Excellence can flourish in any structure provided it is well run, and it would be naive to think that all skilled investors will operate at their best in a boutique environment. That said, Mercer is attracted to many of the features offered by a high quality, well structured, boutique model. The current financial climate highlights some of the risks attached to smaller firms but, where supported by strong manager-specific research, does not preclude investing with a boutique.

We’ve had a boutique boom. Some would say a boutique bandwagon. But challenging market conditions recently have meant closer scrutiny of smaller firms and their ability to flourish or even survive. Investors are re-examining the merit of linking up with smaller-scale operators. So, are boutiques still worth backing? 

This paper discusses the differentiating characteristics of boutique managers, drivers behind their growth in the industry, and how they are coping in the current environment. We discuss their prospects for outperforming, and factors to consider when ranking boutiques against their larger counterparts. We highlight that, in itself, boutique status is no guarantee of success, and it is by no means the only business model which can generate strong investment performance.

But first it’s best to start with the basics – just what is a boutique?

Boutique or not boutique…

Exactly what classifies a fund manager as a boutique can be a contentious question. Our primary definition of a boutique manager is an organization which is substantially owned by the principals of the business. While there may be other capital providers, those individuals doing the investing and running the operation also have a significant stake in the business (and are generally the majority shareholders). Alongside this, to varying degrees depending on seniority, they have a significant say about key strategic decisions affecting the firm.

A second characteristic of boutique firms is that they tend to specialize in one, rather than multiple, asset classes. One might say they have identified a niche area which most closely matches their skills and comparative advantage - they have chosen to "stick to their knitting". The intended pay-off for shunning business diversity and revenue streams from other asset classes is avoiding dilution of talent, enhancing the point of focus, and thereby maximizing the likelihood of success.

To qualify as a true boutique, we contend that a firm will also be managing a relatively moderate level of funds versus peers in the relevant market and accordingly is an agile player. In other words, firms are excluded which, although owned by staff, have grown to possess sizeable market footprints. Such firms are sometimes loosely termed "Big Boutiques", or in some cases perhaps "Barely Boutique" is a more accurate label. [1]

The growth of boutique managers

Since the early 1990s, in many countries we have witnessed a step up in the establishment of boutique firms, either in global or (more often) regional form. Such firms have tended to differentiate themselves by offering higher conviction portfolios that are less constrained by conventional benchmark indices. 

As a broad statement, Mercer’s observation is that boutique managers have had a fair degree of success in attracting both funds and staff away from more established managers. It is difficult to generalize about the relative prominence of institutional versus boutique investment firms globally – it varies on a region-by-region basis. However, it is fair to say that the rise of the boutique manager is a widespread phenomenon, driven by a series of factors which we discuss below. We are conscious that the boutique universe is not limited to those managers directly monitored by Mercer; it is undoubtedly much larger. For example, there are many boutique-type entities operating within listed investment companies and private family investment offices that are not normally accessible by external institutional investors.

Reasons for the boutique boom

"The people who thrive as money managers – as imaginative discoverers of new ideas and successful investments - tend to be jealous of their prerogatives and their freedom. It’s a business that draws people who want freedom and opportunity, and that’s why I feel independence … tends to go hand in hand with the best money management". [2]

From the supply side, driving the rise in the number of boutiques is the fact that they offer investment managers, who have often forged a career as part of a larger organization, the opportunity to work for themselves and determine their own destiny. Professional reputations are placed more directly "on the line" and considerable upside for financial gain exists through sharing directly in the profits of the business. In some cases, the opportunity to leave behind a more bureaucratic environment holds attraction, as does managing a more moderate pool of assets. Alongside these factors, a trend in many countries towards improvements in available technology, outsourcing options and custody arrangements have helped solve a lot of the back office administration problems that have represented a hurdle for smaller operators in the past.

From the demand side, boutiques have attracted investor support primarily because of the potential for higher returns, especially in their early years. Underlying this is the belief that boutiques can have key advantages over institutional managers. Some of these are noted below, with caveats attached:

• They provide access to some of the most experienced investment staff. Often a portfolio manager at a boutique has previously established a record of success at another firm. [3] (Hazard: is the balance right between fresh talent and "old hands"? What experience is there of actually running a business?)

