Asset Management – Industry Overview (Part 1 of 4)

Asset managers are institutions that ‘manage money’ on behalf of certain beneficiaries. What does this mean exactly? Well, asset managers aim to understand client investment objectives and invest client funds in a variety of financial products and asset classes. These asset classes can include public equities/stocks, fixed income/bonds, money markets, commodities, infrastructure, real estate and alternative strategies – including hedge funds, private equity and venture capital.

The asset management industry is a steward of money provided by individuals and institutions, and manages this money in order to meet the unique return objectives of each client. The asset manager can be compensated in a variety of ways including fixed fees, pay for performance, and as a percentage of assets under management (AUM).

Due to the steady nature of the business (taking a percentage of assets under management each year is a pretty sweet deal), asset managers have a business valued more like a basic corporate than other financial institutions such as banks and insurers.

Asset management can be broadly divided into retail and institutional asset managers depending on whose money they handle. However, the largest firms cover both retail and instutional clients – the best example being BlackRock. Clients can be sub-segmented into general retail, high net worth, ultra-high net worth, institutional, pension, and corporate.

Different asset managers may specialize in different asset classes – for instance, Fidelity is known for being a public equity mutual fund while Brookfield is an alternative asset manager that has historically focused on hard assets such as infrastructure, power and real estate. However, there are no set rules and asset managers will often dip outside of their historical expertise, poaching star portfolio managers from other firms to start their own funds in different asset classes.

As a rule of thumb, the higher the average return of the asset class, the higher the management fee. Management expense ratios for equity funds are higher than those of fixed income funds, which are in turn higher than those of money markets funds.

Major traditional asset managers include:

• Blackrock
• Vanguard
• Fidelity
• PIMCO
• Invesco
• Franklin Resources
• Affiliated Managers
• T Rowe Price
• Eaton Vance

Asset Management Business Model

1. Asset Management Fees

Revenue is typically a percentage of AUM plus any administrative fees. Retail asset managers will offer a variety of products including mutual funds, index funds and specialized pools. Some asset managers are merely acting as a temporary custodian, in which case the fee is mostly administrative. When the mandate of the asset manager is to grow the capital, the fee will be higher. The more advanced the strategy and the more expertise required, the larger the fee will be (for instance, a high yield bond manager specializing in oil and gas). For most investors, they will see information about fees in the fund prospectus and marketing materials as the management expense ratio (MER) and any administrative fee.

For alternative asset managers, fees can be substantially higher than 2% of total assets per year, which is the standard management fee of mutual funds. Hedge funds typically charge an additional 20% profit participation fee on profits earned above a certain threshold. Similarly, private equity firms typically earn carried interest, which allows them to receive a share of profits after the fund’s rate of return exceeds a specified hurdle rate.

When the stock market is performing well, most asset managers that are equity or stock focused will have higher AUM at the end of the year. Higher AUM will of course equal higher fees. As such, asset manager performance tends to be correlated with stock market performance. A good asset manager will see assets grow even when the broader market is flat or falling. Especially with stocks having run up continuously since the financial crisis, there is a growing demand for asset managers who are able to generate consistent returns uncorrelated with the market and for asset classes that fulfill this mandate (real estate and infrastructure).

Larger index funds may also use their funds to lend securities to short sellers, which has the potential to generate additional revenue.

2. Asset Management Expenses

Salaries and trailer fees constitute the largest expenses.  Asset managers must pay salaries; the most expensive of which being the portfolio managers for the respective funds. If the PM is seen as a driver of AUM, whether through sales or performance, he can command a much higher share of the proceeds than a PM who is not. Mutual funds are typically sold to investors by third parties, which means that trailer fees will also have to be distributed to the respective salesperson.

3. Trailer Fees and Distribution Channels

Selling through third party channels is a direct cost of sales – as third party and independent distribution channels will take cuts of the MER via trailer fees. As a starting point, trailer fees are 50% of the MER, but depending on buyer or seller power, this can go 60-40 either way. For instance, if a mid-sized asset manager is selling its mutual funds via a small bank, the bank may only get 40% of the MER. Conversely, if the asset manager has a distribution agreement with HSBC, they can expect HSBC to get 60%.

The administrative fee is separate, but if it is included in the total MER structure, it ends up being 40-40-20 (the 20 being for covering administrative expenses).

Asset managers may also outsource to other asset managers for specific mandates that they are not able to satisfy for some portfolios. In which case, the other asset manager will skim a margin off the top or negotiate a split for the MER.

4. Operating Margins

After other selling, general and administrative expenses – including large scale marketing efforts from the ads you may see in the financial district – we get to the operating profit of the asset manager. Asset managers are rarely highly levered, so net income is fairly easy to calculate (although asset managers may have holdings in other asset managers, complicating the consolidation).

Operating margin is a very important metric for asset managers as it reflects how much of the fees generated are kept by the company. This is a major reason for asset manager M&A as there are large economies of scale from cutting general and administrative expenses as well as increasing selling power to third party channels and distributors. As a general rule, higher AUM means a better operating margin for traditional asset managers.

We have prepared a Brief Guide to Asset Management, you can download it now.

Jason Oh is a management consultant at Novantas with expertise in scaling profitability for retail banks (consumer / commercial finance) and diversified financial service firms (credit card / asset management / direct bank).

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