will simply be multinational.

Despite the recent rash of bids and deals, Price Waterhouse reports that the UK market remains fragmented with too many players. “The stockmarket boom of 1993 gave some companies an extended lease of life, but the inevitable will not be put off for much longer,” Duncan warns.

Nigel O’Sullivan, an associate with Bacon & Woodrow, also believes the restructuring process still has some way to go. “Fund management is an operationally geared business and, with fees under increasing pressure, bigger units are needed to bring about economies of scale,” he says. Deals in the sector are also driven by the desire to tap into another brand or gain access to wider distribution networks.

“Controls and professionalism in the industry have changed significantly over the last decade. Now it is a global market and a game of large players – UK fund managers must either play in the premier league or not at all.

But consolidation should lead to better fund management and a higher level of service.”

As British Invisibles’ economic adviser Duncan McKenzie points out while there is a considerable drive to reduce costs and find efficiencies there is no guarantee that these economies will be achieved. “This is a potential threat – although not just in the UK, US houses are experiencing the same problems,” he says.

British Invisibles estimates assets of #2,000bn were being managed by UK institutions at the end of 1996. Importantly, of identified assets totalling #1,844bn, a quarter were being managed on behalf of overseas institutional clients and the UK’s track record in capturing new business has been good.

A Europe-wide survey by InterSec Research in 1995 found UK-based institutions that year won 40% of all appointments valued at #21bn. This included two-thirds of the cross-border mandates.

Such success has made London Europe’s pre-eminent centre for fund management and second in the world after Tokyo. The City’s main attributes include a strong international orientation and concentration of investment expertise.

Its liberalised operating environment, set within a regulatory structure that gives protection against abuses, has also been a vital factor in underpinning London’s status as an international fund management centre.

The City shares its time zone advantages as a global centre with the rest of Europe. But, as the British Invisibles report notes, the fact there is no requirement for UK institutions to focus on domestic government bonds has been a key advantage in attracting new business. The UK has particular strength in equities. These account for about 60% of funds under management.

One potentially important source of new cross-border funds is likely to be the development of funded pensions in continental Europe. The UK fund management industry is also set to gain from this year’s introduction of legislation to allow the establishment of UK-based open-ended investment companies (OEITs). These will encourage more funds to establish an administrative base in the UK and may enable UK houses to capture an even greater proportion of the management.

Hitherto, while much of the management of international equities from European mutual funds has taken place in the UK, the investment vehicles have often been established elsewhere – in Luxembourg, for example.

“How funded pensions develop in mainland Europe long-term and where they are managed is an important issue for the UK fund management industry,” says British Invisibles’ McKenzie. “The formation and development of OEITs is also critical. Now the UK will be able to attract the administration, as well as the management, of more Europe-wide funds,” he says.

OEITs are intended to provide a vehicle which is more familiar to continental European investors. The facility for further flexibility through the introduction of umbrella structures, different classes of shares and so on, should also benefit UK managers.

Brussels is also playing its part in the evolution of a pan-European market with the introduction of the second banking coordination and the investment services directives. These both contain provisions allowing the cross-border provision of investment management services within the EU and should also open up considerable opportunities for UK-based fund managers seeking to sell more of their services abroad.

Traditionally, however, the opportunity to bid for mandates to manage assets elsewhere in the EU has been blocked by informal barriers of an institutional nature such as the control exercised by indigenous banks and insurance companies over distribution channels.

The fact that, along with US firms, the UK investment houses have a well-established track record in the measurement of returns is also clearly in their favour when seeking to win new business. This applies particularly in continental Europe, Japan and emerging economies as they develop as markets for fund management.

Now, however, Japan is about to introduce a system in which management companies in Tokyo, both domestic and foreign, will be able to present their performance in a comparable form with holdings valued on the basis of market prices, rather than the original purchase price.

“As Japan becomes more liberalised its institutions will be able to sell their services to pension fund managers on the basis of their defined track record. To compete it is likely that more UK-owned fund management institutions will set up operations in Tokyo,” says McKenzie. “Having a local presence is the key to getting business in overseas markets such as Japan,” agrees O’Sullivan.

But, as Julian Le Fanu, deputy director general of the International Fund Managers’ Association (IFMA), observes, although overseas fund managers have already gained quite a lot of market share in Japan recently it has been from a very low base. “The movement there is generally within the Japanese component of the industry. The big gainers have been the large Japanese securities houses at the expense of the Japanese trust banks,” he says.

Competition to London as a fund management centre from within Europe comes mostly from Switzerland. Zurich is the next largest European centre for fund management after the UK: placed fifth in the world with funds of $411m under management. Geneva lies in seventh place with $264bn. Paris in eight position with $261bn. Frankfurt, with $157bn under management, lies in 13th place just ahead of Edinburgh with $138bn.

According to data compiled by Technimetrics, London has maintained its share of the European market for equity management over the last few years.