• They provide access to some of the most motivated people in the industry. The task of setting up a boutique is not easy, and credibility and determination are common features of those involved. (Hazard: is there a risk of personal goals overtaking a focus on client outcomes?)

• A smaller number of decision-makers mean that innovative investment solutions are likely to come to fruition more quickly. (Hazard: are these solutions developed with adequate "sounding boards" and perspectives?'

• There is an absence of external primary owner(s) influencing the strategic running of the company with their own objectives or return requirements. (Hazard: does the boutique have industry-standard financial disciplines and processes?)

• Ownership of the firm by key staff can intensify incentives to perform and aid staff retention. (Hazard: how are team members managed who under-deliver, yet are shareholders, and still benefit when the business is succeeding?)

"I think I’ve been in the top 5 percent of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it." [4]

The significant levels of funds under management (FUM) often associated with institutional managers have also played a key role in the rise of boutique managers globally. Many of the more established, and indeed successful (at least historically), equity managers now have FUM at levels which have reduced their nimbleness in implementation and, in some cases, caused them to invest in higher capitalization stocks than they might have otherwise. The existence of managers constrained by high FUM has therefore created opportunities for smaller niche managers.

Importantly, once up and running, boutiques have generally shown a tendency to be quicker to close their door to new money once they have reached a level perceived as optimal (and as a consequence have a closer relationship with a smaller number of clients). A related characteristic is the relatively prevalent use of performance fees, whereby the manager shares with the client a portion of the returns above a pre-set threshold. In combination, these factors mean that boutiques tend to target a higher fee per dollar of assets held.

It will be evident that, while we believe that the advantages noted above hold true for some boutiques, they are not true for all such firms.

Unique risks and characteristics

Despite the attractions, the boutique nature of a firm can raise sources of potential concern, particularly related to its longevity. Business risk is not limited to boutiques of course and there have been many examples of significant changes in ownership or staff impacting on the viability of larger institutional investment managers.  Notwithstanding, some of the particular issues that may present a challenge to investing with a boutique manager are:

• Until they are past the start-up phase, boutiques are something of an unknown quantity and do not have a track record in their own name (discussed later).

• For larger clients, the size of the mandate invested may represent a sizeable portion of the boutique’s total FUM (a potential risk for both parties).

• In the event that funds don’t flow into the business as quickly as anticipated, there may be difficulty in ensuring sufficient committed capital such that there are resources to adequately conduct research and manage the existing funds (without distraction).

• If the business does encounter major difficulties, there is less of a "safety net" in the form of a larger parent to assist financially or with a managed wind-down.

• Boutiques tend to have fairly tight staffing and consequently a heightened exposure to key individuals being unavailable for any reason.

• Related to the above is that separation of roles can be blurry with some individuals wearing more than one hat such as portfolio manager and chairman (governance issues).

• Aspects of investment reporting, such as attribution analysis, tend to be less detailed.

Another factor to be aware of is that, due to their smaller transaction flow, boutiques may have less access to company capital raisings and new issues, i.e. they lack the clout with the broker community held by their institutional cousins. By the same token, their volume requirements are often more meagre, and some brokers are keen to support up-and-coming entities.

It is a widely held view that large institutions can be bureaucratic with investment staff spending a significant amount of time on organizational issues or other "head office overhead", rather than managing money. This is not always alleviated within a boutique, however. In the absence of a wider infrastructure, and unless carefully managed, portfolio managers within boutiques can find themselves having to handle a plethora of fundamental business issues and client enquiries, and dealing with increasingly complicated regulatory regimes in many parts of the world. It also needs to be borne in mind that just because someone has been a skilled investor as part of a larger firm does not necessarily mean they have the skills to run their own business, at least without their investment talents being compromised.

One of the challenges of running a smaller-scale business is managing it as a sustainable entity. Unexpected events such as sickness or changes to career objectives of key players can materially influence the future of a boutique. Equally, it may relate to longer term issues – a desire for initial financial backers to redeem their investment, or simply the ageing process requiring a second generation of individuals to take the firm forward. Few boutiques acknowledge giving active consideration to a short-term or even long-term exit strategy, but for a number it inevitably rests at the back if not front of mind.

