Boutique Fund Managers: Survival of the smallest

It is said that the best insurance policy you can have is the one you never use, implying that you have done well if you never have to worry about the conditions that pay out on the policy.

And for those staring at double digit negative returns on their investments, they may argue that the best investment process is one that doesn’t have to be tested in a steep and protracted downward market.

Yet bear markets are an inescapable part of life and while most managers aren’t trumpeting their success in the past year, some boutique managers see the current climate as the perfect time to demonstrate the benefits of investing with a smaller manager.

Wavestone Capital principal Ian Harding believes 2008 was the year of testing for the process and character of boutique fund managers.

Harding, who previously worked at Colonial First State and started Wavestone nearly three years ago with former CFS staffers Graeme Burke and Catherine Allfrey, said his group saw last year as the best way to stress test their investment process.

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“We saw the advantages of trading through the market downturn to enhance our track record as a boutique manager, and at the end of last year it became clear we had done better than we thought with a high level of alpha generation,” Harding said.

Wavestone clients also seemed to appreciate the benefits, with none redeeming funds to date and Challenger buying a 27.5 per cent equity stake in the long/short manager half-way through last year.

Quick movers

K2 Asset Management head of distribution Andrew Hall believes the current environment is where managers with differing styles will work best. K2 also runs a long/short fund and Hall said the past six months have worked in the manager’s favour.

“We have been able to differentiate ourselves from long-only managers, and returns on a relative basis have been good. We have also been able to promote ourselves as a manager that is empowered to make tactical moves to protect assets and can make those moves quicker,”he said.

While Wavestone and K2 have some longevity in the market, Bennelong Funds Management launched an Australian equities fund into the market in the last quarter of 2008.

Bennelong chief executive Jarrod Brown said the group has been managing private funds since 2002 and should not be regarded as a start-up but rather an incubator of boutique funds that operate under the Bennelong brand.

Under this model, funds and their managers are supported with the necessary infrastructure to bring the product to market, and Brown said the commitment made to the fund is typically within the five- to 15-year range.

“Given that approach, our kick-off date is almost irrelevant to our creating a viable long-term business, and this has been our sales pitch to asset consultants and researchers,” he said.

“We have not had a drift to larger managers and we are encouraged by the interest and noise around our funds. At the same time, we see the same peer set when we compete for funds, which indicates our process is right and the flavour for boutiques continues.”

Closer scrutiny

However, according to Brown, boutique managers are being asked more questions at a deeper level than this time a year ago, focusing on the capabilities of the manager.

“Boutique managers across the board are being questioned closely, unlike anything that has happened before. That is not to say their appeal has diminished; they are still sought after for alpha generation but due diligence has gone up a notch, mainly to ensure the level of comfort of those investing. This has been healthy for us but probably has been challenging for those without the capability to endure a tough market,” Brown said.

Solaris Investment Management executive director and analyst Sean Martin said the boutique story has not been hard to sell and his organisation has received a positive hearing, which he attributes to maintaining investment fundamentals.

“In down times there will always be a focus on performance, but with the added question of whether a manager is only a fair-weather player. We like to be tested and we did well because we maintained the good fundamentals which this team was known for while they were at Suncorp,” Martin said.

Bellwether Partners chief investment officer Bruce Bell said while boutiques will retain their appeal for investors “it would be foolish not to accept that the boutique funds management model will come under more scrutiny”.

Bell’s clients are high-net-worth clients and the manager has about $20 million in funds under management, so he is aware of the need to provide the right messages to current and prospective clients.

“We have not changed our messages to clients, who have been with us for a while, and we have spoken to each of them to give them that opportunity to ask questions,” Bell said. “We have emphasised that we would not be distracted by the noise and flashing lights and have maintained our discipline and focus.”

Bell said he is not seeing signs from his clients of a desire to shift to larger managers and attributes that to a track record within the boutique as well as not linking the process to an ‘inspirational’ individual.

He cited the real-life case study of Bellwether losing its portfolio manager two-and-a-half years ago but being able to proceed in his absence and with his successor because of the underlying process.

