The Economics of Fund Management 1788215338, 9781788215336

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The Economics of Big Business This series of books provides short, accessible introductions to the economics of major business sectors. Each book focuses on one particular global industry and examines its business model, economic strategy, the determinants of profitability as well as the unique issues facing its economic future. More general cross-sector challenges, which may be ethical, technological, or environmental, as well as wider questions raised by the concentration of economic power, are also explored. The series offers rigorous presentations of the fundamental economics underpinning key business sectors suitable for course use and a professional readership. Published The Economics of Airlines, Second Edition Volodymyr Bilotkach The Economics of Arms Keith Hartley The Economics of Construction Stephen Gruneberg and Noble Francis The Economics of Fishing Rögnvaldur Hannesson The Economics of Fund Management Ed Moisson The Economics of Music, Second Edition Peter Tschmuck The Economics of Oil and Gas Xiaoyi Mu

T H E E CO N O M I C S O F F U N D M A N AG E M E N T ED MOISSON

© Ed Moisson 2022 This book is in copyright under the Berne Convention. No reproduction without permission. All rights reserved. First published in 2022 by Agenda Publishing Agenda Publishing Limited The Core Bath Lane Newcastle Helix Newcastle upon Tyne NE4 5TF www.agendapub.com ISBN 978-1-78821-533-6 (hardcover) ISBN 978-1-78821-534-3 (paperback) British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Typeset by JS Typesetting Ltd, Porthcawl, Mid Glamorgan Printed and bound in the UK by CPI Group (UK) Ltd, Croydon, CR0 4YY

CO N T E N T S



Preface and acknowledgements Acronyms and abbreviations

vii xiii

  1. Introduction

1

  2. Organization

15

  3. Business model

39

  4. Managing money

67

  5. Stars and scandals

97

  6. Purpose and sustainability

123

  7. Regulations and responsibilities

141

  8. Sales and products

163

  9. Fees and charging

187

10. Conclusions and the future: have we reached peak mutual fund?

219



229 241 249 251

Glossary References List of tables and figures Index

v

P R E FAC E A N D AC K N O W L E D G E M E N T S

My ideas for this book had been milling around for several years, but there is nothing like having surgery during a pandemic to focus your mind. I was fortunate that Steven Gerrard at Agenda read the resulting outline and suggested that it could form the basis for an addition to Agenda’s series on the Economics of Big Business – short, accessible introductions to the economics of major business sectors. I cannot thank him enough for giving me the chance to take this on. I am not an economist, so readers certainly do not need to be to gain an understanding of how the fund management industry functions and operates. The vast majority of literature relating to asset managers concerns how they invest, so there seems ample room to explore the array of other functions as well. There is even more room to explore asset management in Europe and the UK when so many books are focused on the United States, either intentionally or as a result of it being the world’s largest market for mutual funds. Writing this book has prompted me to reflect on what has changed, and what hasn’t, over the years since I entered the asset management industry in the late 1990s. This has made the process of writing particularly enjoyable as time for reflection of this kind is less easy when writing about what is new in the industry day-to-day as a journalist. Unusually, my earliest experience in asset management was analysing funds’ charges, which perhaps explains why I have found this part of the industry (how it makes money) just as interesting as its investment role (how it makes money for clients). I have been fortunate that over the intervening years I have been involved in researching and writing about funds’ performance, flows, regulations, distribution, as well vii

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as the impact of technology and the development of new products on fund businesses. Working variously at a research firm, inside an asset manager and as a journalist has given me the chance to hear diverse perspectives on the industry, both from colleagues and from those at other firms across Europe, as well as in the United States and Asia. This has been made more interesting, and sometimes more lively, by often trying to explore issues that asset managers tend to prefer to be left unexplored. This book must therefore partially reflect those myriad views, although it also reflects my interpretation of events and actions and so responsibility for the views expressed in this book rests with me alone. I hope to have conveyed information and insights on all of the most relevant issues, although the book’s wide scope inevitably means some areas are not tackled in depth. However, I think the book serves its main purpose, and should be more accessible, as a result. The aim is also to offer enough food for thought to make it of interest to those already working in asset management, and potentially those with a more general interest in better understanding an industry that has a growing influence in the wider economy. My experiences over the past 20 years or so have left me with the lasting impression that there is little room for self-doubt when working in asset management – certainly the wind of self-confidence fills the sails of the industry’s successful executives. It is not really an industry for those that lack this confidence, let alone one for introverts. But as a journalist I find myself regularly questioning my own views and interpretations even as I pose questions to those working in and around the business of fund management. Over the years, hearing recycled thoughts being regurgitated as though profound wisdom is being imparted has sometimes left me longing for more original or contrarian opinions. This seems surprising in an industry that prides itself on being a “people business”, where a range of different people with different views would seem to be a prerequisite. This situation partly reflects asset managers’ struggles to be more diverse, as well as likely reflecting that it is not only a competitive industry, but also one where firms (particularly those operating in multiple markets) are simultaneously cautious about being seen to be too different from the norm lest they make any clients nervous. Being a safe pair of hands when managing clients’ money clearly has its merits. But looking at the way firms advertise themselves or position their brands shows the result: most asset managers simply explain what the industry does (i.e. investing) viii

PREFACE AND ACKNOWLEDGEMENTS

rather than showing how their particular business is different from others. I think this is partly because while every firm can agree it is striving to deliver good financial returns for clients, distinguishing a fund management company from its peers in any other way presents a tension between the interests of investors in funds and the investors in the fund management business. This is the inherent tension, and potential conflict of interest, that asset managers must grapple with, but which they prefer to downplay: higher fees for the business mean lower returns for clients, all other things being equal. The recurring and highly resilient revenue stream that a fund management business provides is one of the main reasons why the industry has moved from a backwater in European financial services to a prized possession over the past 40 years (albeit ebbing and flowing in the intervening years). This was shown in the speed with which the European funds industry recovered from an initial loss of almost €1.3 trillion in assets in March 2020 triggered by the Covid-19 pandemic, as clients withdrew from funds and stock markets fell. But rather than suffering a longer-term hit to revenues, asset levels had recovered by August of the same year. Asset managers in the UK and Europe have not always been in this position. The modern UK fund management industry arguably entered the mainstream in the late 1980s, boosted by the demand from retail investors on the back of tax-incentivized Personal Equity Plans (PEPs) introduced in the government’s 1986 Budget, which had the aim of expanding individual share ownership. In time PEPs were replaced by Individual Savings Accounts (ISAs), but the idea was the same. The power of star fund managers (including Morgan Grenfell’s Peter Young, discussed in this book) to attract these UK clients really came to the fore in the 1990s and they have been a key element of the industry ever since (which isn’t to say there weren’t good fund managers before this period, but they worked in an unglamorous business, not helped by long memories of the chaos caused by Bernie Cornfeld). As a result, the highs and lows of star managers and their relevance to the wider industry are explored in this book, at the very least to provide some form of institutional memory which I think is important not to lose when considering the fund management businesses of today and tomorrow. In a similar way, the post-Brexit world might make it easier to forget the importance of EU regulations in helping the growth of the European funds industry (including the UK). British and US firms recognized the commercial possibilities offered by the EU’s UCITS directive in the late 1990s and ix

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never looked back. More recently, the vast majority of UK and European asset managers have embraced the need for environmental, social and governance (ESG) considerations – or at least recognized the need to pay lip service to this. There are also some firms that are shouting about how they have been ESG investors for many years. Only a very few are turning their backs on ESG altogether. As firms grapple with integrating non-financial considerations into their investment process, it does seem as though asset managers are moving into the next phase of their evolution, even if it is unlikely that aspects such as the appeal of star managers will fade altogether. What hasn’t changed is the push for increased profitability, which is why seeing sustainable investing as a sales opportunity has the potential to be so toxic and why the phrase “greenwashing” is being thrown around so frequently. Profitability is one of the alluring features of running an asset management business, so it is perhaps surprising how this aspect of the industry seems underexplored. This is not to say that all firms are profitable, but certainly an asset management firm does not have to be a high-flyer to be highly profitable. Yet quite a few in the industry seemed taken aback by the UK financial regulator’s findings in the interim report for its asset management market study (published in November 2016). Here the Financial Conduct Authority laid out the relative operating margins for UK companies in different industry groups, with asset managers averaging between 34 and 39 per cent in each of the six years analysed. The FCA found that “industry groups with similar business structures (high human capital, relatively low physical or financial capital) found margins in the 4% to 33% range”. Half of the asset management firms in the FCA’s sample had an average operating margin above 30 per cent and three quarters had an average operating margin above 20 per cent. The FCA’s subsequent willingness to try and intervene on charging levels (via new responsibilities for authorized fund managers’ boards) shocked many in the industry who were used to the market being relied on to take care of such issues. The FCA’s actions were perhaps more surprising after less than ten years since the shake-up in sales practices through the Retail Distribution Review. With EU regulators considering whether there is a need for similar interventions, and with competitive pressures from lower charging funds, this is no time for active asset managers to rest easy. This also means it is the right time to be considering how these firms generate revenues and interact with clients. x

PREFACE AND ACKNOWLEDGEMENTS

Researching an industry is not possible without the knowledge, insights and goodwill of a wide array of people – far too many to name them all here, sadly. Their civility far outweighs the unpleasantness I have also encountered in the industry, as in any walk of like. I am particularly grateful to Paul Moulton and Diana Mackay for their kindness and wisdom. Much of my work has been spent writing about data, so many thanks are due to Brian Reynolds, Martin Wood, Clare Arber, Joy Moon and Alison Blease for their guidance and understanding in making this as accessible as possible over the years. Making the later transition to journalism was only made possible by the tireless efforts of Baptiste Aboulian (long-standing editor of Ignites Europe, the Financial Times’s daily asset management news service), whose support has been invaluable in tackling many stories not covered anywhere else. This work has been made all the more enjoyable for being able to work with many talented journalists, so thanks also to Anna Devine, Siobhan Riding, Robert Van Egghen, David Ricketts, Sandra Heistruvers, Alf Wilkinson, Amie Keeley, Dawn Cowie, Chloe Leung, Aime Williams, Attracta Mooney, Mary McDougall, Dominic Lawson and Jessica Tasman-Jones. I should add that Matt Fottrell’s support enabling me to take on this project is also much appreciated. This book would not have come about without the help of those who imparted their knowledge on particular topics or who pulled together data specifically for it. My gratitude for this goes to Jerome Couteur, Laura Guthrie, Chris Chancellor, Hugues Gillibert, Fabrizio Zumbo, Mary Kenefake, Mark St Giles, Will Mayne, Philip Kalus, Jeff Tjornehoj, Nicky Bloom, Heather Hopkins, Bernard Delbecque, Detlef Glow, Magnus Spence, Jonathan Davis, the team at the Investment Association, as well as others who have asked to remain anonymous. As much as the comings and goings of the fund management industry continue to stimulate my mind at work, it is hard to beat the feeling of simply seeing Claire and William at the end of each day and hearing about what they have been up to. Their forbearance while this book has taken over my life has been extraordinary. Their support, and that of my parents, AP and LM, always encourages me to do what I feel is beyond me, even if I fail sometimes in the attempt. As I would not have got close to writing it without them all, I would like to dedicate this book to my family. Thank you for everything. Ed Moisson xi

AC R O N Y M S A N D A B B R E V I AT I O N S

ACD AFM AIC AIF AIFM AIFMD AIMA AoV AUM CMA EBITDA EFAMA ELTIF ESG ESMA ETF EV FCA FCP FRC GARP GFC HFT IA

authorized corporate director authorized fund manager (UK) Association of Investment Companies alternative investment fund alternative investment fund manager Alternative Investment Fund Managers Directive Alternative Investment Management Association assessment of value assets under management Competition and Markets Authority earnings before interest, taxes, depreciation and amortization European Fund and Asset Management Association European long-term investment fund environmental, social and governance European Securities and Markets Authority exchange-traded fund enterprise value Financial Conduct Authority Fonds commun de placement (contract-based fund structure) Financial Reporting Council growth at a reasonable price global financial crisis (2008) high-frequency trading Investment Association xiii

THE ECONOMICS OF FUND MANAGEMENT

ICI ICVC IFA IOS IOSCO ISA KID KIID LTAF MiFID NAV NCA NZAM OCF OEIC P/E PEP PRI PRIIPs PRA RDR RIA SDG SDR SEC SFDR SICAV SIF SRI TER UCI UCITS

xiv

Investment Company Institute investment company with variable capital independent financial adviser Investors Overseas Services International Organization of Securities Commissions individual savings account (UK tax-incentivized savings plan) key information document (for PRIIPs) key investor information document (for UCITS) long-term asset fund Markets in Financial Instruments Directive net asset value national competent authority Net Zero Asset Managers initiative ongoing charges figure open-ended investment company price to earnings (ratio) personal equity plan principles for responsible investment packaged retail and insurance-based investment products Prudential Regulation Authority Retail Distribution Review registered investment advisor (US) United Nations’ sustainable development goals Sustainability disclosure requirements (UK) Securities and Exchange Commission Sustainable finance disclosures regulation (EU) Société d’investissement à capital variable (corporate fund structure) specialized investment fund socially responsible investing total expense ratio undertakings for collective investment (non-UCITS) undertakings for collective investment in transferable securities

“If you want to make money, don’t horse around with steel or light globes. Work directly with money.” – Bernie Cornfeld

1

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 1. Boston Consulting Group’s figures include assets professionally managed in exchange for management fees; captive assets of insurance groups or pension funds where assets are delegated to asset management entities with fees paid; hedge funds, private equity, real estate, infrastructure, commodities, and private debt. Overall 44 markets are covered, including offshore centres (BCG 2021).