Assessing boutiques

“We believe the building blocks are in place for this manager to perform well for clients. Given the firm is in its early phase of development, we draw attention to an element of risk that the offering will not gain the traction required to be a viable business. However, in context, we believe this risk is not prohibitive for those investors who view alpha as a priority.” [6] 

Mercer follows consistent principles in assessing any type of investment management firm. Particular issues we consider when researching boutiques tend to come under the Business Management category (one of four broad factors in Mercer’s evaluation process alongside Idea Generation, Portfolio Construction and Implementation). Relevant aspects we look at are summarized below:

Organization

Our research involves a review of the firm’s shareholding and capital structure with particular emphasis on how long the business can sustain itself without material levels of FUM. We review the profit sharing arrangements amongst individuals as an indication of the incentives within the structure and how they may align with clients. The nature of the back office, legal and compliance arrangements for the organization are also ascertained. In most cases we take comfort from a high level of outsourcing.

Technology

We identify the systems that are used throughout the business and the investment process. Our research establishes whether the process relies on technology to produce alpha and whether the resources match the demands of the process. Access to IT support is also important. On the dealing and portfolio management side, the improvement in recent years in off-the-shelf systems has been significant, hence reducing set-up costs and improving the reliability of adopted systems. The development of distribution platforms such as Master Trusts and Wraps in some countries over the last decade means that much of the infrastructure required for client service and administration can now be outsourced.

Leadership and people

We look for an appropriate division of focus. Well-structured boutiques clearly distinguish between business management and investment management. We may become concerned if a boutique alters the direction of its specialization - for example, from being solely a domestic equity specialist to pursuing other asset classes. As with all investment managers, we assess the depth and experience of the team, while recognizing that a large team does not always translate into a more effective team. We will accept key person risk on the basis that we are prepared to review a firm immediately if a key individual leaves.

Prior achievements

In cases where the firm is a start-up, we try to learn what we can from the previous track record of the individuals behind the boutique. In many cases, Mercer will have researched the firms they came from and be familiar with the key people involved.  While retaining a forward-looking focus, we seek answers to questions such as:

• To what extent was the past performance attributable to the individual(s) at the new boutique? At times this can be problematic due to positions of responsibility being shared or where there has been frequent changing of roles. 

• Is the intention to carry across essentially the same investment process adopted elsewhere? Do the intellectual capital and relevant tools rest with the previous firm or are they (legally) transportable?

• What level of FUM were they managing and is the process sustainable with a different level of assets?

• Were the individuals regarded as good team players or more individualistic? How did they get on with their colleagues? What was the catalyst for the change?

A comment on operational risk is warranted, given that boutiques are often cited as posing a greater danger in this area. Mercer does not claim to undertake comprehensive due diligence on back office and compliance procedures as part of our manager research process. Rather, it is viewed as a distinct task, and most appropriately dealt with via (1) each firm’s internal and external auditors and regulators, and potentially (2) an operational assessment carried out by a specialist unit such as Mercer Sentinel.

Weighing the case for boutiques

Recent challenges - survival of the fittest

In times when markets are turbulent or in decline, the robustness of investment management business models is inevitably tested. A feature of such models is operating leverage. Whether using a standard asset-based fee or a performance fee, fund manager revenues are invariably tied to the level of total assets managed. After covering core expenses, any additional revenues generated from asset management fees largely represent profit. While this provides attractive margins when asset values are rising, it also works in reverse. As assets and revenues fall, the profit margin shrinks rapidly unless the expense structure is re-adjusted.

The 2008/09 period has been challenging for all fund managers. Equity market declines in the order of 30-40 percent have, in some cases, put business models under threat. Some boutiques are travelling "close to the wind" in terms of breakeven profitability levels. Those experiencing most stress are firms still in the establishment phase, who were sub-scale even prior to the downturn and/or are reliant on one primary revenue stream. Market conditions may have delayed the achievement of a positive net return to shareholders, and in some case the cost/benefit trade-off becomes dubious for continuation of the business. Central to sustainability is having a degree of shareholder support and capital reserves whereby the business can "look through" a period of lower asset prices and consequential revenue impact, without undue cutting of resources and infrastructure.

