DPM in Asia 2017: The State of Delegation
Asia’s private banking industry has undergone significant transformation in recent years, prompted by regulatory tightening, consolidation and industry-wide technological disruption. At the same time, global markets are morphing in ways that are making life difficult for investors. US interest rate normalisation is already underway, which could end a 35-year bond bull market; political uncertainty is intensifying, fuelled by rising populism which threatens to reverse the post-war globalisation project; and long-term historical averages are expected to eclipse future returns.
Yet even as markets and industries evolve, one truth remains constant: discretionary portfolio management (DPM) is the Holy Grail of private banking.
For all that the private banking industry has to offer—whether access to exclusive deals, state-of-the-art product innovations, or cutting edge capabilities to engineer bespoke solutions—investors’ willingness to embrace DPM is the best evidence that a wealth manager has earned the trust of its clients. This is especially true in Asia, where self-made high net worth individuals (HNWIs) traditionally exercise a high level of control over their own investment decisions.
Asia-based private banks have struggled to close the gap with their European counterparts, which boast DPM penetration rates of more than 20%¹ from multi-generational families whose key members today are far removed from the origins of their wealth. Unlike their asset-rich, cash-poor counterparts in offshore Asia (whose wealth is still closely tied to the family business), European HNWIs, for the most part, are in the preservation stage and place less emphasis on day-to-day investment decisions and positions.
The future looks bright for Asia’s private banks, however, with the delegation of investment management (both to funds and discretionary mandates) on the rise, as difficult market conditions render active trading laborious and unfruitful. Even business managers that are accustomed to chasing lush client-directed flows are encountering headwinds in the form of advisory-related compliance risks and revenue volatility that is highly correlated with
In this first edition of Asian Private Banker’s DPM Executive Summary Report, we explore recent developments of DPM in Asia. Powered by intelligence from APB Mandate, the report presents data on DPM assets and penetration within the region as well as insights on tailwinds and headwinds shaping the industry.
Market sentiment has been reinvigorated, in no small part by US President Trump’s promise to “make America great again” via fiscal stimulus, tax cuts and deregulation. The S&P 500 shot up 6.2% from election day to inauguration day—the best streak for any US president over the same period since 1968.
At the same time, major economies are experiencing sentimental and/or material improvement.
China closed the year out with 6.7% growth, headlined by qualitative economic developments, such as an increase in the share of consumption-driven growth, soothing fears of a hard landing. A 1.8% YoY increase in Eurozone inflation during the fourth quarter beat expectations (1.7%). Better macro data in Japan led the BoJ to up its growth forecast for 2017 and 2018 to 1.5% (from 1.3%) and 1.1% (from 0.9%), respectively. The US was relatively less impressive, registering 1.6% growth, driven in part by weaker exports caused by a stronger dollar.
Nevertheless, uncertainty looms.
In equities, private banks are split between those that are optimistic that earnings growth will catch up with current valuations and those that believe that markets are currently driven by unfounded euphoria. A less contentious issue is the wide ranges in equity returns, between best and worst-case scenarios, due to the unpredictable nature of the new US administration.
The macro picture is markedly better for fixed income markets, where relatively greater predictability can be expected, such as a gradual rate hike cycle by the Federal Reserve. But the combination of recovering growth and some of the US administration’s new pro-growth policies (e.g. tax cuts or fiscal spending) increases the risk of an ‘inflation overshoot’. As a consequence, private banks have actively sought floating rate debt, ranging from senior loans to mortgage-backed securities well into early 2017.
Regardless of any discrepancies between house views and asset allocation strategies, the industry agrees on at least one point: tail risks have increased. A wider distribution of probabilities, according to numerous industry players, has reduced the chance of base case scenarios while fattening the tail ends.
DPM assets at private banks in Asia reached a record-high US$120 billion in 2016, a 9.3% increase YoY, representing a penetration rate of around 8% of total AUM. Though some ways off Europe’s rate of more than 20%, the outlook is bright.
In a market populated by first generation wealth that is accustomed to hands-on, self-directed investing, DPM assets have posted 15.5% CAGR over the past five years, significantly outpacing total AUM CAGR of 4.6% over the same period.
Assuming consistent growth in penetration rates, the industry could exceed 20% by 2026. But while the overall DPM penetration rate for Asia-based assets is growing, progress has not been even across the industry, where rates vary widely by business model and value proposition.
<5% - Retail-linked private banks
DPM asset growth at private banks linked with local retail platforms often significantly lags their industry rivals.