1

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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. 2. Author’s estimate; see section on “Why fund charges matter” in Chapter 9.

2

INTRODUCTION

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. 3

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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 Market United States Europe Asia Pacific Rest of World Total

Assets (€ trillion)

Number of funds

23.91 17.73 7.16 2.59 51.39

9,840 57,753 35,974 22,890 126,457

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

3. Approximately 54 per cent of the number of funds in Europe and 63 per cent of the total assets are in UCITS funds. Other European funds are classified as alternative investment funds. This distinction will be covered in the Chapter 7.

4

INTRODUCTION

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 5

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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

4. Data in this section reflect my analysis of mutual fund data available through the Morningstar Direct database. I have prepared other figures and analysis using the same database throughout this book and so references to Morningstar data reflect this analysis, unless a specific report written by Morningstar analysts is cited. Elsewhere I have made use of other fund data and information sources, including Cerulli Associates, Fitz Partners, instiHub, and Refinitiv Lipper. Other figures referenced in this book were prepared by analysts at these organizations, either as part of their wider research activities or specifically in response to my requests for this book. Many thanks are due to the analysts at these organizations for their invaluable help. 5. Morningstar data, as at June 2021.

6

INTRODUCTION

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 Company BlackRock Vanguard Fidelity State Street Allianz J.P. Morgan Chase Capital Group BNY Mellon Goldman Sachs Amundi Legal & General Prudential Financial UBS Franklin Templeton Morgan Stanley T. Rowe Price Wells Fargo BNP Paribas Northern Trust Natixis

Total assets (US$m) 8,676,680 7,148,807 3,609,098 3,467,467 2,934,265 2,716,000 2,383,707 2,210,574 2,145,000 2,126,391 1,736,402 1,720,958 1,641,000 1,497,955 1,474,627 1,470,500 1,455,000 1,430,900 1,405,300 1,389,663

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

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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 bestknown 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). 6. BlackRock, Earnings release for Q4 2021, 14 January 2022.

8

INTRODUCTION

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 9

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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 7. See https://www.world-exchanges.org/.

10

INTRODUCTION

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 11

THE ECONOMICS OF FUND MANAGEMENT

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. 12

INTRODUCTION

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.

13

2

O R G A N I Z AT I O N

Each fund management company is divided broadly into three divisions: its investment management team, those involved in sales and marketing, and support functions including operations and administration. This does not mean that every firm will neatly divide up its business in this way, but the division provides a useful model by which to understand an asset manager’s organizational structure. In addition, various elements of this structure can be outsourced to external organizations (third parties). For example, many start-ups and smaller firms outsource operational and governance functions. This chapter provides an overview of these different functions and the roles within them, as well as areas where outsourcing is used. Approximately 42,000 people are directly employed by asset managers in the UK (IA 2021). A breakdown of these figures shows that operational roles account for half of those employed in the industry, while investment roles account for roughly one quarter of the total (see Table 2.1). The figures provide a useful way to visualize the shape of an asset management business through its staff, despite the composition of larger firms inevitably impacting the overall figures and also bearing in mind that outsourced roles are not included. The 2008 financial crisis hit employment at UK asset managers, with those directly employed falling from 25,500 in 2007 to 24,000 in 2009, according to surveys by the UK asset managers’ trade body, the Investment Association. Employment has risen each year since. The surveys also suggest that one of the most significant responses to the financial crisis was an increase in staff in compliance and oversight functions, which now stand at 8 per cent of the total, up from a low of 4 per cent in 2010, although the current level looks to 15

THE ECONOMICS OF FUND MANAGEMENT

Table 2.1  Direct employment by UK asset managers Activity Investment management Business development & client services Operations and fund administration Information technology systems Corporate finance & corporate admin Compliance, legal and audit Other

Percentage of employees 27 17 16 14 12 8 6

Source: Investment Association (2021).

be stable, having been reached five years ago. The rise in internal IT appointments continues, however, accounting for 11 per cent of the total five years ago and 14 per cent today (IA 2021). The European Fund and Asset Management Association (EFAMA) uses the UK figures, together with equivalent information from France and Germany to extrapolate a European total of around 115,000 individuals directly employed by the asset management industry (EFAMA 2021). The European trade body then considers the indirect employment generated by the industry through related services, such as distribution and advice, auditing, custodianship, legal, marketing, research and technology, and estimates that together these firms help create 644,000 full-time jobs.

Heart of the machine The investment management function, each firm’s front office, is the core of any asset management company. This is made up not only of fund or portfolio managers, but also an array of investment analysts and researchers who provide and investigate investment ideas for fund managers to consider. Detailed examinations of the investment philosophies, tactics, strategies and styles of investment managers largely lie outside the scope of this book, although the role of the investment manager within a firm and as a means to build a business will be looked at in the next chapter. 16

ORGANIZATION

Broadly the role involves researching and selecting particular stocks or other assets to invest in. A fund manager’s views on both the types of investments and the specific assets to select will be influenced by his or her experience and investment philosophy, the changing economic and political environment, and contributions from the rest of the investment team on individual companies as well as wider economic analysis. The fund manager is also constrained in his or her decisions on where to invest, or disinvest, depending on their fund’s investment policy and objectives. This is laid out in the fund’s statutory documents, such as its prospectus. While the objectives may be broad, such as seeking capital growth over the long term, a fund’s investment policy should provide more detail in how this objective will be achieved, for example, by investing at least 80 per cent of a portfolio in publicly listed equities in a particular country or region. The importance of the fund manager’s role is most apparent when a fund is actively managed, in other words, the investments are made as a direct result of his or her decisions. But there are also a growing number of funds that are passively managed, which are known as index-tracking funds, or simply index funds. Rather than relying on the fund manager to pick investments, an index fund picks certain investments based on predetermined rules. These rules are mostly commonly based on the constituents of a stock market index, for example, tracking the FTSE 100 index, which is the 100 companies with the largest market capitalization listed on the London Stock Exchange, or tracking the S&P 500 index, the largest 500 companies in the United States. These funds do require management oversight to ensure the tracking is carried out as efficiently as possible, but inevitably the input of an investment manager or research analysts is dramatically reduced. The investment dealing team also forms part of the front office and carries out the investment managers’ instructions on buying and selling securities, or trades. The team evaluates different trading venues where the buy or sell order can be executed, recording details of the terms of each potential trade, before confirming the trade and ensuring it is settled in time and on the terms agreed. The role also involves the management of a potentially wide array of trades to be carried out at different times for different types of security and for different funds. Record-keeping must be robust throughout, not least as this area has been an area of focus for financial regulators.

17

THE ECONOMICS OF FUND MANAGEMENT

Dealers will trade securities of different types, including equities, fixed income, commodities, and derivatives contracts. The differences between funds that invest in different types of securities will be discussed later. The dealing desk manages trades for index funds too, adjusting holdings when the constituents of an index are updated, or rebalanced. And just as funds invest globally, so dealing desks for larger firms are often located in different parts of the world. For example, a fund manager who invests in emerging markets may be based in New York or London, but execute relevant trades through a dealing desk located in Hong Kong. The over-arching regulatory onus placed on dealers is to provide best execution. Definitions of this vary, but broadly relate to minimizing trading-related costs. The European Union stated investment firms’ obligations on best execution in its Markets in Financial Instruments Directive (MiFID) as being to “take all sufficient steps to obtain, when executing orders, the best possible result for their clients, taking into account price, costs, speed, likelihood of execution and settlement, size, nature, or any other consideration relevant to the execution of the order”.1 This definition is helpful not just to understand the regulator’s perspective, but also to appreciate the range of considerations a dealer must consider when executing a trade. In 2021, post-Brexit, the UK regulator proposed changes to requirements relating to some best execution reporting and some of the restrictions on inducements relating to investment research, although the main principles of best execution remain. One reason for regulators’ scrutiny of trading and its related costs, particularly in Europe, is because of the traditional way that investment banks encouraged firms to use them for trading by offering their investment research on individual stocks, or related industry trends, without making an explicit charge. A similar approach was historically taken by some trading venues by providing data or technology services as part of arrangements to encourage asset managers to trade through these venues. Benefits such as investment research or other products and services, other than execution of trades, are commonly known as soft dollars. The EU banned soft dollar payments for investment research as part of MiFID II, introduced in 2018, but the practice is still widespread in the US and Asia. 1. MiFID II, article 27, “Obligation to execute orders on terms most favourable to the client”, 12 June 2014.

18

ORGANIZATION

Arguments surrounding the pros and cons of banning soft dollars do not need to be detailed here, but the issue does allude to the fact that fund managers receive investment research from outside their firm, and so do not rely solely on their analysts. It would be a stretch to describe this as outsourcing investment research, but many asset management roles can be outsourced. Having made the point earlier that the investment management function sits at the core of any fund firm, it will perhaps come as a surprise that investment management itself is sometimes outsourced. Different ways in which this can be done, including sub-advising management, delegating management and multi-management, will be covered in the next chapter.

Sell, sell, sell As the two drivers of an asset management company’s growth are investment performance and client inflows, so a firm needs an effective business development team to convert investment success or reputation into product sales – and to minimize client withdrawals. Business development (often referred to as distribution) can be broadly divided into four areas: sales, client services, marketing, and product development. Salespeople have traditionally placed great store on their personal relationships. With so many funds available in the UK and Europe, it is not hard to see the value of successfully making a potential client aware of a particular fund, and explaining how it might fit into the client’s range of investments, and then for the client to engage in discussing the fund in detail. Clients in this context are more often firms that control significant client assets, rather than end-investors, and range from independent financial advisers and wealth managers, to corporate and institutional investors. At most larger organizations (such as banks or larger wealth managers) that use mutual funds in their clients’ portfolios, fund selection is a standalone unit and so asset managers’ business development teams need to build relationships with these fund selectors, sometimes known as professional fund buyers. Two challenges for fund salespeople that have come to the fore over recent years are the way in which client relationships are developed and with whom they are developed. Both the UK’s financial regulator, the Financial Conduct 19

THE ECONOMICS OF FUND MANAGEMENT

Authority (FCA), and European regulators, via rules contained in MiFID II, have clamped down on hospitality offered by investments firms. Firms that fall under MiFID II’s rules are only able to accept “minor non-monetary benefits” that are designed to enhance the quality of service provided to clients. These benefits must also be disclosed to the client.2 Rounds of golf and nights at the opera with clients and potential clients have become far rarer as a result. The second challenge is for an asset manager to meet the demand from clients for in-person meetings with individual fund managers. Fund managers’ role and responsibility is to manage the investments in their fund, as well as considering future investments. Meeting clients and potential clients must therefore be fitted in around the day job and firms will often allocate a certain number of days each month where a fund manager is available to carry out sales and marketing activities. This time pressure has also led to greater use of dedicated product specialists. Particularly at firms with a wide range of funds, salespeople are less able to offer detailed insights on the day-to-day management of a particular fund. Product specialists, who sit with the investment team rather than with the sales team, are able to offer investment perspectives to clients. These developments have been accelerated by the growth of dedicated fund selection units at financial services firms. Over the past five to ten years, the increased centralization of fund selection at global banks, together with UK financial advisers outsourcing their fund selection to discretionary investment managers (firms that can make investment decisions on behalf of their clients), has meant the gradual decline of fund houses’ ability to simply push a product, rather than engaging in a more sophisticated discussion with potential clients – similar to that previously associated primarily with institutional clients. Product specialists’ role suggests a harmonious relationship between sales and investment teams, but this is not always the case. The tension most likely to arise relates to which funds the sales team prioritize selling. When a firm has a wide product range – the largest asset managers in Europe have several hundred mutual funds available – then the firm must decide as to which funds are promoted at any one time. Beyond new products that have a new story 2. MiFID II, point 9 of article 24, “General principles and information to clients”, 12 June 2014.

20

ORGANIZATION

to be told, the most likely funds to be promoted are those with the strongest current performance track record and so most likely to attract inflows. While, in principle, a portfolio manager is agnostic as to whether their fund has significant inflows, instead concentrating on its investments, there are situations that can influence this position. The first is an investment-related consideration, namely that if a fund becomes too large it may be harder to manage, for example, selling a large holding may become difficult to do swiftly. In the worst situations, a fund’s performance suffers because of its large size. So a sales team may be tempted to continue promoting a fund beyond a size that the investment team is comfortable – creating potential internal tensions. The second consideration is more commercial, namely that if a fund does not grow it will likely be closed by the firm for not being economically viable. The problem for an asset manager is that a small fund is unlikely to attract inflows from larger clients unless it is at least £50 million, sometimes £100 million, in size because these clients do not want their investment to take on the risk of making up a disproportionately large percentage of the fund’s assets. A fund in this situation is therefore much more difficult to sell. While a fund manager might suggest that this is where the skill in fund sales come to the fore, a salesperson is likely to say that it would be an ineffective use of effort and resources to try and garner interest in such a fund. An unsurprising standoff can result. A closer look at the challenge and importance of raising assets in new funds will be covered later. Employees seeking new client sales are often split from those dealing with ongoing support for existing clients, with the latter normally referred to as client services. The level of service offered by a client services team is likely to vary depending on the size of the client, with more of a bespoke service offered to institutional investors or other large individual clients who are more likely to have specific needs for regular updates on investment portfolios and potentially direct interaction with an individual fund manager. At the other end of the spectrum are asset managers’ direct support for retail clients. The dwindling number of asset managers that service retail investors directly will have a call centre that deals with these clients’ enquiries. Various aspects of client communication, such as updates on documents required by the regulator, are carried out by a firm’s administration function, which is often outsourced. 21

THE ECONOMICS OF FUND MANAGEMENT

The client services team may include personnel focused on responding to requests for proposals (RFPs), although this function often sits within the marketing team. RFPs and due diligence questionnaires are used by institutional investors and investment consultants when looking for asset managers to tender for an investment mandate. They are also used by larger wholesale clients when considering investing with an asset manager. Regularly completing these questionnaires means the RFP has a large pool of regularly updated information drawn from different sources and internal departments that can also be disseminated externally to investment consultant databases, which in turn may well secure future sales. On outsourcing, distribution roles are most commonly given to external companies when an asset manager is selling a product internationally. For example, an investment manager based in New York might set up a UK-based fund using a similar investment strategy to one the firm manages successfully in the US. Rather than hiring a full-time salesperson for its nascent UK business, the firm may instead appoint a third-party marketer, also known as a third-party distributor. Some asset managers combine in-house sales teams and third-party marketers, with the latter used in markets or channels/client types where the firm has less experience. This model has received a boost following Brexit as some asset managers who previously used salespeople based in the UK to sell into continental Europe now must use salespeople based within the EU more extensively.

