The Economics of Fund Management

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INTRODUCTION

Fund managers play an important role in free market economies around the world, controlling more than $100 trillion¹ of financial assets globally, with the ability to invest that capital into companies and to influence the way in which they are managed. Most research and literature on asset management focuses on investing – how fund managers do it, who does it well, the ways in which it has changed, as well as advice on how others can invest too. This leaves a largely unfilled gap looking at the rest of an asset manager’s business, ranging across sales, operations, governance, marketing, risk management, finance and compliance. It is these functions that are needed to turn a solo stock picker into a successful business. They are integral to making investment management commercially viable. And it was these aspects that moved from the periphery to centre stage when Neil Woodford, the UK’s best-known fund manager, was forced to close Woodford Investment Management in 2019 amid an acrimonious split with the firm overseeing its operations. Around 300,000 investors are still trapped in Woodford’s former flagship fund (Martin 2019).

This is not just a British story. Fund manager scandals have broken in recent years at Swiss asset manager GAM, French firm H2O Asset Management, and German Union Investment. Unlike Woodford, these asset managers are backed by large financial institutions. H2O was owned by Natixis Investment Managers (part of French banking group BPCE) and got into difficulties because of its relationship with controversial German financier Lars Windhorst, while GAM was caught up with disgraced Australian financier Lex Greensill. The chief executives of Natixis IM and GAM have both stepped down since these revelations broke.

Understanding how such problems can arise is part of how these businesses make money, the nature of their business models, the role of their compliance and oversight functions and how they incorporate investors’ interests. Each of these will be examined throughout this book. It will also look at fund managers’ increasing focus on sustainable investing – investing with the long-term good of wider society and the planet in mind, not just focusing on shorter-term financial interests. As the large sums of money that fund managers earn are more prominent in the popular imagination than what fund managers do, it is no small task for firms to demonstrate that they are focused on social and environmental issues. A focus on pay is not only the result of the high salaries many in the industry receive, but also a reflection of their role. Fund managers invest other people’s money with the aim of growing it over time, for example, building money for an individual’s retirement. So money that is raised from fund charges and paid to asset managers’ staff is money that is not being invested for their clients. This issue cannot be lightly dismissed: most asset managers that achieve a reasonable size are highly profitable. For example, it is estimated that the European fund industry generates annual revenues of more than €100 billion.²

The book will cover the organization and personnel of asset management companies, the costs, revenues and profitability of firms as well as the regulatory environment in which they work. It will provide an overview of the ways in which funds are invested and managed, as well as the role of star fund managers and a look at some of the stars who fell to earth. The book will then cover how firms compete with one another to sell their services to clients and the way customers are charged, before ending with a look into the industry’s crystal ball. This is not intended as a comprehensive study on the operation or regulation of mutual funds, but it will explain how funds are used as the basic products, or building blocks, upon which an asset manager grows its business.

The intention is to explain how the business of fund management works. It will differ from the extensive literature that provides advice or tips on how to invest or how particular fund managers have invested. The way fund managers’ businesses make money is far less explored.

Some of the basics

A useful starting point is to appreciate that the largest clients to whom asset managers sell their services are not individual or retail investors. Instead, most of the money asset managers look after comes via other organizations (or other branches of their own organization) that interact with retail clients. These include financial advisers, who are employed by wealth management firms or banks, or who belong to independent businesses. Corporate and institutional investors, including insurance companies and pension schemes, also use the services of asset managers, delegating the management of their assets to external firms. These different types of client will often have different expectations and demands as to what a fund manager should deliver or the way in which money should be managed or invested.

The main product around which an asset manager’s business is built is the mutual fund, which is also referred to as an investment fund, collective investment scheme, or pooled fund. Exact legal structures and regulations governing these products can vary from country to country, but the same basic principles apply. A mutual fund is a pool of money contributed by a range of investors, which is managed and invested as a whole and on behalf of those investors. The fund is a distinct legal entity separate from the company and is regulated separately to meet certain standards of disclosure, oversight, and safekeeping of its invested assets with the aim of upholding investors’ interests.