The intimacy between private banks and retail arms brings its own benefits: scalability, cost savings and a pipeline of potential clients and future private bankers. Such setups often include business managers that oversee the entire client segment spectrum across retail, affluent and private banking.
However, there are several common denominators that have been cited as headwinds: business model and client base.
A closeness to retail banking arms can often cause private banks to replicate their business models, which tend to focus on distribution. Over the past ten years, certain revenue lines from both businesses may have looked similar, but in a world of low rates and returns, private banks can only justify greater margins from the premium of effective and compelling advisory or discretionary services. And unlike product distribution businesses, which face increasing margin compression pressure due to competition from technology companies, services like DPM are not as scalable due to their high-touch and sometimes bespoke nature.
5-15% – Universal banks
The range of DPM penetration rates is widest amongst the private banking businesses of large, universal financial institutions that are not linked with significant local retail businesses. Penetration rates are very dependent on how the business is structured and positioned relative to its surrounding subsidiaries and managers’ private banking philosophy.
For financial institutions whose investment banking arms are materially stronger than asset management, there is a tendency to gravitate towards high margin advisory business, be it via exotic structured products or private deals. When asset management businesses are stronger, there is greater willpower to promote DPM, especially if there are existing products or capabilities with strong track records that can be implemented into portfolios for clients in Asia.
Even so, some private banks with strong asset management capabilities struggle to encourage bankers to help grow penetration rates in Asia. A seller’s job market and a legacy of brokerage produce “star bankers” that resist change.
Numerous business managers point out that support from top bankers is crucial when building a sustainable asset base for new DPM businesses. With some exceptions, DPM asset growth relies mostly on the goodwill of leading relationship managers and education rather than top-down directives from management. In certain cases, especially within relatively active intra-region client segments like onshore Taiwanese HNWIs, private bankers’ reticence to generate recurring income stems from the fact that they remain confident in achieving high transactional revenue.
>15% – The Purest of the Pure
In Asia, a double-digit DPM penetration rate already warrants celebration and the high end of this range is occupied almost exclusively by the purest of the pure. Our findings reveal two primary drivers for high penetration rates.
First, many pure play private banks tend to place a more pronounced focus on DPM. This differs from universal banks where there tends to be substantially more diversed revenue mixes, thereby diluting focus on DPM as a
primary value proposition.
Second, pure play private banks tend to hire seasoned relationship managers that are capable of selling and conducting aftersales on multi-asset mandates with limited support. But this is not a luxury that can be afforded by all in a talent pool with limited seasoned private bankers.
Multiple private banks cite low relationship manager sophistication as a key hurdle to building out DPM offerings. Common challenges include an inability to help clients distinguish DPM solutions from other holdings, such as mutual funds.
Notwithstanding progress, the pure play sub-sector should remain wary of competition. A select few global titans are now breaking the double-digit threshold in Asia by various means and, simply, sheer willpower. Some have employed fully fledged internal DPM campaigns replete with educational sessions, intensive marketing and senior management endorsement. Others have relied on internal cultural shocks to convert yesterday’s brokers into today’s wealth managers.
Lower returns, higher volatility and shifting correlations
HNWIs in Asia are accustomed to self-directed investing, often with a strong home bias and high return expectations.
This is for fair reason. From 2001 to February 2017, MSCI Asia ex-Japan registered annualised returns of +8.78% compared with the MSCI ACWI’s +4.68%. The former benchmark downplays some significant short-term gains made in the market, such as newly listed Chinese stocks during Hong Kong’s IPO boom in the 2000s.
Although DPM offerings continued to demonstrate strong discipline and risk management capabilities, their meagre single-digit returns could not compare with what was a theoretically unsound approach that, in practice, proved highly effective.
But the environment is shifting. In 2004, a portfolio could achieve 4% gains with a 15/85 split between equities and fixed income, respectively. By one estimate, today’s portfolios would need to implement 50/50 allocations for the same return with volatility doubled. To add to the challenging investment environment, correlations could possibly shift to a state whereby economic growth and asset price movements are out of synch. In turn, even Asia’s aggressive HNWIs have adjusted return expectations and industry respondents have said that clients are now satisfied with annual performance of about +5.9%.
And it is no longer sufficient to rely on strategic asset allocation (SAA) alone, which would have benefited Asia’s tendency towards home bias and risk taking (primarily through leverage). Over the past 5-10 years, Deutsche Bank estimates that SAA would have accounted for 80% or more of portfolio performance, but today, tactical asset allocation (TAA), individual security selection and risk management may account for more than 50%. Contrarian trading, risk premia or style investing are among the new investment approaches investors could be pressured to adopt in order to achieve their personal objectives.