BOX 2.1  FUND SALES IN THE UK

An indication of the opportunities and challenges for asset managers’ sales teams is shown in the charts below. This data reflects activity in the UK so is not reflective of fund distribution across Europe (as will be shown in Chapter 8), although some of the factors underlying the trends shown have resonance in any market where funds are widely sold. Retail sales here reflect not just the sales of funds directly to end-investors, but also via so-called wholesale channels, such as independent financial advisers and wealth managers. Inflows to mutual funds in the UK have tended to rise each year over the past decade (and beyond), which is reflected in the gross sales figures. Gross

22

ORGANIZATION

sales show overall inflows to funds and do not include any redemptions (outflows). However, firms must also manage client redemptions, and aim to minimize these through good client service and generating good returns. The shadowing of fund sales by fund redemptions is shown in Figure 2.1a. Adding sales and redemptions results in a net sales, or net flows, figure, which is the aggregate change in firms’ assets under management resulting from client movements in and out of funds. So the retail sales figures shown in Figure 2.1b are simply the result of the sales and redemptions in Figure 2.1a. While annual gross retail sales average £223 billion over the past ten years, the average for net sales is £23 billion. Net retail sales are also compared to net institutional sales. The latter suggests a more challenging environment for asset managers in retaining clients’ money, although it is worth noting that institutional clients also frequently invest via institutional mandates or segregated accounts (as explained in Chapter 1), which may account for some of the downward historical trend. Taken together, Figures 2.1a and 2.1b show that asset managers in the UK have not only seen their assets under management grow each year as a result of new retail client money, but that this has grown even when client redemptions are accounted for. Of course, this is in addition to the assets managed at the start of the period. Fund flows in the UK (£ billion) 400

350

Sales

Redemptions

60 50

300

40

250

30

200

20

150

10

100

-

50

-10

-

2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

Figure 2.1a  Sales versus redemptions Source: Investment Association.

-20

Institutional Retail

2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

Figure 2.1b  Retail versus institutional net sales Source: Investment Association.

23

THE ECONOMICS OF FUND MANAGEMENT

Making it look appealing An effective fund sales team will work closely with the marketing team and an asset manager’s distribution head will normally have responsibility for both functions. The rise of digital marketing, and its increased prominence while the industry shifted en masse to work from home during the Covid-19 pandemic, has also embedded the way in which marketing and sales overlap. Digital marketing ranges across websites, email, advertising and social media, underpinned by analysis of the data generated by each of these tools. Asset managers’ websites started life as a shop window offering a high-level advert on a firm’s investment expertise and locations but, as with other industries, have evolved to allow visitors to find useful information within the shop. Most firms will cover three main areas with their website: the company, its products, and investment managers’ views. The company section of a website generally tries to convey the firm’s brand values – how the firm wishes to be perceived and what makes it different from rivals – together with details of its senior personnel and some of the firm’s history. Reiterating that asset managers see themselves as “people businesses”, the corporate section of a website often includes pages on the firm’s people at different stages of their careers and in different roles – accompanied by careers information on how to join the firm and current job openings. The corporate section of publicly listed asset managers also includes an investor relations section for those investing in, or researching, the company itself. The second main section of a website includes details on the firm’s funds. As mutual funds’ NAVs are normally calculated daily, information on these prices can similarly be updated daily on websites. More commonly, updates on how each fund is performing is updated monthly, together with related information on its investment holdings, risk profile, charges, and so on. Funds produce monthly factsheets that lays out this data, together with information that changes far less frequently, such as the name of the fund’s manager, its investment objectives, and legal structure. Factsheets may also include awards that a fund has been given, highlighting that these are ultimately marketing documents that are not required by regulators, although aspects of their format and content are caught by financial regulations. While most firms now provide data directly on web pages that was once commonly included in their paper factsheets, the two-sided PDF factsheet document shows no sign 24

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of disappearing. Their survival partly reflects financial advisers continued use of factsheets for illustration purposes with their clients. The area of websites that has developed most over recent years is that offering investment managers’ views and insights. Rather than being overtly specific to an individual product, investment managers and analysts give their views on a relevant and timely topic that has implications for the firm’s clients, be it the impact of a political election, recent stock market moves, the rise or fall in inflation, factors affecting sustainable investing, and so on. In addition, monthly commentary from a portfolio manager on the past month’s investment activity and factors affecting his or her fund’s performance are often produced and sometimes integrated within factsheets. Firms employ dedicated investment writers to work with the firm’s investors and analysts to prepare this wide array of regularly updated written material. This work can also include audio (such as podcasts) and video interviews with fund managers and other senior figures at a firm for updates on investing or the firm’s activities. Communications across a firm’s website (which can also be distributed in other ways) are collectively referred to as “content”, an undescriptive term that is now commonly used. Asset managers have been relatively cautious with their forays into social media, largely using LinkedIn and Twitter to distribute content available on their websites. Part of this caution reflects compliance teams’ concerns that social media interactions should not breach regulations, for example, being deemed to provide financial advice without the relevant qualifications or not being able to include terms and conditions in a conversation on social media. This approach also reflects that interacting on social media is labour intensive, particularly for firms whose primary client base is intermediaries rather than direct retail customers. BlackRock serves as a useful illustration: the firm has almost 450,000 followers on Twitter for its corporate account, as of July 2021, but more than twice that many on LinkedIn, the online business network, while its YouTube channel has around 15,000 subscribers, fewer than its number of employees. Followers across the industry tend to skew towards the US, rather than the UK and Europe, for example, BlackRock’s UK Twitter account has fewer than 5,000 followers. Some individuals within the industry who offer distinctive views have built up a significant social media presence, the best example in Europe being Sasja Beslik, chief investment officer at SDG Impact Japan, and previously at PFA, 25

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a Danish pension fund, and previously at Nordea Asset Management, who has over 200,000 Twitter followers, in July 2021. M&G Investments’ fixed income team has been willing to offer engaging views for more than 15 years in its Bond Vigilantes blog, spearheaded by head of public fixed income Jim Leaviss, and its Twitter profile reflects this, with a little under 40,000 followers. Fundsmith and Woodford Investment Management (before its collapse) are examples of UK asset managers with strong direct retail client bases but with differing approaches to social media. The former apparently stopped tweeting in late 2020 and has fewer than 10,000 followers, while the latter was an active communicator on social media and had almost 30,000 followers before deciding to close in October 2019. Asset managers typically invest more time and resources into targeted email campaigns, rather than the potentially more scattergun approach of social media or search engine optimization (increasing the visibility of a website via search engines such as Google). This involves building and maintaining a mailing list of clients and potential clients that is segmented between different client types, what individuals are interested in, and the way in which they can be approached (for example, compliance with the EU’s General Data Protection Regulation). Another way to draw potential clients’ attention to particular areas of a firm’s investment expertise is for fund managers to talk to financial journalists, and asset managers have developed public relations teams to try and take advantage of this. Financial media spans trade publications that are most commonly aimed at financial advisers or wealth managers, national newspapers that have both daily business coverage and weekend personal finance sections, and television. In addition, some investment platforms and investment research firms have developed their own online community of readers and viewers, creating another outlet that falls within asset managers’ media activities. External PR agencies are used extensively by fund houses, not only as a means to outsource media relations as a whole, but also as an additional support for day-to-day activities, as well as taking on an advisory role for establishing a firm’s media profile strategy. The traditional print media overall has suffered from a fall in advertising revenues over many years and investment-related titles are no different. The response to this trend has been to shift to digital advertising as well as using the profile of their own brands to host investment-related conferences, 26

ORGANIZATION

generating revenues both from attendees and sponsors. However, asset managers remain significant advertisers. Spending varies considerably by firm, by country and over time, but the biggest fund management advertisers in the UK spend more than £5 million a year. Meanwhile, it has been sensible for media outlets to embrace conferences as one of the largest portions of firms’ marketing budgets is spent on events and conferences, although this has been reduced with the shift to online events as firms moved to home working in 2020. Regulators’ clamp down on hospitality offered, referred to earlier, has meant firms have had to improve the content of their investment managers’ presentations and discussions, moving away from being essentially a product pitch to instead include a clear educational dimension, such as explaining recent economic events and setting them into an historical perspective, or explaining the different aspects of ESG investing. One way of signalling that a conference is not simply a sales event is to include several asset managers, with each firm presenting on a different topic and joining a panel discussion. More traditional roadshows are also used by firms, for example, with a fund manager touring a particular country to support the promotion of a new product. A survey carried out by Cerulli Associates (2021), an asset management research firm, gives a sense of the size of large firms’ marketing budgets. The research reveals how widely marketing budgets – covering social media, design and branding (including sponsorship, billboards and thought leadership papers), media relations, events – can vary, which is likely to reflect the relative size of different firms and the different types of client they focus on. Pan-European annual marketing budgets ranged from €750,000 to at least €10 million in 2021, with most having a budget of between €5 million and €10 million. Budgets for each of the four activities similarly vary for different firms, although each typically ranges between €100,000 and €5 million. Social media budgets, including web advertising, search engine optimization (SEO) and email campaigns, tend to be the smallest of the four activities, while branding and design is the marketing activity that firms appear most willing to spend more than €1 million a year (see Figure 2.2). Firms’ ability to record and track interactions with clients across multiple so-called touchpoints (websites, emails, events, etc) has created an opportunity for data analysts to explore the way in which asset managers interact with their customers and, as a result, to improve the effectiveness of their 27

THE ECONOMICS OF FUND MANAGEMENT

Asset managers’ European marketing budgets Under €250,000, 6%

Over €10m, 18%

€750k to €1m, 22%

€1m to €2.5m, 16%

€5m to €10m, 28% €2.5m to €5m, 10%

Figure 2.2a  Proportion of firms’ total marketing spend

30 25 20 15 10 5 0

Social media Under €100k

Design & branding Media relations

€100k to €250k

€250k to €500k

€500k to €1m

Figure 2.2b  Proportion of firms’ marketing spend by category (%) Source: Cerulli Associates (2021).

28

Events Over €1m

ORGANIZATION

marketing activities. For example, what types of communication and content is most effective at engaging clients in different distribution channels or countries. As with other industries, asset managers’ customer relationship management (CRM) systems store and then analyse interactions with clients in order to tailor marketing accordingly. A marketing team will also seek to develop an overarching brand strategy for the firm. Most commonly this is associated with an asset manager’s logo, but also includes all aspects of the way a firm presents itself, which in turn reflects its culture and values (or how it would like the outside world to see these). At small firms, this can be closely identified with the funds it offers as these will be limited in range and will likely reflect a single, coherent investment philosophy. But as firms grow and its product range widens along with the different types of clients it attracts, the firm’s brand becomes more important. Those with responsibility for the firm’s brand aim to encapsulate in the brand the way that the firm wants to be seen by its clients and then to promote this externally. One problem for each asset manager is how its brand, and the message this tries to convey, stands out from its competitors. Most often the brand focuses on what a firm does, i.e. investing, which all its rivals also do. Proclaiming that a firm is big and stable is also common, despite it being a claim that many competitors can make. This might suggest that in order to overcome negative perceptions of fund managers, firms have converged on similar brand attributes, making it harder to distinguish themselves from one another. Similarly, as concerns about the sustainability of investing have grown – covering areas such as the environment and social responsibility – firms across Europe have stepped up their efforts to show that they share these concerns. While clients might find it difficult to identify a difference between these brands, many asset managers are content to fit in with the crowd. This is not to underestimate the emphasis that asset managers place on their brand, but that using it to distinguish a company from its rivals in the eyes of a retail investor is not the aim in many, or most, cases. The profile of some asset management brands has clearly risen on the back of their size. These firms are certainly willing to defend their brands as a result. For example, a blockchain start-up had to change its name from BlockRock to Blockchance after BlackRock learned of the German firm’s branding (Alabi & Moisson 2019). And asset managers can surprise. Standard Life Aberdeen, the 29

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asset manager formed from the merger of Standard Life and Aberdeen Asset Management, announced in April 2021 that it will rebrand as abrdn with an ambition for the firm to be seen as “modern” and “digitally-enabled”, although its new name will still be pronounced “Aberdeen”. Branding, design and other marketing-related consultants abound across industries and this is no different in asset management, with consultants brought in for particular projects or campaigns, such as a rebranding exercise. So outsourcing is common for particular roles and projects, but responsibility for sales or client relations will also include marketing, however rudimentary, even at the smallest firms.