Martin said this was the same message Solaris was passing onto clients in the closing months of last year, emphasising that experience counts and the benefits of having a management team that has been through a downward cycle in the past.

And, like Bell, he also saw the benefit of the investment team having a stake in the game via an equity interest in their own business.

“An equity stake is an effective way to ensure you do not get distracted by other issues and boutique managers who have similar structures to this have done well because they could not afford distractions in 2008,” Martin said.

Building in longevity

Brown regards this issue of financial backing as linked to longevity and survival and said that when Bennelong was building its model for boutiques it believed they needed backing to be viable in the long term.

“Questions are being asked about the long tail of boutique managers and who will survive, and we believe backing is the issue because there is a difference between a small team and a small team with backing,” Brown said.

“The barriers to entry are higher than some first perceive and investors, asset consultants and researchers are looking at how committed boutique managers are. It is a process we have gone through as well as an incubator, and we have seen some unreasonable expectations which we have had to pass on.”

Bell also sees new boutique managers struggling to break into the market at present and believes it is inevitable that some will struggle and fail.

As a genuine boutique manager he stated that new boutiques will need an injection of funds from high-net-worth investors, and despite running lean will have to reach a break-even point early in their development unless they can attract clients that have a high level of conviction in the capability of the boutique manager.

Boutique or burnt out?

But the same criteria that will make or break new managers are also likely to benefit existing managers, with Bell seeing a slowdown in the launching of new boutiques.

“There has been a bubble that has since slowed down since more managers have been reviewed and we should expect some changes in mandates within the boutique funds sector. The focus will be on how the investment team works and on consistency. If a manager can’t demonstrate that, they will probably struggle in the long term because as a boutique you live on what you kill,” Bell said.

Wavestone’s Harding also foresees a tough future for boutiques, saying there are too many and some were sub-scale before the stock market dropped, a situation Wavestone chose to avoid by partnering with Challenger.

Yet he questions business plans that need three to five years before the manager is successful but do not have any indication about the resources or partners involved to sustain an operation for that length of time.

“Established boutiques and those with credibility can service and attract new money, even in this environment. But many others may just end up burning their cash, and doing well in this market will count for much more than during a good market,” Harding said.

He believes those managers who come unstuck would do so because they focused only on profit and loss positions of their underlying investments and not the cash flow and balance sheet positions. He sees this as the fracture point where the gap has opened between fund managers who focused only on potential investments in the bull market but are unable to offer capital preservation in the bear market.

Yet is it likely that one of their peers may fall over or succumb to the pressure and shut up shop?

Harbridge Investment Partners managing director Jenni Harding doesn’t believe any failure will come about as a result of breaches of the capital requirement of the boutique manager’s Australian Financial Services Licence (AFSL).

Harding said these capital requirements are generally covered by the custodian of the underlying funds that holds the assets, with boutique managers only needing to hold 2 per cent of their cash flow for the quarter to avoid breaching their AFSL.

However, Harding, who works with new and existing boutique managers in the areas of compliance, marketing and business planning, said the threat may come from responsible entities (RE) that are concerned by declining levels of funds under management (FUM).

“I am aware from my dealings with REs that some may consider shutting down a fund or fund products if FUM fall to levels that are too small to maintain. These funds still have fixed costs which also impact FUM levels and this pressure will apply to boutique managers as well as larger fund managers,” Harding said.

Growth in lean times

So, do the deep pockets of the big end of town hold an attraction for the boutiques?

Brown does not think so, given the lean times affecting all managers.

“In this environment, most managers should probably consider more deeply every expense decision. It is easy with shareholders miles away to sign a cheque but that doesn’t work for a boutique,” Brown said.

“I don’t necessarily wish for a return to a larger budget. Rather, I have to be more aware of how I spend the funds I have and ensure they are adequate for the growth we have planned.”

The curious case of being boutique

There is a saying about all boats rising when times are good, but taking a look at the numbers for the past 12 months, it would be easy to believe all the boats have been torpedoed below the waterline.