Private investor behaviour
Lower market predictability and risk-adjusted returns drive increase in delegation and decrease in active trading
Different market conditions necessitate different behaviour.
Even in Asia, where the HNWI segment’s historical infatuation with active trading is well-known, brokerage activity is slowing. After a US taper tantrum in 2013, Greater China equity losses in 2015 and a record-worst start to global markets in 2016, appetite has been severely dented. In 2016, overall brokerage volumes fell by as much as 30% for some private banks while the broader industry muddled through a 13.8% drop in structured product trading volume.
Understandably, some Asian HNWIs, especially clients with strong offshore liquidity, have made a wholesale shift into cash positions. However, growing fund penetration rates amongst Asia’s private banks is strong proof that investors are increasingly willing to delegate assets for active management. Although the industry registered a -6% year-on-year change in fund inflows in 2016, banks still managed to achieve an average 11% penetration rate.
Further, there is a greater willingness to not only test delegation but to use it functionally to substitute existing allocations. This is best evidenced by the recent uptick in demand for unconstrained bond funds and fixed maturity bond funds in the region – in a little over one year, successful private banks have converted up to 2% of total non-UHNWIs’ AUM into such strategies, which are often viewed as substitutes for other yield-oriented positions such as buy-and-hold bond investments or yield enhancement structured products.
Other tailwinds for DPM could come from a gigantic transfer of wealth that is underway in Asia. According to a 2015 UBS estimate, the next generation of clients could inherit US$1 trillion in ten years and US$3 trillion in 30 years from UHNWIs alone, representing 43% of the segment’s total wealth in the region.
This demographic shares cultural characteristics that are likely to lead to a greater adoption of delegation services.
In particular, a Western-educated generation —often with some practical experience in the financial services industry—shares a greater appreciation for strategic long-term, diversified, portfolio management and less interest in day-to-day self-directed investing, that lends itself to delegation.
Business environment (Part I)
Brokerage margin compression and revenue volatility encouraging private banks to seek stickier and more predictable revenue
Whilst private banks in Asia may still hold an edge in pure brokerage business when it comes to primary issuances, structured products, prime brokerage and OTC bonds, a stampede of low-cost online brokerage players that are currently waging a price war against banks, are exerting downwards pressure on trading margins. In February this year, Fidelity announced a nearly 40% cut to standard commissions per online trade on US stocks and ETFs to US$4.95. Less than nine hours later, rival Charles Schwab matched the price, publicly acknowledging that the cut was in direct response.
Even for those private banks that can justify higher margins due to advisory capabilities, the industry at large acknowledges that Asian HNWIs’ risk appetite can be volatile relative to their global counterparts and general asset price movements. Despite an expectation-beating economic recovery, energy price stabilisation and a boost provided by US President Trump’s policy promises, more than 80% of private banks in Asia say that their clients have not participated (or have failed to meaningfully participate) in the recent global equity rally.
Private banks are already shifting their business models to attract more recurring income to offset a potential downturn in transactional income. Ten years ago, it was not unusual for private banking revenues to be split 80/20 between transactional and fee-based. Today, the industry average stands at 64.5/35.5 on a bank-weighted basis.
Business environment (Part II)
Regulatory risks favour DPM
Even without headwinds from global markets or competitors, significant regulatory tightening has slashed private banks’ appetite for transactional business.
As a direct result of the Global Financial Crisis, which brought home the cost of lax governance, regulators have increased investor protections. Burdensome client due diligence procedures and sales processes, not to mention hefty fines, have suppressed any willingness on the side of banks to take on risk.
By one estimate, global banks have paid US$321 billion in fines for wrongdoings since 20081. Key areas of regulatory scrutiny in Asia include sales and advisory processes – revenue sources that are driven by both relationship manager demand and end-client demand.
According to media reports, HSBC Private Bank (Suisse) SA appealed against a decision by Hong Kong’s Securities and Futures Commission (SFC) to impose a record-high US$78 million fine and the revocation of its advisory licence (“Type 4”) linked with the alleged mis-selling of Lehman-linked structures. Another unnamed private bank in the region was well-known to have had a cost/income ratio exceeding 200%, due in part to the cost of settlements over mis-selling disputes.
The SFC is expected to further tighten conditions this year by formalising product recommendation processes. This involves the introduction of a client suitability clause clarifying that an intermediary has solicited the sale of, or recommended, a financial product to the client and that the financial product is “reasonably suitable”. The industry is unsure as to whether this will lead to increased mis-selling claims but it certainly builds a clearer framework for clients who wish to pursue this course of action.