Developing new products The creation of new funds might not necessarily seem to be a sales or marketing activity for an investment firm, but rather an operational activity to support a fund manager. However, launching new products is an important part of the way that asset managers grow their business and so product development typically sits within a firm’s distribution division. Clearly the function is not needed for particularly small firms or those that remain focused on a small number of products or with a small investment team. But as asset managers expand and try to retain client assets through different market cycles they almost always expand their product range and so need a team to monitor the different products that investors might buy, what resources are needed to support those products, and whether potential products make commercial and investment sense to launch. The responsibilities of the role vary depending on how a firm is structured, but the product development process includes market research to understand clients’ potential demand as well as analysing competitors’ funds (their features, past performance and inflows). New funds are launched either due to perceived client demand, or prompted by a firm’s investment managers, although asset managers tend to refer to both aspects when bringing a new product to market. Important responsibilities that often sit with the broad product development function also include areas relating to the ongoing development of existing funds, such as responding to new regulations, which 30

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some firms consider to be product management rather than product development, but all fall within the realm of product-related roles. At the start of the process for launching a new fund, product developers work with the investment side of an asset management business to lay out the funds managers’ proposed investment process and objectives, as well as establishing whether relevant resources are in place or if new appointments would be needed. This investment approach is then simulated to see how it would have performed in the past, known as backtesting. A live dummy portfolio will also be set up so the prospective fund can be managed before being approved by a regulator and launched publicly. This process also helps with the operational aspects of developing a new product, which ultimately comes down to whether the firm can operate the proposed fund successfully, so the product development team must ensure that the personnel and systems are in place to do this. Many firms will carry out an economic viability assessment of the proposed fund. Clients’ tolerance for different fee levels is likely to have been discovered through the market research process, so this information can be used to establish how much revenue will be generated by different levels of inflows from clients over its initial years following launch. Into this mix will be added whether seed capital will be available for the fund, in other words money invested when the fund launches, either from an internal source (which is more likely when the firm is part of a larger organization, such as a bank or insurer) or from an external client (for example, a client who already invests with a particular fund manager and is looking to diversify its investment with a slightly different portfolio). Seed investors are likely to be offered preferential terms, such as a lower annual fee when investing. Similarly, larger clients who invest in the fund early are sometimes offered preferential terms, also known as an “early bird” fee discount. Drawing this analysis together enables the asset manager to evaluate the likelihood of the fund being profitable and how long this should take to achieve. Financial regulations play an important part in the product development process. This includes both evaluating different legal structures that can be used for the fund and where it is best to establish it. These two considerations will be influenced by factors such as what type of client the intended investor in the fund will be (such as a UK pension scheme or Italian retail investors), where the likely clients are based, and what the tax implications will be for the 31

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investors. Once a firm has confirmed the details of the fund it plans to launch there is then a regulatory approval process, by which a fund has to demonstrate it meets the criteria laid down by a national or international regulator to be launched, which can take several weeks or several months (although some regulators boast that particular fund structures can be approved in a matter of days). For EU funds being sold into multiple markets there is also the possibility of further due diligence checks by national regulators. A product development team will often have responsibility for some aspects of the ongoing oversight, maintenance and product-related support for a fund after its launch, although some of these aspects might be the responsibility for separate product governance and product management teams, depending on how an asset manager is structured. Product governance has come under greater regulatory scrutiny with the EU’s MiFID II rules requiring firms to regularly review their products, as well as the UK’s rules requiring asset managers to assess the value their funds have delivered to investors – introduced following the FCA’s critical Asset Management Market Study, published in 2017. These interventions have upped the pressure on firms to ensure that each of their funds is performing as intended, that the charges can be justified and that appropriate operational processes are in place, among other criteria. The attraction of launching new funds can be seen by breaking down the growth in European mutual funds’ assets under management over the past ten years. The overall size of funds launched more than ten years ago has risen by one quarter, from €5.5 trillion to €6.86 trillion, while three quarters of the industry’s asset growth relates to funds launched in the intervening years, adding €4 trillion (see Figure 2.3). It is worth noting that overall growth among funds launched prior to 2011 reflects both the growth in some funds’ assets as well as the decline in assets from other funds losing clients, or being closed or merged away. But whether it is a truly novel fund or a repackaged and relaunched product, the appeal of offering new funds is clear. The related area of product management requires technical knowledge of each fund and liaising with different internal departments to ensure that up-to-date information is reflected in each product’s regulated documents, such as a fund’s annual report and accounts, its prospectus, and key information document. The team will also manage the process of making any changes to a fund in light of new regulations, such as those related to the EU’s Sustainable Finance Disclosure Regulation, which includes a requirement 32

ORGANIZATION 12.00 1.02

10.00

2.96

8.00

Funds launched before 2011

Funds launched 2011-2017

6.00

4.00 5.49

6.86

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2.00

-

Dec 2010

Dec 2020

Figure 2.3  New funds drive industry growth: European fund assets (€ trillion) Source: Broadridge Financial Solutions.

for asset managers to sort each fund into a different sustainability category depending on the product’s characteristics. Product-related roles also manage the process of closing or merging funds. This most often takes place when a fund is too small and so is not considered to be economically viable, but also when the fund is not performing sufficiently well (although this normally only threatens a fund’s closure when its underperformance threatens the fund’s size), or when a fund manager leaves (again this may have consequences for a fund’s assets if clients withdraw their money). A fund may be merged with another similar product if the firm wishes to retain the former’s assets, rather than handing money back to clients through a fund closure. Fund mergers are most likely to happen if a fund is underperforming, or if there are reasons to move the assets to a similar fund in a different jurisdiction. This latter situation arose when asset managers with UK-based funds wanted to move their continental European clients into EU-based funds following Brexit. A final point on the product function relates to outsourcing. This is unusual in product development, which largely reflects that if product development is 33

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a significant part of an asset manager’s growth plans then the firm will be of a sufficient size that it can afford to have a full-time team, as well as being of sufficient complexity that an in-house team is appropriate. Consultants may be brought in in an advisory capacity for particular products, for example in launching funds in a new domicile, such as those smaller UK firms needing to launch products based within the EU following Brexit.

Keeping an eye on colleagues Asset managers’ oversight roles include compliance, risk, legal and internal audit. At a basic level, the compliance team’s role is to ensure that the organization, and all of its personnel, complies with the laws and regulations that relate to it and the funds that it oversees. In addition, the compliance team puts in place policies, procedures and training to ensure that employees adopt the best practices to ensure the spirit and letter of the rules are followed, which will likely include standards suggested by industry bodies, such as the Investment Association and the CFA Institute. Compliance’s role is therefore to prevent adverse legal or reputational consequences for failings in the business or in its funds. As most asset managers operate in more than one country, through their investments, sales or operationally, then the compliance team also needs to be aware of where and how regulations overlap or diverge and manage business activities accordingly, as well as ways in which this changes over time, or might change in future. An asset manager’s legal team, separate from the compliance function, has responsibility for both fund-related issues and corporate matters. Funds lawyers offer advice on issues including fund structures and the treatment of clients. Lawyers with corporate responsibilities, which may also have responsibility for compliance, advise on the application of rules and regulations to a business, as well as aspects ranging from employment issues to mergers and acquisitions. The use of external lawyers to complement internal advice is also a common occurrence in asset management. Where the middle office begins and ends is not well-defined, but two functions that are commonly included are risk and transaction management, which 34

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both provide operational support to investment-related functions. They are also areas that some firms outsource to external providers. The investment risk team monitors activity in investment portfolios, to ensure they remain within their agreed objectives and guidelines. The investment risk team uses quantitative analysis to assess changes to the level of risk in a fund or other portfolio, such as its volatility of returns and concentration of holdings, and to check that the correct risk controls are in place. Risk also involves monitoring investment transactions to check how changes in holdings affect the risk profile of a fund in ways not immediately apparent to the investment management team. Internal audit adds a further line of defence to an asset manager in checking on the adequacy and effectiveness of internal controls offered by compliance and risk teams. The function checks aspects including financial reporting, valuations, liquidity management, as well as risk management and transaction reporting. The aim of the role is to provide an independent view on these activities, much as an external auditor does, and establish an audit trail of activities, as well as advising a firm’s senior management on any issues arising. The role also tracks potential risks and ensures they are being monitored, such as new regulations and broader industry trends (for example, potential “greenwashing” of sustainable investments).

The nuts and bolts Operational and administration roles are split between those relating to funds and those relating to the corporate entity. The former is referred to as the back office and is often outsourced to banks, such as BNP Paribas, BNY Mellon, JPMorgan, Northern Trust and State Street. The fund administrator’s first role relates to the valuation of a fund’s assets, as well as the related regular calculation of the fund’s NAV, also referred to as pricing. Linked to this is fund accounting (different from a fund audit), which involves calculating a fund’s gains and losses, including any income it receives from its investments. This process enables the calculation of each fund’s performance, i.e. the returns generated for investors. The creation and maintenance of these records also provides an array of data points that are 35

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used to audit a fund’s activities, either as part of the oversight process or for annual reports and accounts. The second role of fund administration covers share registration (keeping a register of shareholders) and transfer agency, which involves administering the movement of clients’ money into and out of the fund, including the payment of dividends from the fund. A linked role is known as shareholder servicing, which involves communicating with shareholders on aspects including legal and regulatory documents and updates. This role also involves responding to enquiries from investors (typically retail investors) and so covers aspects of client servicing that would initially sit internally within an asset manager’s business development team. A related but separate back office role is that of custodian and depositary. The existence of these roles reflects the fact that an investment manager does not own its clients’ assets, but manages them on behalf of the fund, which is a separate legal entity. To ensure this separation, another organization has responsibility for the safekeeping of a fund’s assets. Fund custody involves protecting the shareholders’ assets and preventing a fund manager from having access to the assets themselves. The depositary protects shareholders’ assets (although this is often delegated to a custodian), as well as being responsible for the supervision of the conduct of business of the fund’s operations, thus providing external oversight of these activities. With responsibility for a fund’s assets, whenever investment decisions are made, the custodian or depositary is involved in ensuring the transaction is properly processed and settled. In a similar way, the function will also be involved in foreign exchange transactions and securities lending, if this is undertaken by the fund. A related role is that of the trustee, which exists in countries where trust-related law governs funds (notably the UK). Its role is similar to the control function of the depositary in other jurisdictions, but the trustee does not have a custody role.

Last but not least Centralized, corporate roles account for approximately one quarter of fulltime employees at UK asset managers (based on the Investment Association’s 36

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survey) and are largely equivalent to functions at businesses of a similar size. These include finance, human resources, and information technology, as well as a firm’s reception, maintenance, security and catering staff. The role of finance covers aspects including the monitoring and management of costs and revenues for the business, using and disseminating this management information through the business, as well as offering a more strategic view of a firm’s financial strengths and weaknesses, which may be used in its development or in potential mergers and acquisitions. Human resources’ responsibilities range across contracts and employment terms, internal training, employees’ health and benefits. A growing focus for asset managers’ HR teams over recent years is diversity and inclusion. While progress in this area varies between firms and geographically, many asset managers have been accused of being slow in making their workforces more diverse (across aspects including gender, race, sexuality, social background, and neurodiversity) and to value the contribution of a diverse range of employees. IT is included here as a corporate function, although many of its activities are specific to individual roles in an asset management business, for example, monitoring and analysing investment portfolios, transactions, fund accounting and client reporting. Indeed, increases in IT spend are a common pattern among asset managers precisely because this reaches into virtually all aspects of an asset manager’s business with the ostensible aim of improving efficiency (or a client’s experience) and thus reducing costs (and retaining clients) over the longer term. The massive rise in the quantity of data needing to be managed across investment, marketing, product and client services functions (among others) has also increased the workload and capabilities needed within firms’ IT teams. This responsibility includes both the management of the underlying data and the systems used to access and analyse it. Operational risk is one example of a corporate function with a significant focus on IT, such as ensuring back-up for system failures. This function creates and updates disaster recovery plans and procedures so that an asset management business can continue in case of an emergency. Not all functions need to continue in temporary adverse circumstances but, for example, asset managers in London will have premises outside the City in case of an attack similar to those carried out on 11 September 2001 in New York and Washington. Those with responsibility for operational risk have had to revamp their policies as the industry moved to homeworking as a result of 37

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the 2020 pandemic. Working from home has also increased the scrutiny of the robustness of firms’ cybersecurity. One area of recent focus for asset managers’ IT teams, and for their external service providers, is blockchain. Blockchain is a technology that proponents say creates a safe way to share information across multiple parties in a model known as a distributed ledger. The select group of approved users can make changes to the database instantaneously without an intermediary – such as a bank or clearing house – having to first approve transactions. Instead each change to the database is time-stamped by participants and cannot be deleted, making it easy for all participants to trace past activity. Although industries ranging from insurance to professional services have used variations of distributed databases for at least two decades, the technology gained real prominence in 2009 with the introduction of so-called cryptocurrency Bitcoin (see Chapter 4). Asset managers and their service largely remain in a development phase to see how blockchain can be used in asset management, be it for portfolio management, fund distribution, or administrative purposes (Van Egghen 2016).

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BUSINESS MODEL

The internal functions of an asset management organization are similar across organizations, even if the way individual roles are defined are likely to vary between firms. However, differences between the types of business managing mutual funds are much more apparent. Some of these aspects overlap, but it is still helpful to be aware of a firm’s size, parent company, ownership, and operational structure when comparing firms. After exploring these considerations, the chapter will then move on to explain the value chain in which fund management businesses sit, their associated costs, revenues and profitability.

Boutiques vs Behemoths It is possible to set up a fund management business with relatively few resources. Improvements in outsourced services and technological advances have made it eminently feasible for those with knowledge and experience of the industry to get a business off the ground. (Making the business a financial success by attracting clients is a different matter, which will be discussed later). The lack of office infrastructure and reliance on those providing services externally was put under pressure through the pandemic and proved resilient. Traditionally the greatest barrier to entry for the UK and European funds industry was deemed to be regulation, but many small firms say that even this is not the hurdle that it once was.

