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asset management

Page history last edited by Brian D Butler 15 years, 2 months ago

 

Asset Management Industry

 

 

This is the industry where you give other people your money, and you pay them a fee to look after it for you.   Its a big industry.  Professionally managed assets at the end of 2006 was a market of $64 trillion USD.  Absolutely huge!   It includes mutual funds, hedge funds, and private equity.   In this portal we will discuss all of these industries under one common umbrella of "asset management"

 

 

Table of Contents:

 


 

 

 

 

 

What are they selling?

 

Exclusivity.  The fact that you will have very smart people managing your money, and trying to offer you better returns that you could get on your own, by simply purchasing an index fund that tracks the general market. 

 

Putting your money with a profession manager is like going to a fancy store on 5th Avenue and buying hand-made Italian shoes. But for the fact that the portfolio manager makes no promise that they will offer you a good product, nor that you will see a positive return.  All that you have to go by is their past performance, and the hope that they can do it again (and that it was skill, and not luck that brought them the great past returns). 

 

 

 

The fund management industry is very profitable, and growing quickly

 

While the average client may not see great benefits from active fund management....the fund managers themselves are doing VERY well  (note how many new billionaires there were since 2002 in the hedge fund and private equity circles!).

 

Fund management industry fees are growing around 15% per year because markets typically rise 8% per year, and there is a typical savings rate of growth of 5+%.  So, on an average year, the rate of fees received by the fund management industry grows by 15%.   And, this growth seems to be constant in spite of the industries massive size ($64 trillion + USD).

 

 

Large performance fees

 

The performance fees are in addition to the basic base fee.  The base fee (small) helps the portfolio manager to cover his fixed costs.  The larger performance fees are a bigger percentage of the gains and are justified in that they only really make money if you make money.  This gives the fund managers the incentive to seek returns, and not just to hold your money.   These performance fees are especially popular with hedge funds and other alternative assets.   But, in reality, do higher performance fees really guarantee higher returns (as most clients seem to believe)?  Probably not.

 

For example, Hedge Funds may charge 2% annually, and an additional 20% performance fee of all profits that they make.  So you will give away 20% of all profits plus 2% per year just of the right to have this person hold onto your money.  Ouch. They had better be really, really good to justify this very high take. 

 

 

Where is the competition?

 

But this should not happen:  under most situations in capitalism, if there is an industry as big as this, growing as fast as this, with double digit annual growth, there should be a massive influx of competition, that should drive down returns.   The strange thing is that in "fund management" this swarming of new entrants does not seem to be happening (at least not on a vast enough scale to drive down profitability). 

 

Profitability:  The average fund manager has a profit margin of 42%, according to a study by Boston Consulting Group.

 

 

Root of the problem:

 

This is because competition is NOT based on price, as you would expect, but instead is based on reputation, and on the basis of past performance.   Most investors dont look at the fees, but rather look at past returns as a means of selecting the fund in which they will invest their money.

 

But the problem with picking funds based on past performance is that there is very little chance that past performance is a good indicator of future performance.   Instead, what happens is that most consumers end up chasing past returns, only to find that they invest into a fund near the peak, and miss most of the upward movement.  the problem is that it is nearly impossible to determine ahead of time which fund manager is going to get "hot" and will seriously beat the market (in the industry, this skill of beating the market is called "alpha"). 

 

 

 

 

 

 

 

 

 

 

Changes in the Industry

 

1.  Pension Funds dictate a move away from equity funds and toward hedge funds

 

2000-2002:  there was an equity bear market.  

 

In response to this bear market, many pension funds (influential buyers of asset managers funds) realized that they had made a mistake by purchasing too many funds with exposure to equities.  The problem for pension funds is that they have fixed agreements to pay out benefits at some point in the future, and so being invested in equities was no longer deemed safe once they realized that equities could go down as well as up.  Some pension funds began investing in bonds, which were safer because they had guaranteed payouts in some specified time.  But, the problem is that Bonds did not pay out enough return, so the pension funds would need to invest much more upfront in order to meet future obligations.  They then began looking for alternatives. 

 

So, Pension funds began to look for "asset classes" that could profit from both an upswing and a downturn in the market.  Hedge Funds were deemed the perfect solution.  In addition to hedge funds, the pension funds also began looking more seriously at private equity and other "alternative assets" funds.