A customer will put money in a fund with the aim of receiving a higher return on the money invested than if it was left on deposit in a bank. Other benefits of a mutual fund can include the reduction of risk through its diverse range of investments; a reduction in costs by being part of a larger investment pool than if an investor was making investments on their own; tax advantages, such as holding a fund via an Individual Savings Account (ISA) in the UK.

The fund’s investment manager decides where and how to invest – buying and selling shares or other securities – within the constraints of the fund’s stated investment policy and objectives and the manager’s investment style or philosophy. Fund managers are also under an obligation to act in their clients’ best interests, sometimes referred to as a fiduciary duty, although interpretations of this vary.

Sizing the industry

Assets in mutual funds grow both from clients giving more money to asset managers and from fund managers investing that money successfully. Mutual fund assets globally totalled €51.4 trillion at the end of 2020, according to data collected by the European Fund and Asset Management Association (EFAMA). While funds based in the US account for almost half of the world’s total assets, the market accounts for less than 10 per cent of the number of funds. By contrast, Europe accounts for over 45 per cent of the world’s number of funds, while accounting for just over one third of global fund assets.³ The ratio of funds to assets is even higher for the younger Asian and Latin American fund markets.

Table 1.1 Size of the global funds industry

Source: EFAMA, International statistical release, as at December 2020.

This book will explore asset managers globally, but with a more detailed focus on activity within the UK and Europe and addressing the economics of the fund management industry that have led to this apparent proliferation of mutual funds in the region. Separating different fund markets in this analysis also enables more accurate conclusions to be drawn as market dynamics, such as the relative importance of different client types, vary from country to country. Adopting an artificially global view is likely to give conclusions skewed to the US, as a result of its size.

Asset managers also invest money through other investment vehicles not captured by these statistics, as information is less readily disclosed, if at all, most notably for institutional mandates or segregated accounts (where a contract is entered into directly between an institutional investor and an asset manager with the investment objectives agreed between the two), as well as so-called hedge funds and other investment strategies that do not use a traditional mutual fund structure. The similarities, differences and overlaps between mutual funds, mandates and hedge funds will be discussed later in the book. Estimates vary as to the total size of the asset management industry worldwide (including funds and mandates), but, as stated earlier, management consultants Boston Consulting Group put the global figure at $103 trillion at the end of 2020 (BCG 2021).

In Europe, mutual fund assets totalled €15.37 trillion at the end of 2020, 54 per cent of overall managed assets, while mandates accounted for €13.05 trillion (EFAMA 2021a). The greater share for funds has risen steadily since 2011, having dropped in the aftermath of the financial crisis in 2008. However, the split between funds and mandates varies between European countries. In the UK funds account for 40 per cent of total assets, in France the proportion is 58 per cent, while it is 79 per cent in Germany. These variations partly reflect that some countries also have fund structures that cater solely for institutional clients. These funds have less restrictive regulatory requirements, but they must meet criteria as to the type of client and/or the minimum size of investment, which is often several hundred thousand euros. The largest market for these types of institutional funds is Germany and its Spezialfonds, although other examples with sizeable assets include Brazil, Ireland, Japan and Luxembourg (EFAMA 2021a).

The resilience of the funds industry globally was also shown in 2020 as it grew by $7 trillion, a 16 per cent annual rise, despite the impact of the Covid-19 pandemic, most notably in March 2020 as stock markets slumped and many investors withdrew money. Approximately 30 per cent of the annual growth came from client inflows, or new money being invested in mutual funds, while 70 per cent of the industry’s growth was the result of an increase of the value of funds’ investments. The importance of both inflows from clients and funds’ performance – the returns they generate for their investors – will be explored later on.⁴

This growth is less surprising when looking back over the past 12 years since the global financial crisis, and seeing that the world’s mutual fund assets have grown from $16.7 trillion to $51.4 trillion, a compound annual growth rate of 9.8 per cent. Funds based in Asia Pacific have grown the most over this period, increasing their share of global fund assets from 7.8 per cent to 12.7 per cent, while North America and Europe-based funds have lost market share as a result of slower growth. Asia’s growth has been led by China and India, with compound growth rates of 22 per cent and 16 per cent, although most markets in the region have grown faster than the global average.