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The large number of small asset managers – commonly referred to as investment boutiques – is a pronounced feature of the industry. There are more than 1,650 firms managing mutual funds with less than €20 billion in assets under management and so rank outside the largest 100 firms in Europe. Many of these firms remain profitable despite their relatively small size (see Figure 3.1). Smaller firms tend to limit the range of products they manage and offer to clients, feeding into the perception that boutiques are more focused in their approach to investing. This is reflected in some academic research showing that there is a “boutique premium”, in other words that fund managers at smaller, standalone investment firms perform better than other businesses (Clare 2020). In some countries, the development of boutique asset managers is more pronounced, for example, France often promotes its credentials and the number of investment boutiques active in the market. It is largely as a result of the belief that investment managers work better in small teams and should determine their own implementation of investment strategies that some large asset managers adopt a so-called multi-boutique model. These firms let investment management remain with the affiliated fund houses that they own, while other services and functions – such as sales and fund administration – are centralized within the parent company. Multi-boutiques include BNY Mellon Investment Management and Natixis Investment Managers, while Legg Mason retained this model even after it was acquired by Franklin Templeton in 2020. For these firms, the distinct names and branding of affiliated investment managers is clear, although other multi-boutiques have single branding through the business, such as Swiss firm Pictet Asset Management. There are no clear lines determining where firms no longer considered small might be considered medium-sized or large. It is possible to differentiate between firms based on their scale, but a firm’s assets under management will change in significance depending on the universe of rivals it is being compared against. For example, global comparisons will tend to favour firms active in the US (the world’s largest fund market), while European comparisons will not reflect that many firms are active in only one market (and so compare more favourably in that market). While greater scale tends to mean that a firm widens its product range, this need not be the case. For example, the UK’s Fundsmith manages £33 40

BUSINESS MODEL Smallest firms, 15.4% Largest 10 firms, 29.7% 51st to 100th largest firms, 18.3%

31st to 50th largest firms, 13.7%

11th to 30th largest firms, 22.9%

Figure 3.1  Distribution of European fund assets by firm size Source: Broadridge Financial Solutions. Data at December 2020.

billion in four investment strategies in mid-2021, while France’s Carmignac manages €39 billion across 24 investment strategies.1 It is also possible for a firm to stay close to the areas of investment expertise for which it is best known even as they expand further, for example, US firm PIMCO remains primarily a fixed income manager despite overseeing more than $2 trillion in assets under management.2 But each of these approaches is distinctive, with the largest firms offering a wide array of products and those aspiring to greater scale often seeking to achieve this by expanding their investment capabilities and accompanying products. Despite these grey areas in determining which firms are large and which sit in the middle ground, there is a widespread view that medium-sized firms are being squeezed. The “squeezed middle” is the result of clients moving more of their assets either to the largest firms that offer a wide suite of products and additional services, or to investment boutiques for a limited number of specific products with exceptional performance. The logic of this appears sound and is supported by evidence including professional fund selectors in 1. Companies’ own figures. 2. PIMCO’s own figures, as at 31 December 2021.

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Europe indicating they want to invest with a mix of large and small firms. However, medium-sized fund houses in the UK and Europe have proved resilient, reflecting both their ability to offer some funds where performance has stood out, as well as many of these firms adjusting and expanding their product ranges to cater to different client demands. This is not to deny that some of the largest firms have grown strongly, with these firms more likely to offer index-tracking funds and exchange-traded funds where scale is more important to asset managers as the fees charged are lower than actively managed products. Demand here is particularly pronounced in the US. But at the same time firms of different sizes have been able to adapt and grow.

Independent vs internal An asset manager’s parent company, or lack thereof, offers different benefits and challenges for a firm. Being part of a bank, insurer or broader financial services firm provides the potential for the parent group’s clients to be sold its in-house funds. Some bank-owned asset managers are clear that their products are treated in the same way as those from external fund houses. But at the very least, a potentially lucrative sales channel is open to the in-house manager and, at the other end of the spectrum, some asset managers generate their sales primarily or even exclusively via their parent company’s customer-facing representatives. The parent company also opens up opportunities for new funds to be seeded with internal money, which can be an important initial step for attracting larger clients, even if this seed capital may be withdrawn over time. By contrast, independent or “pure play” asset managers are standalone businesses that must attract inflows from external clients. This has an obvious sales impact compared to firms with a bank or insurer parent, however, the latter firms may find it more difficult to develop business relationships with rival banks or insurers (although this is not necessarily the case). And just as boutiques promote their credentials as focusing on a limited range of investment strategies relative to larger firms, so independent asset managers often promote their credentials as focusing on external client needs and ambition 42

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for high returns, while banks and insurers can be more conservative in their approach. One twist on this dichotomy is the growing number of independent asset managers that are buying distribution channels and offering financial advice to customers, opening a potentially new channel for clients to invest in an asset managers’ products. In this way, the asset manager is the group’s parent entity. Fidelity and Vanguard, for example, both offer services beyond their core investment management expertise. In the UK Fidelity runs Adviser Solutions, an investment platform for financial advisers and wealth managers, while in the US the firm offers planning and advice services. Vanguard’s financial advice business in the US is currently being expanded to the UK. Meanwhile, acquisitions made by Schroders, a UK-listed asset manager, provide useful examples of the importance some firms place on expanding in wealth management and financial advice, and not relying solely on their investment management and sales capabilities to expand a business. The firm completed its acquisition of Sandaire, a UK multi-family office, in 2020, having bought the wealth management business of Thirdrock Group in Asia in 2019, and took full ownership of UK adviser technology platform Benchmark Capital in 2021. Schroders entered into a joint venture with Lloyds Banking Group to launch a financial planning service for the UK market, Schroders Personal Wealth, in 2019. The firm also bought a stake in Nutmeg, an online wealth manager, in 2014, which was later acquired by JPMorgan Chase. The firm’s recent acquisitions were kick-started with the purchase of Cazenove Capital in 2013, combining it with Schroders’ own wealth management business. Most recently, UK asset manager abrdn bought investment platform Interactive Investor, which has more than 400,000 customers, in December 2021.

Private vs public Whether a firm is publicly listed or privately held can make a difference to the way an asset management business is managed. Critics of listed firms suggest the demands of shareholders tend to be too short term to be compatible with the long-term approach that they suggest should be the hallmark of a good 43

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investment manager. Within the industry these critics are most frequently found at firms with private partnership structures, although not exclusively so. Paul Marshall, founder of hedge fund firm Marshall Wace, says a partnership structure creates “distributed leadership [that] spreads a culture of excellence and challenge. It also makes [the partners] each more dispensable” (Marshall 2020). Publicly listed firms defend their structure as requiring a responsiveness to client demands that forces them to adapt, while pointing to the fact that delivering good fund performance is at least as important as for private firms, without which clients would leave, in turn affecting their share price and so creating a virtuous circle where investment managers’ performance is highly valued. Table 3.1  Largest managers of UK-domiciled funds Company BlackRock Link Fund Solutions Abrdn Baillie Gifford Royal London Legal & General Fidelity Vanguard Scottish Widows HSBC Schroders Jupiter Liontrust BNY Mellon Threadneedle Janus Henderson Fundsmith M&G J.P. Morgan Invesco

Total assets (£m) 96,802 83,769 66,159 65,317 61,091 57,098 55,821 52,079 41,671 39,014 37,770 35,665 31,692 31,267 30,233 29,782 29,526 27,267 26,487 25,229

Source: Investment Association. Retail and institutional funds, as at December 2021.

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Some privately-owned asset managers are family-owned. The best-known of these is Fidelity, which has two businesses: Boston-headquartered Fidelity Investments, which serves US clients, and Bermuda-headquartered Fidelity International, which is responsible for clients outside the US. Fidelity was founded in 1946, with Fidelity International becoming independent of the US organization in 1980. Both organizations are owned by the founding Johnson family together with Fidelity executives and former employees. Abigail Johnson is CEO of Fidelity Investments and chair of Fidelity International. Confusingly, a separate Johnson family owns more than 40 per cent of Franklin Resources, the publicly listed asset manager that manages Franklin Templeton, which is headed up by Jennifer Johnson (Mooney 2017). Schroders has a similar structure, also being listed while the founding Schroder family controls 47 per cent of the business.3 A look at Europe shows the range of ownership models among some of the industry’s largest players, with France’s Amundi and Germany’s DWS also listed, albeit each has a majority stake held by a bank, Credit Agricole and Deutsche Bank respectively. Meanwhile, one of Switzerland’s largest asset managers, Pictet Asset Management, is part of the Pictet Group, which in turn is a private partnership and was originally founded as a private bank. If one looks hard enough, there are other, rarer ownership structures that offer their own benefits. For example, CCLA is owned by the charities, religious organizations and local authorities for whom it manages money. But most successfully, and still uniquely, is the mutual ownership structure of Vanguard. In the US, Vanguard is owned by its funds, which are in turn owned by the funds’ shareholders, effectively making it a client-owned company in an attempt to align the interests of the firm’s leadership team and clients. The firm’s European and international business is owned by its US business, rather than by clients directly, but with the same intended benefits to its customers.

Outsourcing management Other management and ownership models exist where the management of the funds business is separate from the management of the parent company. 3. See http://www.schroderhedgefunds.com/de/us/institutional/global-heritage/. 45

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Private equity investors are the clearest example of this, with their ownership of asset managers offering a variation on the “pure play” model, giving the underlying business financial support but not a distribution network. This model is rare among large fund management businesses, with the best example being US bank Wells Fargo agreeing to sell its asset management business to private equity firms GTCR and Reverence Capital Partners in February 2021. Another example is London-listed cash shell AssetCo, which came to prominence in 2021 when Martin Gilbert, the founder of Aberdeen Asset Management, took a 9.9 per cent stake in the firm and became its chairman. The firm exists to acquire and operate asset managers. Northill Capital is an example of a similar approach, albeit the firm takes stakes in a range of small investment management companies and provides “long-term, patient capital”. The firm is in turn owned by Waypoint Capital, which manages the investment interests of the Bertarelli family. Former senior executives at Northill have recently set up on their own by launching Alderwood Capital, with similar aims. In the US, publicly listed Affiliated Managers Group sits between this model and that of a multi-boutique, describing itself as a “partner to independent active investment management firms”. The firm is sometimes described as an investment manager, but investment management is carried out by more than 35 firms in which AMG has stakes, including AQR Capital Management, Artemis, and Winton. A separate management model that is specific to the funds industry is the management company. This entity does not technically manage an asset management business at all, but the extraordinary demise of Woodford Investment Management, led by former star manager Neil Woodford (see Chapter 5), means that the ability to outsource this management and oversight function warrants being covered here. A management company does not own the fund management business, but its powers mean that it can override the views of its investment manager on the running of individual funds – as the Woodford case has shown. The management company model has also come into the spotlight as a result of Brexit. A management company normally delegates the investment management of a fund to another entity (often part of the same parent company). However, the UK’s departure from the EU led to uncertainty over the way in which services related to funds (including investment management) could be delegated to entities outside the EU and whether the EU might decide 46

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to tighten up rules in this area to ensure the EU-based entity still had ultimate responsibility for all activities. This uncertainty was in addition to certain practices that Brexit ensured could no longer continue, such as UK-based management companies operating within the EU. One specific area relating to delegation was addressed by the memorandum of understanding agreed in 2019 between the European financial markets regulator, the European Securities and Markets Authority (ESMA), and the UK’s FCA permitting delegation of portfolio management between the EU and UK. To illustrate this, Aberdeen Standard Investments Luxembourg is a management company that delegates investment management of different funds established in Luxembourg to investment managers Aberdeen Asset Managers Limited in the UK, Aberdeen Standard Investments Australia, Aberdeen Standard Investments Inc in the US, Aberdeen Standard Investments (Hong Kong), as well as to sub-investment advisors Aberdeen Standard Investments (Japan) and Aberdeen Standard Investments (Asia) based in Singapore. This is a typical approach for a company this size. The management company has the ultimate responsibility for the overall management of a fund, including investment management, fund administration and distribution. In the UK, the equivalent entity is the authorized corporate director, or ACD, although this role combines the management responsibilities of a management company with oversight responsibilities by also providing a board of directors (a minority of whom are independent), albeit one step removed from the fund. In this way, open-ended funds in the UK have an unusual governance structure (that is frowned upon in other industries), whereby a corporate entity, rather than individuals, serves as the fund’s director. In the EU and US, the management company and fund board are separate. To address the challenge of the same entity managing and overseeing itself, the depositary has a particular duty to oversee the ACD in the UK (St Giles 2021a). Most larger asset managers retain the management company or ACD role within their business. However, many smaller firms outsource this to a third party. In the UK, outsourced ACDs are referred to as host or third-party ACDs. Several of the largest host ACDs in the UK each have responsibility for between 100 and 200 funds.4 As they are often used by smaller fund houses, 4. Data from Monterey Insight, as at 31 December 2020.

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their assets under management are smaller than companies with similar sized product ranges. But the largest host ACD, Link Fund Solutions, has assets of more than £85 billion.5 The ACD’s regulatory responsibility for each fund means it is this entity that is accountable to the regulator. Even if the investment management of a fund is delegated to another firm, the UK’s FCA still regards the ACD, rather than the investment manager, as bearing ultimate responsibility for how the fund is operated and supervised from day-to-day. To be clear, an investment manager setting up a new business (or changing the operational structure of an existing business) appoints a host ACD that then oversees that business’s funds and makes decisions that can include lowering the funds’ fees or closing a fund. As a result, the relationship between the host ACD and investment manager has come under increased scrutiny to ensure the former maintains a wholly independent stance. The potential tension in the relationship became public when Link Fund Solutions decided to suspend the £4 billion Woodford Equity Income Fund in June 2019, blocking investors from withdrawing money from the fund. This decision was reached with the agreement of Woodford and with a view to the fund being reopened once a significant portion of its unquoted and less liquid stocks were sold. But by October the two groups’ views diverged and Link’s decision not to reopen the fund and instead to wind it up was not accepted by Woodford, who said the decision was not in the long-term interests of investors. This decision had implications for the whole business, with the planned closure prompting Woodford to take the “highly painful decision” to close his firm.6

Linking up the value chain Asset managers do not sit in isolation, only needing to worry about their funds and their customers. As has been suggested earlier, firms are part of a more complicated chain of companies that reach from the fund to the end-client. 5. Ibid. 6. Neil Woodford statement, 15 October 2019.