 

Read more in our discussion of private equity fund raising 

 

 

2.  Increased reliance on Intermediaries for reaching retail clients

 

Rather than dealing with retail clients directly, many traditional fund managers now prefer to deal with intermediaries, or third parties such as brokers, private bankers , advisers , and pooled investments called "fund of funds".

 

Reasons for this trend: 

  1. the fund managers can save money on marketing (no longer needing to invest in branding a fund, and selling to retail investors)
  2. Banks such as Merrill Lynch and Citigroup got out of the fund management business to focus solely on client relationships with important clients.  This separation between production (fund management) and sales (intermediaries) is a strong result of the need to create better relationships with key clients, and the desire to spend more on marketing and less on fund management.
  3. Commoditization of basic fund management (because of cheap ETF's)  resulted in a greater need to specialize (hedge funds had an opportunity here).

 

Problems with this trend:

  1. Increased churn:  because customers don't know the fund managers, and don't develop a relationship with them, they feel no attachment, which results in fewer long term relationships
  2. since intermediaries must justify their high fees, they quickly dump funds that underperform

 

 

3.  Fund managers no longer needed to get "diversification"

 

In the past, people looked to fund managers in order to get the benefits of diversification in their portfolios.   You would invest in a mutual fund because you learned that a well diversified portfolio had less risk than owning just a few stocks or bonds.  This was right.  But, back then the only way to get diversification was to buy a mutual fund from a professional manager who actively chose which assets to own.  This is no longer the case.  Nowadays, there you no longer need the active managers, but instead can choose to invest the market index through an ETF. 

 

With these index funds, the business of diversification has become a commodity.  You can cheaply gain all of the benefits of diversification, so the fund managers can no longer use this as a selling tool.  So, now if the professional fund managers want to sell their funds, they now have to focus on the active skills as justification for you giving them your money.  This has made their jobs harder, and explains why many traditional banks such as Merrill Lynch and CitiBank have gotten out of the business, and also why sophisticated hedge funds have risen in importance. 

 

 

 

 

Challenges for the industry:

 

While the industry as a whole might be very profitable, there are many funds that fail (especially as we have seen in 2007-2008 as Bear Stearns had two funds, and then the company itself go down in flames).   By the very nature of the business, these funds take on risk, and sometimes get caught on the wrong side of a big bet.   Famous examples of massive failures are Long Term Capital Management in 1998 (USA), and Société Générale in 2008 (France). 

 

Beyond the occasional flame-out, there are other main challenges for managers of fund management:

 

1.  Investing styles come in and out of fashion.

  • small boutique funds can seriously beat the market for a time, but can get crushed when markets change 

 

2.  Size of funds is not an advantage.  

  • Even though there may be economies of scale in that it doesn't take more advertising, management or brain power to run a big fund compared to a small one, there are other disadvantages.
  • Big funds might move the market prices against the trades
  • as a fund gets too big, it starts to mirror the market, and look alot like a diversified portfolio...reducing the advantage of a smaller fund
  • the bureaucracy of a large fund often drives away key talent

 

3.  How to maintain situation of (a) high fees, but (b) below average returns (on average) for the average investor.

 

4.  How to add value to justify the high fees

  • there is a challenge from "passive" funds such as ETFs , many of which are set up to identically mirror the actively managed funds, but at a lower cost.
  • not only are there ETF's that track the big indexes (S&P 500,etc), but there are also newer ETFs that track the STYLES of Hedge Funds.  These mirror funds are offered at a much lower cost.  But, in response, most hedge funds respond that these new ETFs are mirroring what they have done in the past, and not what trades they will make in the future.  We will see what consumers think over time...but this is a new challenge for many fund managers as ETFs turn many of their products into "commodities".
  • ETF's are like the Wal-Mart of finance, and are a direct challenge to traditional fund managers (who have traditionally been more of the Bloomingdales to Wall-Street).   These new ETFs allow investors (personal, and Hedge Funds) to gain cheap and easy access to an asset class, and to make bets quickly and cheaply. 

 

5.  Relationships matter less

  • investors chase returns
  • so, even if you have 12 great years in a row, but two bad ones...expect investors to flee, and your fund might collapse.  Its about "what have you done for me lately", more than a track record and potential.
  • This is even more true today as many fund managers are separated from clients and now distribute mostly through intermediaries (who are more ruthless about chasing returns).