Increased regulatory stringency concerning advisory businesses has not been limited to major international financial hubs such as Hong Kong and Singapore. For example, Taiwan’s Financial Supervisory Commission (FSC) imposed a TWD72 million (US$2.4 million) fine on 16 banks in 2016 for mis-selling target redemption forwards (TRF), a structured product market that registered US$2.4 billion in sales in Taiwan in 2016, down from US$5.3 billion in 2014.
Larger private banks are adjusting, whether by hiring or implementing tech solutions to streamline processes and to reduce compliance risks via strict scrutiny and aligned bank-wide communication, while smaller private banks typically rely on experienced, senior relationship managers to exercise prudence when advising clients.
Irrespective of size or business model, however, a drastic shift in the relative risk between DPM and transactional business is likely entice private banks to build out their discretionary offerings in Asia, especially if they have already been stung
The Road Ahead
Five years ago, growth in the discretionary portfolio management space seemed anything but certain due to booming markets, supportive monetary policy and heavily active client trading – whether advisory-driven or self-directed. Fast forward to today and the dynamics at play between global markets and client behaviour, coupled with a business environment that encourages the delegation of portfolio management over active brokerage, suggest that private banks will see a greater share of revenues coming from flat-fee offerings going forward.
Still, the road ahead is not without challenges.
Equipping relationship managers
For private banks that cannot afford the infrastructure spend to have sidelined private bankers in aftersales processes, continued education is critical. According to a recent survey conducted by Asian Private Banker, DPM heads rated their private bankers’ knowledge of discretionary offerings an average 6 out of 10 average. Many respondents pointed out that relationship managers typically only have strong investment knowledge and competency in a few asset classes or products and lack a well-rounded multi-asset understanding.
The same DPM heads point out that there is a pressing need for banks to finetune their aftersales processes and promote, where relevant, the key features of discretionary portfolio management, including enhanced transparency for greater risk management, direct access to portfolio managers, customisation of asset allocation, security selection and content. Otherwise there is perception risk in terms of differentiation from investing in other managed products, like mutual funds.
Family office in-sourcing
For the UHNW segment, DPM asset growth faces headwinds from disintermediation due to the insourcing of active portfolio management.
Though the market remains split how ‘best’ to engage family offices – whether via concierge services, investment advice or fully-fledged active management – there are signs that some are moving towards institutionalised portfolio management. One headline example is the reported launch of a family office by top Alibaba executive Joseph Tsai in 2015. This set up is said to follow Yale’s endowment approach by focusing on long-term, illiquid investments.
The growth of Asia’s independent asset manager (IAM) industry also increases the risk that potential clients will disintermediate private banks. This is especially true of those mid-sized clients who claim to have needs that are too sophisticated for retail offerings but whose account sizes are too small to receive UHNW servicing. Julius Baer projects that between 2014 and 2020, assets management by IAMs in Asia will grow 14.9-16.9% CAGR to reach US$55-60 billion.
Tech players challenge status quo
In addition, an increasing number of technology players are encroaching upon the wealth management market, promising to deliver low-cost, scaleable multi-asset solutions. A flurry of new and familiar names are entering the realms of digital investing to deliver diversified portfolios, often made up of ETFs, with annual fees as low as 25 bps.
While unlikely to appeal to the higher end of the HNWI spectrum which places a premium on human-to-human interaction and manual portfolio management, digital solutions find favour with lower-end clients. Even at larger private banks, pressure from margin compression and regulatory risks is driving developments in scalable tech solutions to service the lower end of the HNWI market.
The Road Ahead
Given the trajectory of Asia’s private banking industry, few believe that transactional business will experience a renaissance with brokerage activities returning to pre-crisis levels. Understanding the behavioural traits of clients that take the transactional route is critical when cultivating a banker culture that is conducive to building out flat-fee revenue streams.
Yes, there are tail risks that could undermine this trend. Brighter investment opportunities in onshore markets such as China and Indonesia, backed by stronger currencies, could stunt diversification momentum and, once again, lead to concentrated positions in home markets. Trump’s decision to appoint a more dovish Fed Chair could result in sustained policy accommodation and prolong the current fixed income boom. Broad industry-wide failure to deliver reasonable performance in difficult market conditions could cause permanent damage to DPM demand.
Despite these challenges, those private banks that are able to achieve high DPM penetration rates will reap such rewards as predictable revenue, lower regulatory risks, the avoidance of performance-destroying self-directed investment behaviour and, most importantly, the trust of clients.