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The value chain is the different elements of any business’s activities that are needed to create a product or service (asset management is no different from other industries in this respect) and have been detailed in the previous chapter. When an asset manager’s value chain is considered, it is necessary to include additional links in the chain that are sometimes needed to deliver a fund to the customer. This is also relevant as these aspects create additional costs that the client will ultimately bear in order to invest in a fund, even if they do not relate directly to an asset management company. This distinction is relevant as the shorter, company-specific value chain includes the costs that an asset manager can control. But the end-client needs to be aware of the longer chain of costs as these each result in charges that the client ultimately bears, even if indirectly. Financial regulators will also be aware of this longer value chain when setting rules on the way that asset managers, and related businesses, can charge their customers. Additional companies and services involved in delivering, or distributing, funds to the end-investor include the following: • Retail intermediaries. From an asset manager’s perspective, firms offering financial advice effectively act as fund distributors as they occupy the space between the asset manager and retail clients. These include independent financial advisers (IFAs), wealth managers, private banks and online investment services. These intermediaries, particularly in the UK, often outsource the fund selection process to other firms, such as discretionary investment managers and specialized fund research firms. • Institutional consultants. Investment consultants advise institutional investors, including charities and defined benefit (DB) pension schemes, on how best to invest. While institutions then invest directly with an asset manager, they still incur their investment consultants’ costs (as well as benefiting from their advice). • Investment platforms. These are essentially online accounts where investors can hold funds, shares and other investments in one place with the aim of reducing administration and costs compared to investing directly with each company. Financial intermediaries and asset managers use platforms to outsource this administrative burden too. Platforms’ distinct place in the value chain is most apparent in the UK and US. In continental Europe, they are more commonly an internal function within a bank or other financial 49

THE ECONOMICS OF FUND MANAGEMENT

services firm, reflecting the dominance of such institutions in fund distribution in many European markets. These business-to-business platforms are distinct from direct-to-consumer platforms, although some firms offer services for both groups of clients (e.g. Fidelity offers both Adviser Solutions, formerly known as FundsNetwork, and Personal Investing platforms in the UK). • Direct retail investors. A small proportion of retail clients invest directly with an asset manager. These investors are worth mentioning here, however, because although investing directly with an asset manager removes a link in the value chain, it does not necessarily mean that the overall costs are lower for the client. Asset managers incur additional costs when administering an individual’s investment directly and, as a result, many fund houses no longer receive such individual investments. For firms that do, annual fund charges will likely be higher than those for investments directed from financial intermediaries or institutions. This value chain is presented graphically in Figure 3.2. The diagram is not exhaustive, for example, some distribution channels and fund service providers are omitted. At this point a distinction needs to be made between countries and regulatory regimes where asset managers can pay intermediaries out of a fund’s assets and those markets where such a practice is banned and so the intermediary charges their client directly for the advice and other services they offer. The best example of this is the regime that came into force following the UK’s Retail Distribution Review (RDR). RDR, which came into effect in December 2012, sought to end the use of sales commissions being paid from a fund’s assets, known as trail commission. This is also known as a rebate or retrocession as the fee was levied by the fund but then paid back to the intermediary. RDR’s ban on rebates did not include funds bought through a life insurance company or a pension wrapper. Funds available directly from an asset manager have also typically maintained their fees at pre-RDR levels. To adapt to RDR’s rebate ban, asset managers either launched rebate-free share classes or used lower-fee share classes previously reserved for institutional investors. So-called clean share classes that exclude such commissions have become ubiquitous in the UK as a result.

50

Flow of capital Advice / influence Costs paid from fund (not always permitted)

Investment consultant

Workplace pension scheme

Unit-linked insurance plan

Direct

Investment platform

Figure 3.2  Where an investor’s money goes

Source: author. Chart is illustrative and not intended to be exhaustive

Individual

Financial adviser

Fund ratings

Where an investor's money goes

Auditor Directors

Index provider

Custodian

Mutual fund

Asset manager

ESG analytics

Administrator

Sell-side research

Companies (equity; debt)

Government debt

Real estate; Commodities

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Equivalent rules do not apply across Europe, nor in most other countries around the world, although country-specific rules have been introduced in the Netherlands and, to a more limited extent, in Switzerland. The closest the EU has come to the UK’s approach is MiFID II, which banned independent intermediaries from accepting inducements – payments from third parties, such as retrocessions. Non-independent intermediaries, such as a bank’s advisers, can still be paid via retrocessions. Independent advisers are obliged to charge for their services separately from the charges incurred by investing in a fund, so cost-conscious IFAs will look to reduce costs for their clients either by lowering their own fees or looking for funds that have lower annual charges. So, while an asset manager no longer has a hand in setting the fees an IFA receives, these fees may still have implications for an asset manager’s revenues. When looking across Europe, it is apparent that many fund shares classes not only charge annual fees to their clients, but also a one-off initial charge (and, to a much lesser extent, an exit charge). While annual charges are paid from the assets of a fund, the one-off initial charge is taken from a customer’s money before it is invested (so a 5 per cent initial charge applied on an individual’s £10,000 investment means £9,500 is actually invested in the fund). While these charges are clearly relevant to an investor (half of Luxembourg-based fund share classes with this mechanism in place charge at least 5 per cent7), it is levied to pay a financial intermediary rather than the asset manager, so is less directly relevant for the latter’s revenues (although it is also obviously relevant in incentivizing an intermediary to use a particular asset manager’s funds). Meanwhile, in the UK it is rare to find initial charges linked to a fund and instead are most commonly charged by a financial intermediary directly (either as a percentage fee or as an absolute amount, such as £100). Research from NextWealth shows how these costs add up for a UK retail client who pays an average of 1.87 per cent a year, including fund charges (both active and passive are included), financial advice, as well as costs for fund selection and the investment platform (see Figure 3.3). Research from the UK regulator has previously come to a similar conclusion, having found that average annual fees charged for financial advice total 0.8 per cent, together

7. Author’s analysis of Morningstar data, as at March 2022.

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Platform 0.25%

Ongoing advice 0.68%

Discretionary management 0.37%

Fund charges 0.57%

Figure 3.3  Average fees paid by UK advised clients (%)

Source: NextWealth, Financial Advice Business Benchmarks, September 2021.

with a further 1.1 per cent for product-related charges (ranging 0.4–2 per cent) (FCA 2020). Awareness of this longer value chain that includes the retail client helps to explain why asset managers might want to develop a financial advice capability. RDR’s separation of the direct commercial link between financial advisers and asset managers (through the ending of trail commission), and an accompanying regulatory emphasis on the advice intermediaries give to clients, has resulted in greater use of lower charging index-tracking funds, resulting in lower revenues for many fund managers. At the same time, RDR’s changes have helped emphasize that IFAs control relationships with end-clients. Asset managers have a commercial incentive to control this relationship themselves, while also wanting to curry favour with intermediaries. While this has played out most strikingly in the UK, the same dynamics are at work, to a greater or lesser extent, in other markets around Europe and globally. Understanding these dynamics also sets the scene for a consideration of how new entrants from different industries might look to disrupt the sector. For example, some within asset management fear the entrance of a technology giant such as Google or Amazon deciding to enter the arena. Others have dismissed these concerns because of the highly regulated nature of mutual 53

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funds. However, when considering the whole value chain, and not just the parts that asset managers control, it is possible to see that a new entrant with a strong retail client base might seek to cut out mutual funds altogether, instead coming up with another way to give its customers exposure to investments such as the stock market. This might use buy or sell signals resulting from internet searches, for example. One of the most striking ways in which asset management and technology have come together is with a mutual fund being used as the primary cash management tool on Chinese e-commerce giant Alibaba’s online payment platform Alipay. Alibaba was co-founded by Jack Ma, one of the world’s wealthiest people. The fund, Yu’E Bao, is a money market product managed by Tianhong Asset Management and is one of the world’s largest mutual funds with $150 billion of assets at the end of March 2021 (Fitch Ratings 2021).

Watching the pennies Asset managers have two broad and overlapping areas to monitor when considering the management of costs: business costs and fund charges. Each function within an asset management company, detailed earlier in this chapter, accounts for the business costs that must be managed, including the potential for varying degrees of outsourcing with the intention of reducing costs. These business costs should, in turn, be reflected in the annual charges levied by a firm’s mutual funds together with a profit margin. However, asset managers are far more likely to set their funds’ charging levels based on accepted market rates rather than calculating the actual costs of managing a fund. This will be addressed later. Asset managers generate revenues from ongoing charges levied as a percentage of each fund’s total net assets. So, in principle, maximizing revenues is achieved by minimizing business costs, maintaining fund charges as a high as the market will bear, and increasing fund assets. Identifying areas to minimize business costs in general terms is not complicated, given an awareness of the different functions within a business. Investors sit at the core of any asset management business, so headcount in investment managers and research analysts tends to be preserved if at all 54

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possible, even if the personnel change. However, revenues are generated from the funds investors manage, so if an individual’s performance slips for a prolonged period then they may be replaced, or if a fund closes (often because of underperformance), then the manager’s future is also more likely at risk. Strategic decisions may be taken by a firm as to what funds or investment strategies it wants to offer clients, affecting investment management personnel as a result. Normally asset managers are ambitious to expand their product range, as noted earlier, but firms sometimes change priorities, particularly if assets in an area of the business are too small or are deemed unlikely to grow. Marketing roles were traditionally among the first to be made redundant when an asset manager embarked on cost-cutting exercises. This has tended to reflect the view that marketing was used as a means to promote funds, particularly new products, and so seen as a cost rather than a revenue-generating part of a business. Making sales and marketing activities more digital, effectively creating an audit trail for sales, over recent years has therefore been a boon for marketing teams as it has made it far easier to demonstrate where sales leads and client interactions have started and developed. The outsourcing of back-office functions is widespread in the industry, albeit not universal. Using a third party to carry fund administration and similar roles aims to lower costs for an asset manager as the third party undertaking the role is able to achieve economies of scale (lower overall percentage charges as a result of servicing a larger pool of assets), as well as improving efficiency with a dedicated service provider. The potential to reduce costs for end-investors has a dual aspect: both a reduction by using a third party, but also the removal of the temptation to keep back-office charges higher for an in-house service as this is a revenue stream for the asset manager’s parent company. Firms providing outsourced services for asset managers’ back offices also seek to undertake similar roles for firms’ middle offices, such as risk and transaction management, which provide operational support to investment-related functions. However, the number of firms outsourcing these areas is far more limited than for the back office and is more likely to take place for specific services than for an entire job function. Oversight and compliance roles have expanded significantly over the past ten years, accounting for 8 per cent of all UK asset managers’ direct employees, 55

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twice the proportion in 2010, according to the IA’s surveys. However, this level has remained stable over the most recent five years, suggesting that while firms may not be expanding this function further, these positions have resisted possible cutbacks. IT is an area where asset managers have been most willing to invest over recent years, with these roles accounting for 14 per cent of all direct employees, up from 11 per cent five years ago, according to the IA. At the same time, this is an area where firms have tended to employ additional contractors. While it is not clear if there has been an underlying shift to bring IT specialists in-house, it remains the area where firms have increased direct headcount the most. A focus on technology has been bolstered by management consultants and other external advisers regularly advising asset managers to increase their use of technology throughout their businesses – across operational, security, risk, marketing, sales, compliance (“regtech”) and investment roles – to improve efficiency and reduce costs. Consultancy firms often provide services to advise firms on how to undertake projects increasing the use of technology. This has been an increased focus for consultants over recent years, whereas over the prior decade or more the emphasis was on the need for asset managers to outsource more roles, where consultants were also able to provide project advice. The proportion of asset managers’ costs spent on different functions has shifted over the past five years, global research by Boston Consulting Group suggests (see Figure 3.4). The biggest increases in spending have been for distribution and IT, the former up by 20 per cent and the latter by 18 per cent between 2016 and 2020. The latter increase is no surprise when considering the emphasis on technology noted above. The higher proportion of costs invested in sales and marketing function is perhaps more of a surprise, not least when equivalent spending on investment management has fallen by 11 per cent over the same period. Absolute spending on investment management increased, but it was squeezed as a proportion of total spend. This shift reflects the competitive nature of the industry, changes in distribution (covered elsewhere in this book) and the resulting need to spend more, most notably on hiring salespeople, just to maintain the same level of client assets. Decisions on which areas of a business to focus spending are partly discretionary and reflect a firm’s distribution strategy. However, BCG’s analysis 56

BUSINESS MODEL 100% 90% 80%

38

34

Investment management

70% Business management

60% 50% 40% 30%

16 20 12 11 13

0%

Information Technology

11

20% 10%

Operations

20 2016

24

Sales & Marketing

2020

Figure 3.4  Breakdown of retail fund managers’ costs (%)

Source: BCG. Business management includes compliance, human resources and risk.