One advantage of boutiques with significant self-ownership is flexibility on the cost side in terms of remuneration (a major part of any people-oriented business). Reducing or forgoing salaries in favor of other incentives, be it through deferred payments or enhanced longer-term business value, can mean resourcing is maintained through lean periods. This is not a long-term solution, however. 

As a general statement we do not envisage wholesale collapse of boutique sectors in various countries, but we do foresee an increase both in outright casualties and in merger and acquisition activity. Anecdotally, the global downturn has increased the number of boutiques looking to partner with institutions. Business values have reduced materially in the past year as earnings multiples have declined. Boutique incubators and other potential acquirers can naturally be more selective in such an environment. At the same time, the pace of start-ups of new boutiques is inevitably on the decline. Taking a more sanguine angle, the widespread freeing-up of industry talent may aid the growth of budding players going forward.

"There will be increasing numbers of ‘Ronans’ on the streets – skilled warriors answering to no master – easing dramatically the key constraint to growth of the industry, namely finding experienced people. While some will attach themselves to the relative security of large funds, many will try their hands at starting their own shops, however tough fundraising may be for a while." [7]

For Mercer’s part, in the current environment we are emphasizing our research on the business management factors referred to earlier. We are looking more intensively for signs of cutbacks which impact on core investment capability, and any indications that a business model is unlikely to be sustainable due to balance sheet or cashflow problems. Positive cashflow is a strength, but timing assumptions around the achievement (or maintenance) of profitability need to be re-evaluated. We are also more conscious of signs of depleted morale within the organization. A particular focus is on instances where the manager has experienced recent underperformance to the extent that the investor base may be unsettled, creating heightened redemption risk.

Performance fees have additional relevance. For firms with a high reliance on such fees, a recent period of good returns versus index may be their saving grace, and for those on the other side of the ledger it may be a double-whammy on top of lower market levels. Ideally base fees, rather than performance fees, should be covering operational costs.

Comments on performance

An obvious question to ask is whether boutiques perform better than non-boutiques. But ahead of considering this, putting pure investment capability to one side, why might this be expected to be the case? A few of the drivers are that boutiques tend to:

• Manage a lower level of assets than institutions (as noted), allowing for more nimble trading of the portfolio and the ability to pursue the full opportunity set of stocks, i.e. a wider alpha universe.

• Set themselves up when the market opportunities for their particular investment approach and area of focus are attractive.

• Have more of a bias toward smaller cap companies than benchmark indices (this higher risk should over time entail greater reward).

• Have a particularly strong hunger to succeed in the early years, given that a strong track record will boost investor interest and the viability of the business.

• Operate under mandates which allow a higher degree of flexibility such as relating to the degree of portfolio concentration and use of cash (albeit with associated higher risk versus equity benchmarks).

This being the case it is perhaps not surprising that, on balance, studies of boutique versus non-boutique performance tend to come out in favor of the former, and that the strongest performance of boutiques tends to be in their earliest years. That said, the ability to attract, retain and motivate talent is inevitably also a factor (at least to an extent).

As implied, delaying an investment into a promising boutique’s strategy may mean that, in the interim, the firm’s FUM grows to a point where performance is compromised or a cap is imposed on the acceptance of additional monies, i.e. the "sweet spot" has passed. Accordingly, and contrary to some perceptions, Mercer does not require a track record of performance specific to a new firm in order for it to be considered for recommendation to clients.

In considering the actual performance of boutiques, Mercer carried out an assessment of Australian equity managers. This market was chosen as suitable due to it containing a reasonable selection of boutiques/non-boutiques for over a decade, whilst still having a workable sample size for analysis purposes. Broad guidelines used to classify managers as boutique as opposed to non-boutique related to the manager (a) being substantially owned by those investing the money and running the business and (b) having low-moderate FUM and staff numbers relative to peers. The data related to "broad cap" rather than specialist small cap funds, and the benchmark used was the S&P/ASX 300 Index.

