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Evaluating the business structure of an asset manager is an important qualitative input into the rating of their funds.But do the shareholders and business executives of a fund manager really impact how portfolios are managed day to day? Or are fund selectors simply ticking a box? Our sense is that business structure really matters and that we can evidence that it affects how funds are managed.
We can use an example to bring this to life by creating a fictitious fund management business that maximises short-term profits and sales opportunities, rather than maximising returns to their clients. Such a firm would probably link their fees to their asset growth, so that they were paid whether they delivered good value for money or not. And their portfolio managers that were good at raising assets would be saddled with more and more funds to run.
Fund lists across the firm would be extensive, ensuring there is always something to sell. The business is likely to have limited evidence of capping their funds, and fairly common evidence of behemoth funds that inferred managing business risk ranked above investment risk. Incentives for fund managers would be linked to profit or revenue, rather than excess returns. Where incentives were linked to returns, they would be based on short-term, peer group comparisons, rather than tougher, passive alternatives. Communications would be sugar-coated and obfuscating, because where there is mystery, there is margin. When it comes to tough decisions that pit profit against principle, they choose profit – passing the costs of the sell side on to clients.
This is clearly an exaggerated, cynical view of a fund manager’s business, but we have caricatured it to make the point. In this example, the evidence is strong that the shareholder and business directly influence how funds are managed. For example, successful fund managers may become diluted or even quasi-portfolio administrators if saddled with too many funds to manage. They may also find it tougher to trade in smaller investments because the firm – or their fund – has such large assets under management. They may also be looking over their shoulders at their peers, encouraging them to avoid those important contrarian decisions that play out over the long term. Aside from incentive-driven behaviour established by the business, there is also the issue of organisational culture.
Culture is that set of aggregate beliefs and behaviours inside a firm that is often set by the executives and feeds down into the wider organisation. A good culture is reflected in many different ways, like the honesty of communications, caring for staff and staff diversification, the ability to admit mistakes, what behaviours get rewarded and the degree to which the end client is prioritised.
This all tends to manifest itself in one key way from an investment perspective: the ability to attract and retain good people over long periods, which again directly impacts fund management. Business structures should be an enabler, not a disabler of the investment team.
Those aspects that work against the client – such as bulk assets, consensus thinking, running too many funds, turning fund managers into salespeople and cut-throat cultures – all find their way into the running of client portfolios. Those firms that can structurally align best with their end clients over the long term can, and should, be rewarded with better fund ratings over time.
This article was originally published in FT Adviser on 4th July 2018