suggests cost pressures and spending also vary between business models. The researchers split firms between those that are primarily focused on institutional clients (such as pension funds and insurers) and those more focused on retail clients (wholesale channels including wealth managers and retail banks), as well as further dividing up the universe of asset managers by those that are part of, or affiliated to, a larger group (such as a bank) and those that are independent and so can only sell to external clients, or third parties. BCG analysed changes to firms’ cost-to-income ratios (which simply divides each company’s costs by its income) over the past five years. Falling ratios show institutional firms becoming more profitable, with the average cost-to-income ratio for affiliated institutional firms falling by 12.6 per cent and the average for third-party institutional firms falling by 2.4 per cent over the period. On the other hand, rising ratios are the result of costs rising at a higher rate than income. Affiliated retail firms’ average cost-to-income ratio rose by 4 per cent and by 4.7 per cent for third-party retail firms over the same five-year period. Rising distribution costs revealed in Figure 3.4 is one reason why overall costs for retail funds are rising faster than the income they have received. 57

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Paying the big guns A significant part of asset managers’ cost base is salaries, which can be considerable. Publicly listed asset managers disclose overall staff costs, indicating the level of pay across the industry, although breakdowns quantifying the costs asset managers incur for the different roles and functions detailed above are not publicly available. The data used here covers larger asset managers, with the smallest firm employing less than 200 staff and the largest firm’s headcount reaching 18,400. There is not a strong correlation between the number of employees and average pay levels across these firms, suggesting that the data is applicable to a wider universe of firms than just those included in this analysis. Analysis by the author of the wages paid for 13 large publicly listed asset managers in Europe and the US (see Table 3.2) suggests the median compensation per employee is €135,600, up by around 20 per cent on 2020. The mean pay level is closer to €200,000, skewed upwards by the high pay for senior executives. While some individual fund managers are paid more than their CEOs, the level of CEO pay still offers a guide to the higher ranges of pay in the sector. Total compensation for 19 CEOs at listed asset managers rose by more than 45 per cent in 2021 to reach €5.7 million, having fallen in 2020 as a result of some chief executives partially forfeiting their pay in light of the Covid-19 crisis (see Chapter 5). Highly profitable industry Turning from costs to revenues and profitability, there are an array of sources for establishing a robust guide to these key metrics for asset managers internationally. BCG carries out a global survey of asset managers, the Investment Association surveys its members in the UK, while McKinsey’s work includes analysis of firms in western Europe. Table 3.3 includes figures from each report covering data for 2020 and are included here to show the broad similarity of the findings, rather than to identify inevitable differences between surveys that cover different asset managers and with internal methodologies that differ slightly between one another. It is likely that the lower revenues in the UK relative to western Europe reflects the larger institutional client base 58

Stephen Bird Valérie Baudson Mark Coombs Larry Fink Asoka Woehrmann Christopher Donahue Jennifer Johnson Peter Sanderson Ian Simm Martin Flanagan Richard Weil Andrew Formica John Ions John Foley Luke Ellis Hendrik du Toit Gavin Rochussen James Barham Peter Harrison

Abrdn Amundi Ashmore BlackRock DWS Federated Hermes Franklin Resources GAM Impax Invesco Janus Henderson Jupiter Liontrust M&G Man Group Ninety One Polar Capital River and Mercantile Schroders Median

Source: author’s analysis of companies’ annual reports for 2021.

    CEO

Company

Table 3.2  Pay at listed asset managers (€’000)

1,041 800 119 1,319 2,400 692 650 723 335 694 637 541 409 1,166 1,093 770 411 419 595 692

CEO base pay 3,326 2,160 2,927 31,644 6,951 5,706 8,519 917 2,672 11,337 8,279 2,991 7,811 5,326 7,474 5,717 1,237 1,112 10,094 5,706

CEO total pay 73.8 92.6 n/a 144.6 n/a n/a 82.2 n/a n/a 165.1 141.7 135.6 175.1 103.3 163.0 162.0 n/a 97.5 119.9 135.6

Median employee total pay

5,463 5,300 310 18,400 3,600 1,968 10,300 605 200 8,500 2,200 584 205 6,993 1,498 1,168 167 288 5,750 1,968

Headcount

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Table 3.3  Profitability, costs and revenues of asset managers

Net revenue (% of AUM) Operating costs (% of AUM) Profit (% of revenues)

UK

Western Europe

Global

0.26 0.18 28.0

0.328 0.192 41.5

0.237 0.157 34.0

Sources: IA, Investment Management in the UK (UK); McKinsey, Global Asset Management Survey (Europe); BCG, Global Asset Management 2021 (global).

for the former (paying lower fees), while the global figures will include US asset managers that are larger than European firms (reducing costs relative to assets) and have larger passive fund business (reducing revenues). Rounding these figures for ease of use, asset managers are shown to have average operating costs of around 20 basis points (0.2 per cent) of their assets under management, while their net revenues average 30 basis points (0.3 per cent) of assets. Profits are found to average 35 per cent of firms’ revenues (where profitability is calculated as revenues less costs divided by revenues). While these surveys reveal similarities in the level of profitability for asset managers, historical data does not present a consistent trend in profitability, fluctuating slightly each year. As a result, average profit margins range from 28 to 41.5 per cent across the three surveys over the past 12 years. The data suggests that revenues are being squeezed as demand for lower-cost passive funds rises. At the same time, asset managers have been successful in reducing their costs while overall industry assets have risen following the hit taken in 2007 and 2008 from the global financial crisis. Averages inevitably mask variations between firms. The Investment Association’s research shows that profitability across 58 firms ranged from -46 to +89 per cent (with an average of 28 per cent). The vast majority of firms assessed are profitable, however, with 91 per cent achieving profitability in 2020. Or, as BCG put it in its 2020 report: “Although these consistently high margins far exceed those in most other industries, asset managers cannot afford to rest on their laurels”. The UK financial regulator has analysed asset managers’ profitability as part of its review of the sector. The FCA’s analysis is interesting as it was carried out not only to understand how asset managers compete, but also to include a consumer perspective and “ensure investment products offer value 60

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for money”. Its asset management market study began in 2015 (FCA 2015) and culminated in final rules and guidance being set out in 2018 (FCA 2018a). The FCA interim (FCA 2016) and final (FCA 2017) reports concluded that “sustained, high profits” were maintained through the years it examined “despite a large number of firms operating in the market”. Its findings are broadly consistent with the surveys quoted above and finding an average profit margin of 36 per cent, which ranged between 34 and 39 per cent between 2010 and 2015. The FCA also found that the average profit margins for firms servicing institutional clients was approximately 32 per cent, compared to 37 per cent for retail clients – reflecting that while the costs of servicing retail clients are higher than institutional clients, this was less than the difference in revenues generated from those clients. While finding that profitability varied between asset managers, the FCA also found that firms reporting below-average profit margins in 2010 and 2011 later recovered these to near the industry average in the later periods assessed (ending in 2015). “Even in relatively lean times just after that financial crisis, asset managers were generally not experiencing sustained periods of loss that need to be compensated for during better times”, the report’s authors wrote. “Firms in a competitive market would generally be subject to competitive forces which bring profits down towards a normal rate of return over time, typically proxied by the firm’s cost of capital for that activity”, they added. The regulator’s critical assessment concluded that “the weight of evidence suggests that profitability is high relative to market benchmarks” and that its findings were “consistent with competition not working as effectively as it could”. How firms compete will be looked at in Chapters 8 and 9.

How much are asset managers worth? Potential buyers valuing an asset management company will consider a range of factors that are relevant across industries, several of which have been discussed above, including costs, revenues and profit margins. One of the attractions of asset management as a business is the ongoing revenues the firm generates from its assets under management. As explained elsewhere, these increase (and decrease) as a result of both client flows and the returns 61

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generated by the funds (and mandates) the firm manages. And while active fund managers dismiss index-tracking managers for only ever generating market returns (beta) for their clients, these same market returns are baked into active managers’ revenues just as they are for passive firms – normally to the company’s benefit (rising markets increase assets and so increase fees, regardless of the skill of an active manager). Two valuation methods used across industries are also used as part of the valuation of asset management companies. One is discounted cash flow (DCF) and the other is comparable company analysis, neither are unique to value asset managers. In discounted cash flow analysis, a business’s future cash flows are forecast under a range of different scenarios. Using a discount rate (the commercial interest rate charged for short-term loans), it is possible to calculate the current value of these future cash flows and so estimate the value at which buying a company makes commercial sense. Comparable company analysis uses information on the current market value (and related trading multiples) of a listed company to estimate what these values would be for a similar business. Such analysis is done by calculating either a company’s enterprise value (EV) divided by earnings before interest, tax, depreciation and amortization (EBITDA), which is a measure of profitability, or its price-to-earnings (P/E) ratio, which measures a company’s share price relative to its earnings. Rick Potter, a partner at Alderwood Capital and expert in the field of asset manager acquisitions, has concluded that the difficulty in making accurate predictions means that asset manager valuation “remain as much an art as a science … Despite the wealth of academic research, and the complexity of some of the models used, valuation will always be dominated by subjective inputs” (Potter 2013). One method that is distinct to the fund management industry is valuing a firm based on its assets under management. For this reason, it is useful to look at this more closely. While prospective purchasers of companies will inevitably carry out more detailed analysis of an asset management to calculate a valuation, a reasonable rule of thumb is 1–2.5 per cent of a firm’s assets under management. Valuations for traditional asset management companies (as opposed to alternative managers such as hedge funds or private equity firms) have generally been falling over the past 20 years. Deloitte research finds valuations averaging 2.6 per cent of a firm’s assets under management 62

BUSINESS MODEL 3.5

3.3

3 2.6 2.5 2.1 2

2.2

2.5 2.0

2.2

2.4

2.3

2.2 1.7

1.5

1.3

1 0.5 0

2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

Figure 3.5  Asset management valuations, median value of listed asset managers as percentage of AUM Source: Deloitte.

each year for the period 2010–14, but 2.1 per cent for the period 2015–19 (Deloitte 2020). This pattern continued in 2020 and 2021. The trend of falling valuations does not follow an even decline each year in Deloitte’s research, but separate analysis that includes more historical data would suggest the broad trend identified is robust. Researchers at the University of Bologna analysed the valuation of 50 US and European “pure” asset management firms between 2008 and 2017 and found the average firm value was equal to 3.01 per cent of its assets under management (Bigelli & Manuzzi 2019). European asset management firms are found to have a higher average level of annual fees than US firms (1.23 per cent versus 0.94 per cent) leading to an average higher value as a proportion of assets under management (3.73 per cent versus 2.61 per cent). Further anecdotal evidence suggests valuations for European asset managers in the late 1990s and early 2000s were towards the upper end of these figures, at least 2.5 per cent of firms’ assets. For example, when Swiss bank UBS announced its acquisition of GAM in September 1999, the latter had assets under management of $13.9 billion. At the time of the announcement, the agreed price was expected be up to $675 million, valuing the company at 4–5 per cent of its assets under management (CNN 1999). GAM’s annual pre-tax profits for 1999 totalled $38 63

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million.8 Merrill Lynch similarly valued the UK’s Mercury Asset Management at approximately 3 per cent of its £100 billion assets under management in 1997 (Stevenson 1997). However, the late 1990s was also a time of significant variations in the prices firms were willing to pay, suggesting very different interpretations of the prospects for investment management firms at the time. NatWest Bank bought Gartmore from French bank Indosuez for just under 1 per cent of its assets under management (Eisenhammer 1996), while Insight Investment, at the time part of HBOS, bought Rothschild Asset Management for around 0.6 per BOX 3.1  ABERDEEN: ACQUISITIONS AS BUSINESS STRATEGY

Over a 40-year period, Aberdeen Asset Management adopted a trailblazing approach (within the UK industry) to acquire other firms as a means to grow its own assets, coinciding with fund management moving from being a financial backwater to a high-profile, and reliably profitable, industry. Led by Martin Gilbert, Aberdeen’s leadership team recognized the importance of building assets The firm was created in 1983 when Gilbert, the chief executive, and other senior executives bought out a £50 million investment trust in Aberdeen. Having listed on the London stock market in 1991, the firm hit the acquisition trail in 1999 with the purchase of Prolific Financial Management from Scottish Provident and never looked back. Purchases included, among others, Murray Johnstone and Equitilink in 2000, Edinburgh Fund Managers in 2003, most of Deutsche Asset Management’s UK business in 2005, Credit Suisse’s international asset management business in 2009, parts of RBS Asset Management in 2010, Scottish Widows Investment Partnership and Artio Global Investors in 2013, and then Arden Asset Management and Flag Capital Management in 2015. Gilbert capped this journey with a merger in 2017, joining Aberdeen with insurer Standard Life to create Standard Life Aberdeen, although the firm was later rebranded to abrdn. In all, Aberdeen lays claim to 60 acquisitions with Gilbert at the helm. With distressed firms and funds being among Aberdeen’s targets, it is striking to see how often the firm features in the following chapter (on Stars and Scandals), stretching from Bramdean to Deutsche-Morgan Grenfell and 8. With thanks to Philip Kalus, managing partner at Accelerando Associates, for his thoughts on valuations.