The first chart below shows the median and 10th/90th percentile returns versus benchmark of the two manager categories. Over the period from April 1995 to April 2009 the general pattern is one of boutique outperformance, although less so more recently. [8] Of note is that managers with a value style were amongst the pioneers in launching boutiques and generally delivered strong alpha after the bursting of the 'tech bubble' in 2000/01.

Rolling Three-Year Excess Returns of Boutique and Non-Boutique Managers

An investor will also be concerned with the risk taken to achieve the return. As measured by tracking error, the study found that boutique managers fairly consistently demonstrated more risk – an average over the period of around 4 percent compared to around 2.5 percent for non-boutique managers. The chart below of information ratio outcomes illustrates the extent to which risk was being adequately rewarded. [9] On average, boutique managers were able to generate a superior information ratio (around 20 percent higher). However, it was not demonstrated with a notable degree of consistency.

Rolling Three-Year Information Ratio of Boutique and Non-Boutique Managers

Key messages for investors

In summary, the following key points can be made:

• There are identifiable advantages in utilizing boutiques such as accessing a nimble investment approach, higher conviction portfolios and the motivational incentives associated with the business structure. But simply having boutique status in no way guarantees enhanced returns. Like all managers, boutiques need to be assessed on their individual merits.

• In our view it is appropriate for investors to allocate some of their assets to boutique firms where the anticipated rewards outweigh the perceived risks. Recent market conditions have highlighted the potential downside of allocating to boutiques, particularly relating to business risk, but we maintain that the scope for rewards remains. 

• Manager-specific qualitative assessment is more relevant than ever in the toughened economic environment. Both winners and losers will emerge. As part of Mercer manager research, we seek to anticipate severe stress at firms, but at a minimum be ready to swiftly adjust our advice to clients should more concrete signs of reduced capability emerge (or we identify better capability elsewhere).

• The role of a high quality institutional manager in a portfolio should not be discounted. The reality is that there are a large number of talented fund managers working within institutional models who are quite capable of delivering strong performance because that particular environment suits their temperament and style.

• Evidence from a Mercer study of the Australian equity market over a 14-year period suggests that boutique managers have tended to outperform their non-boutique counterparts, while also showing a willingness to take on more risk (as measured by tracking error). Boutique managers have shown an ability to convert risk into return relatively efficiently, as indicated by information ratio outcomes although these outcomes were not consistently higher than for non-boutique managers.

• Bear in mind that even if a manager collapses, be it a boutique or any other firm, in the vast majority of cases the assets will be held in custody by an external party and hence legally ring-fenced. These assets can then be transferred elsewhere or redeemed as appropriate, i.e. the value of the assets is not lost.

• Around the world there have been plenty of instances of small firms achieving strong performance and significant business success. The natural outcome of this is strong growth in FUM and sometimes a desire to expand the business model into new areas – areas outside the realm of what drove the initial success. And at some point in the lifecycle of a boutique the question of an exit strategy for the founders enters the equation. These issues provide a challenge both to the owners of the firm and those who research it. The universe of players is never static, and we expect a future environment where up-and-coming managers continue to stake a credible claim for the boutique space.

Footnotes

This contains confidential and proprietary information of Mercer and is intended for the exclusive use of the parties to whom it was provided by Mercer. Its content may not be modified, sold or otherwise provided, in whole or in part, to any other person or entity, without Mercer’s written permission.

The findings, ratings and/or opinions expressed herein are the intellectual property of Mercer and are subject to change without notice. They are not intended to convey any guarantees as to the future performance of the investment products, asset classes or capital markets discussed. Past performance does not guarantee future results.

This does not contain investment advice relating to your particular circumstances. No investment decision should be made based on this information without first obtaining appropriate professional advice and considering your circumstances.

Information contained herein has been obtained from a range of third party sources. While the information is believed to be reliable, Mercer has not sought to verify it. As such, Mercer makes no representations or warranties as to the accuracy of the information presented and takes no responsibility or liability (including for indirect, consequential or incidental damages), for any error, omission or inaccuracy in the data supplied by any third party.