 

 

 

 

 

Active (alpha) funds vs.  Passive (beta) funds:

 

Active:  "alpha" is known as the skill of the investor.   This is a type of fund that attempts to "beat the market",  or offer their clients a better return that the market as an average.  The theory is that if you are better than average at picking investments, you should be able to offer your clients a better return.  Rich clients love to hear this.  They dont want to think that with all of their millions of dollars, they are just getting an average market return.  They think they should be able to do better (or else, what is the point of being rich), so they are willing to pay the "best and brightest" on Wall street a good fee for offering their skills to beat the market.  This explains why bankers in Wall Street get paid so much money.  Its all in the fees, and the psychology of the rich clients that are willing to pay to (hopefully) get higher returns.  Alpha is highly desired, and is very hard to come by (for a sustained period of time).  

 

Passive:  "beta" investors seek to return the market average.  Whether that market be the S&P 500, some foreign market, or any asset class... passive investors can play the market with ETF's, at a much lower cost than paying for active managers, and not chasing "alpha" (with your check book open).

 

 

 

Strategies to outperform the market

 

** see our discussion on alpha

 

 

 

 

Opportunities for Fund Managers

 

The active fund managers (not the passive ETFs) have continued to attract new customers in spite of their higher costs.  One big reason is that people want professionals managing their money, and who better than the professional fund managers, who will benefit from the following trends:

 

1.  Retirement Funds:

As people get older and also as the government / corporations shift more of the responsibility for retirement planning toward the individual, there will be a massive opportunity for professional fund managers to step up and fill that void.   They are currently benefiting from the convergence of two trends.  One, is that the baby boomer generation in the US, Europe are aging and are nearing retirement age.  Two, is that governments and corporations are shifting more emphasis on the need for individuals to plan for their own retirement.  The problems with pension systems will create opportunities for asset management professionals. 

 

2.  Foreign wealth

As emerging markets produce more wealthy people, many of them will look to the US and European fund managers to professionally manage their money. Because of the reputation of these professional managers, you should expect that much of this wealth will be professionally managed by them.  Sovereign wealth fund may seek advise of western asset managers, as will many of the new million / billionares from the developing world.

 

 

 

 

 

 

Industry structure - ie, who are the players?

 

 

Raising money from clients 

 

Money comes into the fund managers from:

 

1.  Direct from retail consumers

  • people invest directly into the funds

2.  Intermediaries:

  • Pension funds
  • Insurance companies
  • Private Banks is when banks see private individuals who have sizable assets. The term "private" refers to the customer service being rendered on a more personal basis than in mass-market retail banking, usually via dedicated bank advisers. Historically private banking has been viewed as very exclusive, only catering for high net worth individuals with liquidity over $1 million
  • Other Brokers, funds, etc

 

 

Fund managers

Here is a list of the top asset managers world wide.  Note that companies such as Merrill Lynch and Citigroup are not apart of this list, as they have outsourced the fund management to some of these groups, and have become essentially distributors and sales forces for the actual fund managers.

 

 

 

 

 

 

Intermediaries:

These are the groups that sell the funds to individual clients.  These groups have enormous sway in advising clients about which funds to invest in.  

  • brokers
  • advisers
  • bankers

 

Potential conflict of interest

 

Since these intermediaries often get a % of the fund managers fees, they have the incentive to sell the more expensive funds rather than the inexpensive choices such as ETF's.   There is therefore an incentive for advisers and brokers to push things like hedge funds and private equity, rather then ETFs.

 

 

 

 

 

(Some of the) Strategies of Fund management companies

 

 

1.  Outsource the actual fund managemnt, and focus on clients

  • examples include:
  • Merrill Lynch (sold fund management to BlackRock)
  • Citigroup sold to Legg Mason

 

2.  Be an active alpha fund manager...or a passive (beta) fund

 

3.  Size and Specialization

  • small, specialized fund with a few hundred million dollars - focus on performance
  • large, diversified funds such as Fidelity - cover as many areas as possible (reducing risk of one bad performance, or of change in markets)
  • hybrid funds...such as Bank of New York Mellon...with $1 trillion spread among many boutique funds

 

4.  Asset class decisions

  • stick to traditional asset classes such as equities and bonds, or
  • alternative assets such as hedge funds, commodities

 

 

 

 

 

 

 

 

 

Internal links

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Digg!

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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