A focus on mutual funds as a means to analyse the economics of the fund management industry does not mean institutional clients will be excluded. Traditionally the mutual funds industry has been viewed as servicing retail clients, while mandates have been used for institutional clients. However, this split is now out of date with many institutional investors using mutual funds and, for example, institutional investment consultant Mercer now ranking among Europe’s largest mutual fund providers, with assets of more than €100 billion.⁵ This has been supported by institutional demand for exchange-traded funds, a newer breed of mutual fund. It is worth adding that mandates have also begun to be used by wealth managers, rather than institutional investors, but this move has so far been very limited in terms of overall assets.

In addition, much of the discussion around whether to use a mandate or a mutual fund comes down to economics: the balance between how much a client is planning to invest and the level of fees a fund manager will charge. This calculation will affect the willingness or ability of either party to use a mandate or a fund. Similar calculations will also be weighed by asset managers when setting the fee levels of their mutual funds, so mandates are an additional consideration for firms but not the result of a fundamentally different assessment.

Table 1.2 World’s largest asset managers

Source: Thinking Ahead Institute, WTW, Pensions & Investment. Data at December 2020.

A service wrapped in a product

Any analysis of the economics of the industry must assess the products it sells. The asset management industry is interesting in that it sells a service wrapped in a product. This is apparent in the way asset managers emphasize that their industry is a people business, in other words it is ultimately the calibre of the fund managers and the employees around them that make their businesses successful with the service they offer, rather than the industry selling a commodity produced on a conveyer belt. This will be explored later in the book.

The fund management industry is also a large employer. In the UK alone there are around 42,000 people employed directly by asset managers and 72,000 employed indirectly in administration and dealing activities, according to estimates from the Investment Association, the UK’s asset management trade body. In addition, there are 27,500 financial advisers in the UK (FCA 2021).

Not all asset managers look the same. Some of the world’s largest and best-known fund houses are independent, standalone firms, such as BlackRock, Vanguard and Fidelity. But others are part of investment banks, such as JPMorgan Asset Management or Goldman Sachs Asset Management, or insurance firms, such as Legal & General Investment Management or AXA Investment Management. German insurer Allianz owns two asset managers, Allianz Global Investors and PIMCO.

This mix of ownership flows through the industry and is also reflected in some firms being publicly listed while others are held privately. BlackRock, which manages more than $10 trillion of assets,⁶ is publicly listed on the New York Stock Exchange, alongside competitors including Invesco and Franklin Templeton. In Europe, Amundi and DWS are listed, albeit a majority stake is held respectively by French bank Credit Agricole and Germany’s Deutsche Bank. Baillie Gifford, one of the UK’s largest asset managers, is a private partnership, while one of Switzerland’s largest asset managers, Pictet Asset Management, is part of the Pictet Group, which in turn is a private partnership. There are significant family stakes in firms including privately-run Fidelity (the Johnson family) and publicly listed Schroders (the Schroder family).

Ownership of these firms has an impact on the distribution of their products, for example, a bank-owned investment manager being able to sell funds via its parent company’s own banking network. Alternatively, an asset manager that has a wealth management division can sell its funds through that channel. This highlights how asset managers are part of a value chain, with each link in the chain providing a service (and incurring a cost) that has an impact on the product delivered to the end-client. The main elements of the chain are the investment manager, back-office functions supporting the investment manager (such as the safekeeping of assets and keeping a register of investors), intermediaries advising their clients on which funds to use (for example, a bank, independent financial adviser or investment consultant), an investment platform where the funds can be bought and sold (this feature is particularly prominent in the UK), and the end investor. This chain could also be extended to include the companies in which a fund manager invests, although this link is normally excluded from consideration in this context and lies largely outside the scope of this book as it relates to investing rather than the business of asset management. However, where investee companies are addressed later is in relation to asset managers’ increased focus on sustainability. The value chain is set out in Figure 3.2.