Between 1987 and 1992 London increased its share from 32% to 35% – mostly at the expense of the major Swiss fund management centres. London, however, has been losing its share in relation to both Paris and Frankfurt.

“Competition is clearly the biggest threat to the UK fund management industry. It has to be able to show it can give the best service,” says McKenzie. However, he believes the US, with its similar trading culture, is most likely to draw business away from London. “Paris and Frankfurt are not credible alternatives and do not have the innovative trading culture which London has evolved over 200 years,” he adds.

It is generally agreed that US pension funds will continue to invest large proportions – 10% plus – of their funds in foreign markets. The UK is the favoured site for such investment although, as the IFMA’s Le Fanu points out, as the investment policy of US pension funds has become more international and the pool of assets larger, US firms have become more interested in managing them. This has taken some funds back to the US. “But US managers are also increasingly managing the international part of their portfolios out of London,” he says.

However, according to a report on the competitive advantage of the UK fund management industry by the Corporation of London and the London Business School as part of its City Research Project there is a continuing shift from “home” country management – the use of managers in the country from which the funds are derived, to “host” country management – using managers in the country in which funds are to be invested. This reflects the fact that host country managers tend to perform better in their own markets than those in the home country.

Since the UK’s equity market is disproportionately large relative to GNP, the report concludes that the shift to host country managers benefits London-based firms as foreign funds seek UK managers for their UK portfolios.

However, UK funds available for equity investment are also disproportionately large. “London-based firms could be harmed as UK funds look abroad for managers of their expanding foreign portfolios,” warns the report.

When it comes to marketing itself overseas, the recent crisis at MGAM has been a setback for UK fund managers in as much as it casts doubts on the quality of their business management.

But Le Fanu believes UK firms are unlikely to lose overseas clients as a result. “It was a danger that UK houses would all be tarred with the same brush. But since it is less a reflection on the regulation of London and more a case of lack of poor internal management controls at one particular firm, they are more likely to put across the message: ‘We aren’t like them, our style is different’. UK pension trustees, meanwhile, might move from one UK house to another but are unlikely to take their business overseas,” he says.

When it comes to selling themselves on their past performance the return on UK pension funds at 10.23% a year between 1984 and 1993 was higher than in any other European country, except Ireland.

Latterly UK managers appear to have been struggling to get a grip on their global equity strategy. They are seen to be waiting with increasing desperation for the US stockmarket to tumble and vindicate their decision to sell into what remains a soaring market.

Last year many UK pension funds ended up with a bigger exposure to Japan than to the US. Since July, Wall Street has outperformed Tokyo by nearly 50%.

“Last year was a bad period for some UK fund managers. Some have underperformed the indices and some UK pension clients might be starting to get a bit worried. They got the timing wrong – but against managers in other countries they have still done reasonably well,” Le Fanu asserts. “UK managers undoubtedly made a wrong call on the US/Japan equation and were overweight in smaller companies but, generally, they are still ahead of the pack,” he says.

“Every fund manager takes a view on which market is more or less favourable and it may yet come right,” agrees McKenzie. “The UK also gives priority to equity investment which, essentially, is a play based on economic growth as opposed to investing in government bonds. Taken over 50 years this strategy has done very well with good returns compared to other markets,” he says.

Nevertheless, London’s traditional value-based methodologies are seen to have failed it, albeit temporarily. Some observers believe the growth and momentum strategies favoured by many US managers are becoming more influential – certainly on Wall Street itself, and also in the illiquid emerging markets.

According to the City Research Project report, one of the most important distinctions in London is whether funds are managed actively or passively.

London is currently dominated by active fund management techniques, but the importance of passive management is increasing. “Although you pay a lot more for actively managed funds, index-linked tracker funds do just as well,” one observer maintains.

Falling between the two is quantitative fund management. Popular in the US, under quantitative fund management statistical regularities in past stock performance are used to predict future returns.

With their performance and, in fact, the very need for their existence, being called into question; fund managers could also soon be facing repercussions from the introduction of the European single currency. “Fund owners may wish to see their capital invested only in other countries in the single currency zone. However, with its proven international and investment expertise the UK will still be in a position to capitalise on wider investment strategies irrespective of whether it joins the Euro-fold or not,” McKenzie predicts.

“The only sense in which the UK might lose out is in pricing transparency.

But, given London’s history of innovation, this is not likely to be a huge problem,” he maintains. “But it will be interesting to see how things shape up – particularly if the rules around the single currency generally are framed deliberately to exclude the UK.”

London is well placed to maintain its dominance as an international fund management centre and, as further liberalisation takes place, particularly in Europe, to benefit from further growth. With rising competition, however, there will need to be further restructuring and consolidation to refine the resources available, develop more sophisticated distribution systems and provide a better quality of service.

Above all, since any gains by other countries are likely to be at its expense, the UK must banish complacency and continue to foster the dynamism and innovation on which its reputation has been built.

Joanna Gant is a freelance journalist.