According to data from Standard and Poor’s (S&P), the median return for non-boutique Australian equity large cap managers was -35.9 per cent for the 12 months to the end of December. Their boutique peers had a median return of -33.45 per cent, while the ASX 100 returned -37.21 per cent (figures are net of fees).

It might be stating the obvious, but these numbers look brutal.

So what happened to the boutiques and their much vaunted ability to outperform their much larger competitors?

It’s still there if you look beyond the negative symbols in front of the return figures, with Standard and Poor’s Funds Services analyst Justine Gorman stating that boutique managers did well in comparison to the ASX 100, 200 and 300 benchmarks. (The ASX 200 returned -38.44 and the ASX 300 returned -38.92.)

“It is what we would expect for active managers. There were some who performed below the index, but so far no real pattern has emerged in terms of individual investment style and performance. Rather the key issue has been stock-picking ability and selection,” Gorman said.

And what a difference that stock-picking ability made at the close of December, with Morningstar data showing a range of returns for boutique managers in the large cap space ranging from -21 per cent to -60 percent, while non-boutique managers in the large cap space ranged from-11 to -72 per cent, for the year to December 31.

Of course, boutiques still had the last laugh, even if it was through gritted teeth, with the average return in the large cap space -36.10 per cent compared with the non-boutique manager average return of-38.79 per cent. (See the attachment for the top 50 performing large cap and small cap boutiques.)

Despite the negatives, there has not been a flight from boutiques back to larger managers and neither has there been the view that boutique managers are less capable or less attractive than they were during the boom times.

Mercer Investment Management chief investment officer Russell Clarke said the reasons both institutional and retail investors have turned to boutique managers still remain and cites the commitment and focus of boutique managers as part of their ongoing appeal.

“We are not seeing funds switch between boutique managers and larger managers, rather clients are responding to fund manager-specific issues. What we are seeing is an increased focus on the financial strength of the manager and its business skills,” Clarke said.

This is taking place in both the larger manager and boutique space, but Clarke does see a heightened interest in these issues for boutique managers.

He said questions are being asked about the viability of some boutique managers with scrutiny in the areas of positive cash flow, time frame to profitability and the likelihood of that actually taking place.

“Questions need to be asked about the capital adequacy of some of the smaller managers because at one stage during the bull markets it appeared boutiques were relatively easy to setup,” Clarke said. “Yet, they were probably set up without the expectation that markets would fall by more than 50 per cent,” Clarke said.

However, Jenni Harding, managing director of Harbridge Investment Partners, a consultancy that works with new and existing boutique managers, said any contraction of the market has yet to take place and, rather, that there are a number of new managers who plan to launch businesses and funds into the current economic climate.

“These new start-ups are in both the hedge funds and mainstream asset classes and see the current climate as a way of generating a track record during a tough time,” Harding said.

And while some may question the wisdom of launching when new money is tight, Harding said the level of activity is high with many of the debutantes planning to go it alone for the time being.

“They have had the big parent experience and want to get away from that, so some will stay in the wholesale space at the start to do what they are good at — managing money.”

While Harding admitted funds may be tight for new managers, this is partly a product of the calendar as well as the market. She said that funds are static for the moment following the Christmas break, but expected reviews in the March and June quarters to lead to some movement of money.

Whether this will ease the pressure on local managers remains to be seen, with Gorman stating the lack of movement in terms of new investments into boutique managers was a symptom of the wider malaise affecting every Australian fund manager.

Yet it has also raised the question of sustainability for S&P, which is conducting research into how many boutiques are riding out the current storm.

Hindsight may turn out to be the best measure of sustainability in the boutique sector, but Clarke expects a high rate of survival in the Australian market. He said the wholesale problems that plague the US market are not present here and rather than managers going under, he predicted mergers and acquisitions.

“We expect about 90 to 95 per cent of managers to survive,especially if they have high ratings. But only the strongest will survive. But they will not always be the largest, just very good at what they do.”

Jason Spits

Top 50 boutiques tables