Supply and demand

When considering the sale of mutual funds, it is striking that the asset management industry seemingly pays only limited heed to the traditional laws of supply and demand. (This is separate from the application of these laws to the companies in which fund managers invest and might compete with one another to buy). The law of demand suggests that the higher the price of a product, the less will be demanded, other things being equal, while the lower the price of a product, the more people can afford it and so will purchase more of it. But the fees charged to investors have not fallen in proportion to the number of mutual funds growing. Many funds have been able to attract significant assets from clients, almost regardless of their fee levels. Instead the two biggest factors in pushing down fee levels have been regulatory intervention and the use of different types of mutual funds that track a predefined list, or index, of securities, rather than relying on an investment manager to select investments.

The extent to which the fund management industry turns the laws of supply and demand on their head will be considered later, particularly the importance of other things being equal when it comes to customers comparing funds. The laws of supply and demand also raise questions about the extent to which fund management is a service or a commodity, as well as clients’ perception of the products they invest in and the price they pay for this.

These pressures have also not held back mutual funds from being launched, as the figures on the number of funds referred to earlier suggest. There are more than twice as many mutual funds as there are companies listed on stock exchanges around the world, with more than 59,000 public companies in March 2022, according to the World Federation of Exchanges.⁷ This apparently illogical and/or inefficient situation will also be addressed.

Laying out fund managers’ overall size and activities should indicate the importance of the industry in touching the lives of virtually everyone in the world’s developed economies, and increasingly within developing economies too. This encompasses fund managers’ role in allocating capital to companies, helping people save for their retirement, and underpinning insurance products. This gives some sense of the reach of the industry, even when many are unaware of asset managers’ activities, and why their profitability and often high salaries are all the more relevant to society as a whole.

How funds make money

It is worth setting out some more detail on the way a mutual fund works before moving on to look at the organizational structure and business model of the firms that manage them. This will be useful to better understand the impact of actions taken by these companies. As mentioned above, a mutual fund is a pool of money contributed by a range of individuals and organizations. When people invest in a mutual fund, they are buying shares in it, and the fund manager is obliged to act in the interests of those shareholders. (Some funds are not structured as companies, as will be addressed later, but the same principle remains valid as a means to evaluate asset managers’ role and activities). The term mutual is appropriate: each share that the shareholder holds in a fund is invested the same way. Here, and throughout the book, references to mutual funds relate to so-called open-ended funds. Closed-ended funds will occasionally be referred to and will be explained at that time.

A mutual fund’s size, the amount of money in the pool, reflects the number of shares (or units) in the fund multiplied by their price. This is known as the fund’s net asset value (NAV), which is the total value of a fund’s assets, less its liabilities. The net asset value divided by a fund’s number of shares is referred to as the NAV per share. A fund’s NAV is most commonly calculated daily for mutual funds – the fund’s valuation – although a fund can be valued over other periods, such as weekly or monthly. A fund’s assets will change each day as a result of money moving into and out of it from investors. This is known as sales (shares in a fund being sold to investors) and redemptions (investors redeeming or withdrawing money from a fund), alternatively referred to as inflows and outflows. A fund’s size will also change as a result of the value of its investments, in other words the return that a fund generates for its investors, which is commonly referred to as the fund’s performance. The value of each investor’s share in the fund will vary accordingly, rising as the fund’s investments rise in value, and falling if its investments fall.

The size of the fund matters to fund management companies because this is a crucial aspect in determining how much money they make. Each fund charges its investors indirectly by taking a percentage of the fund’s assets and paying this to the fund company and to other firms that help to ensure the proper day-to-day operations of the fund. There are other ways to charge fund investors, most notably performance-related fees, which will be discussed later in the book. But for now, it is worth giving a few examples to demonstrate the importance of the relationship between a fund’s size and its annual charges.

A fund with £10 million of assets, which would be considered small, that charges investors 1 per cent a year makes the company £100,000 a year in revenue. A £100 million fund with the same charge makes the company £1 million a year, while a £1 billion fund generates £10 million a year. Or if an asset manager is willing to push up its percentage charges, then fund size matters less. So, if a £500 million fund’s annual charge is doubled to 2 per cent then it can pull in £10 million a year. The largest funds in the UK and Europe are over £10 billion in size. With a 1 per cent charge, such a fund makes £100 million a year. The bottom line: the larger a fund gets, the larger the fees it generates for those managing it.

The size of a fund’s percentage annual charge also matters for an investor. Not just because of potential concerns about the size of salaries that individuals might receive from fees generated from the funds they manage. But, more importantly, it matters because these charges directly impact on the returns that investors receive. By charging a percentage of a fund’s assets to meet its costs – 1 per cent in our example – the growth of the fund is reduced by the same amount. So if a fund’s investments rise in value by 9 per cent in one year, the return to the investor is 8 per cent. Mutual funds are required to quote performance figures net of charges to their clients, showing how much investors in the fund receive, rather than just how well the individual fund manager is doing by selecting and holding the right investments at the right time. However, performance without the impact of fees (gross performance figures) are often used for institutional clients.

Many retail investors pay little attention to a fund’s annual charge, but it continues to be a significant issue that financial regulators monitor and, at times, intervene on. For example, a former head of the US financial regulator has said: Money management firms operating mutual funds want to maximize their profits through fees provided by the funds, but the fees, of course, paid to these firms, reduce the returns to fund investors (Donaldson 2004). So for an asset manager, there is both an incentive to perform better to help its clients, as well as an interlinked, and potentially conflicting, incentive for the fund management company to grow assets by getting more investors to put more money into each of its funds. These two areas represent the main functions of a fund management company and can be seen in its operations divisions. The range of functions that sit within each of these divisions will be covered in Chapter 2, as well as aspects where roles can be outsourced to external companies.

Following this, Chapter 3 will discuss asset managers’ business models, including their ownership structures, how they interact with other businesses in an extended value chain, and issues relating to cost management and profitability. The chapter will also address the valuation of asset management companies.

Chapters 4 and 5 will detail the role of the fund manager as investor, steward, and sub-advisor, as well as discussing fund manager skill. The relative importance of high-profile fund managers in attracting clients will also be covered, before moving onto some case studies of where former star investors have become better known as scandals, including Neil Woodford, as well as older cases, such as Peter Young and Bernie Cornfeld. These examples serve as a form of institutional memory for the industry and also lead onto a discussion of culture at asset management firms.

Chapter 6 will explore the interlinked issues of fund managers’ purpose – as opposed to their role or function – and sustainability, including client needs, the allocation of capital to companies, and the rise of ESG considerations. Chapter 7 will provide an overview of the external regulation of funds, both in the UK and across Europe, including how it has accelerated the growth of the industry, and how Brexit has changed this. The chapter will also examine different European fund structures, as well as the tension between asset managers’ desire for less regulation (and its associated costs) and regulators’ instinct to regulate (to safeguard investors’ interests).

Chapter 8 will look at the importance of fund sales and product development in asset managers’ growth, including how firms sell their funds, and explain different client types and distribution channels. Chapter 9 will consider how firms make money from their clients, including different charging models, as well as price competition (or lack of it) in the UK and Europe. The final chapter will draw together different strands from the book and look at some of the challenges ahead for the industry.

1. Boston Consulting Group’s figures include assets professionally managed in exchange for management