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Woodford Investment Management. This is not to suggest any wrongdoing on the Scottish asset manager’s part, but instead highlights how underlying client assets are, in principle, just as valuable when invested in funds that are badly managed as those that are well-run. It was not always plain-sailing for the firm, however. Aberdeen played a leading role in the split capital investment trusts scandal and at one point it looked as though the crisis might bring down the firm. A form of closedended fund in the UK, the fixed term products were increasingly sold as safe investments during the rising stock market of the 1990s, despite their structure increasing the risk to investors’ capital. The risks to investors was increased by some split-cap managers investing in other split-cap trusts. These cross-holdings amplified the trusts’ decline in value as stock markets dropped in 2000. Many shares in split-cap trusts became worthless when they reached their wind-up dates in this period, leaving many small investors facing financial ruin. In total, it is estimated that 50,000 savers lost around £700 million in the debacle (BBC 2005). Gilbert, Chris Fishwick, who oversaw the firm’s split-cap business, and other Aberdeen senior executives were hauled in front of the House of Commons’ Treasury Select Committee to account for their activities. Fishwick was infamously accused of being the “unacceptable face of the city” by one member of parliament on the committee. Fishwick left the firm at the end of 2002 with a bonus of £1.4 million for the following year (Moore 2002). Gilbert has subsequently said that the crisis was the most important event in his working life and acknowledged that his firm “almost went down” because of it (Hosking 2021). To assess the success of Aberdeen’s business strategy, analysts at Numis Securities have calculated that under Gilbert’s watch, Aberdeen delivered total shareholder returns of around 17 per cent per annum from 1983 to 2021 (McCann 2021). When looking only at the period when the firm was publicly listed, from 1991 to 2001, total shareholder returns were around 11 per cent per annum. This compares well to the overall UK market of around 8 per cent, although the UK asset management sector averaged 12 per cent over the same period, Numis finds. The research suggests that it was the firm’s pre-IPO performance that really stands out. Including those early years leads Numis to conclude that Aberdeen’s performance from 1983 to 2021 “is not substantially different” to the approximately 18 per cent per annum achieved by Warren Buffett’s Berkshire Hathaway over the same period. Despite leaving the firm at the end of 2020, Gilbert was not finished, and took over shell company AssetCo and immediately started on the acquisition trail once more.

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cent of its assets under management in 2002 (Connon 2003). Yet other deals at the time reached almost dizzying heights. Prudential bought M&G for £1.9 billion in 1999, valuing the company at 10.3 per cent of its assets (Garfield 1999), while Amvescap (now known as Invesco) valued Henley-on-Thames based Perpetual at 8.9 per cent of its assets a year later (Connon 2003). The extent to which a company is valued outside rules of thumb valuations based on assets under management (either higher or lower) will depend on fee levels charged across the business and associated levels of profitability. Deloitte illustrates this with a hypothetical example of two firms with assets of $30 billion that could be valued at $450 million, based on a valuation of 1.5 per cent of assets. But if one firm’s average fee is 1 per cent and the other’s is 0.5 per cent, then annual revenues from the first firm’s assets are twice those of the latter firm. Deloitte calculates earnings before interest and tax (EBIT) of $90 million for the former (so its $450 million valuation represents 5 times its earnings) and $23 million for the latter (the same valuation represents 20 times its earnings). Deloitte finds that between 2010 and 2014 asset managers were valued at 11 times earnings on average, which fell to 9.5 times earnings between 2015 to 2019.

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Fund managers sit at the heart of an asset management company, providing an investment service that is then wrapped in a product and sold to clients. It is these investment products that form the building blocks on which an asset manager builds its business. A firm’s investment management team undertakes a range of activities, with security selection – the decision to invest in a particular stock or other asset – representing the culmination of contributions from other members of the team. Linked to this are the decisions to disinvest from investments, reflecting that investing is an ongoing process. An investment management team broadly covers three other areas: economic analysis, asset allocation, and company research. Increasingly, data analysis represents a fourth, distinct contribution to the process. As with many other functions, these roles may overlap or be divided up in different ways, which will be partly dictated by the size of the company. Economic analysis provides a macro view of the economic and political backdrop for individual countries or sectors, together with views on how the dynamics shaping these markets might change in future. This includes a mix of short-term perspectives, such as the impact of a particular political election or Bank of England’s decision on interest rates, and longer-term strategic changes, such as the ripple effects through the economy of more people working from home. Asset allocation is the strategy or tactics relating to which types of securities to invest in and when, as well as ensuring the portfolio of investments is appropriately diversified and in line with the fund manager’s approach to investing. Most funds will use asset allocation insights as one of the inputs to 67

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decide how a fund should be invested. However, some funds’ primary focus is on getting judgements about the correct asset allocation across a wide range of potential assets. For these funds, the rest of the investment process is focused on how best to implement the fund manager’s views on asset allocation, rather than focusing on individual companies. For example, the manager might implement his or her views by investing in a range of exchange-traded funds that replicate the returns of particular countries’ stock markets. Investment analysts carry out research into individual companies, drawing on external research as well as their own analysis of a company’s profile, past growth and future prospects. This can then be assessed in relation to the profile of a particular fund’s investment objectives. Different asset managers make greater or less use of external research, while firms providing external research aim to provide analysis or insights beyond what an internal team can undertake or in less explored areas.

Engaging with companies Fund managers are likely to interact with senior executives at any company before taking a stake in the business to better understand its financial metrics, prospects for how these will change in future, and the way the firm is managed. This interaction does not stop once the investment is made, but continues to ensure that the fund manager’s views on a company remain robust and to help explain any changes in the company and its future prospects. But this is not solely about understanding companies’ financial performance or the headline metrics measuring this. Fund managers engage more fully with companies’ management to properly undertake their role as stewards of their clients’ money. The distinction between investment and stewardship is underlined by the fact that asset managers’ stewardship teams are normally separate from their investment management team, although the exact structure may depend on the size and resources of a firm. Stewardship has moved into the spotlight over recent years as part of the increased prominence of environmental, social and governance (ESG) criteria in investing. While fund managers’ engagement with investee companies might, on the face of it, be covered simply by the term governance – i.e. 68

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ensuring that the governance of companies is robust and understanding what are the value and aspirations of senior management – some asset managers have long had a wider view of stewardship encompassing non-financial aspects of companies’ activities, as well as including a company’s interactions with wider society and the economy, including the notion of being a responsible corporate citizen. This idea of responsible investing, or socially responsible investing, is used as a means to identify and mitigate risks and improve the growth prospects of companies in which fund managers invest. When viewed in this way, engagement cannot be entirely separated from financial considerations, as stewardship proponents undertake their work non-financial aspects have financially material implications. The most common public manifestation of engagement is a fund manager’s announcement of its voting intention at an upcoming company meeting. Typically votes against a company’s plans follow previous engagement efforts by the fund manager in an effort to make a company’s senior executives change their minds. Disagreements do not inevitably lead to disinvestment by a fund manager, however, particularly if he or she has a long-term investment horizon and is prepared to see change implemented gradually. ESG analysis has sometimes been characterized as a fairly black or white approach to decide whether or not to invest in a certain company based on its environmental or social credentials, but this misses the engagement dimension, for which voting serves as a useful reminder. Some asset managers will also view engagement with governments, regulators, industry bodies and other influential groups as part of their stewardship role to help shape capital markets and the wider economy. While socially responsible investing (SRI) and ESG has steadily grown in importance over the past 20 years, the focus has intensified recently through a combination of environmental issues entering mainstream political discourse, the Covid pandemic turning the public’s attention to companies’ responsibilities to wider society, and regulations related to sustainable finance. In turn, this has helped ensure that engagement and stewardship are inextricably linked to ESG. These aspects will also be discussed in Chapter 6.

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Setting objectives Mutual funds are obliged to make their investment objectives explicit in documents that must be provided to clients before they invest, while a fund’s manager is obliged to adhere to these objectives in the running of the fund. In this way, an investor should know in broad terms how their money will be invested, as well as the likely levels of risk and potential returns their money will be exposed to compared to other funds. As these aspects are fundamental features of individual funds, a closer look at investment objectives and policies, as well as how risk and return are understood by fund managers, would be useful. The investment objective tends to be a high-level statement on the aims of a fund. Often this appears largely superficial once several funds have been compared. For example, it might state: “the fund aims to increase the value of your investment over a period of five years or more and provide a growing level of income”. The investment policy is more detailed and describes how the objective is to be achieved, in particular the universe of assets in which the fund will invest. The latter should include main categories of eligible financial instruments (such as equities and/or bonds and/or commodities), whether the fund has a particular geographic focus (such as the UK or Europe or emerging markets) or a market sector focus (such as technology or the environment) for its investments. In a similar way, some funds incorporate religious or other ethical considerations into their investment policies, for example, excluding companies involved in alcohol, gambling, tobacco, firearms and adult entertainment. Shari’ah-compliant funds are most prominent among such funds in Europe, which will include an advisory board of Shari’ah scholars to advise on investments, while there are more funds incorporating Christianity-based exclusions in the US. A fund’s objective should also include the degree of discretion that the fund manager has in making investments or restrictions limiting investments, as well as whether the fund is managed with reference to a market benchmark. A benchmark is often a stock market index, such as the FTSE 100 or S&P 500, which actively managed funds will sometimes explicitly aim to outperform over a specified time period. More commonly benchmarks are used only for marketing purposes to show how a fund has performed compared to a wider market of similar investments. 70

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Alternative, 220

Property, 207

Other, 317

Money Market, 1,505

Allocation/ Mixed Asset, 1,872

Equity, 6,239

Fixed Income, 3,590

Figure 4.1  Size of European fund asset classes (€bn)

Source: Morningstar, as at December 2021. European mutual funds and ETFs, excluding funds of funds.

Fund managers are most commonly associated with investing in companies (also known as stocks or equities) listed on stock markets, such as the London or New York Stock Exchange. While equities are the largest type of asset invested into by funds, equity funds only make up 30 per cent of mutual fund assets across Europe, while making up roughly half of fund assets in the UK and almost 60 per cent in the US. Different types of asset are collectively known as asset classes. The other main asset classes are bonds, money markets, commodities and real estate (see Figure 4.1). However, when considering asset classes as a means to group similar types of funds together for comparisons, then alternatives and mixed assets are also commonly used. Funds of funds (discussed later in this chapter as part of multi-manager funds) are sometimes treated as a separate asset class due to their different structure, but their underlying investments will align with a broad fund asset class. Investing in equities involves risk because the price, or value, of a company can fall as well as rise. If the price of a company in which a fund invests rises, this is a capital gain. Companies also pay dividends to shareholders (including 71

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funds) that invest capital in the company, so equity funds can also generate income for their investors. Fund investors do not have to receive this as income, but can also have the dividends reinvested with their investment in the fund, boosting their overall return. Bond funds invest in debt issued by companies (also known as corporate bonds or credit) or that issued by governments. Government or sovereign bonds issued by the UK government are known as gilts, while German government bonds are bunds and US government bonds are US Treasuries. Bond issuers therefore borrow money from lenders (mutual funds in this case) to raise money to finance long-term investments, or for a government to finance its current spending. The bond issuer guarantees a fixed rate of interest (bond funds are also known as fixed income funds) payable during the life of the bond and to redeem the bond at a specific price at the end of its life (known as its maturity). A bond’s yield is the actual annual return an investor can expect if the bond is held to maturity and is calculated as the coupon (the interest paid on a bond) divided by its current price. There is a negative relationship between a bond’s yield and its price, which reflects that falling interest rates push up the value of older bonds as they still have the higher coupons previously available. Similarly, if interest rates rise then the value of older bonds falls. One point worth adding is that it is possible for bonds to have negative yields, thus offering the unappealing prospect of guaranteed losses for those holding the bonds to maturity. However, many fund managers do not hold bonds to their maturity date and a manager might take the view that yields will fall further in future – pushing up the capital value of the bonds if he or she is proved correct. Money market or cash funds offer investment features similar to cash deposits, with a low level of risk together with low expected returns. They do this by investing in short-term money market instruments, such as bank deposits, certificates of deposits (offered by banks) and commercial paper (a short-term debt instrument issued by companies), as well as bonds with very short maturities (typically less than 90 days). While the returns generated vary with interest rates, their net asset value should remain relatively stable (this can vary depending on the particular type of money market fund). However, there are rare occasions when the net asset value of a money market fund falls below $1 (or €1), which is called colloquially “breaking the buck”, 72

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in other words the income from the fund fails to exceed its operating expenses or capital losses, and so investors might not get back the money they invested. The asset manager can waive fees as a way to overcome investor losses, although in the past in extreme cases central banks and financial regulators have stepped in. The best-known instance of a fund “breaking the buck” is the Reserve Primary Fund in September 2008. The fund had a relatively small allocation of $785 million to short-term loans issued by Lehman Brothers (about 1.2 per cent of the fund’s $64.8 billion assets) (Jones 2008). When Lehman Brothers announced it was filing for bankruptcy on 15 September 2008, the Reserve Primary Fund faced redemption requests totalling $40 billion in one day. Unable to meet such large requests, the Reserve Management Company delayed redemptions from the fund for seven days. This was insufficient to calm investors and on 29 September the firm announced that its fund was being liquidated.1 Taken together, these three broad asset classes offer varying degrees of risk (here defined as the potential for the money invested in a fund to lose its value) as well as varying potential capital returns. And within each asset class, there are also varying degrees of risk and potential returns, for example, developed markets (typically lower risk) compared to emerging markets (typically higher risk). Higher risk investments typically offer higher potential returns. Recognizing these differences and customers’ need for these different characteristics at different times – reflecting either market conditions or investors’ circumstances – asset managers also offer a fourth fund asset class, namely mixed asset or multi-asset funds. These products offer a blend of different asset classes within the same fund. The mix of asset classes and regional investments within such a fund is typically actively managed and so varies over time, although some mixed asset funds have a static asset allocation. The distinction between a mixed asset and multi-asset fund is a slightly grey area, although use of the latter term usually reflects that the fund can invest in asset classes beyond equities, bonds and cash. These can include commodities, real estate and so-called alternative investments. Commodities and real estate here are not investments in companies with exposure to these asset classes, but investments in physical commodities (or derivatives linked 1. The Reserve Management Company, “Important notice regarding Reserve Primary Fund”, 29 September 2008.

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to commodity prices), including agricultural commodities, metals and precious metals, oil and gas, or investments directly in real estate or wider infrastructure projects. Real estate investments relate to commercial property, including industrial (such as warehouses), retail (such as shopping centres) as well as offices and student accommodation. Alternative investments is an umbrella term for assets not referred to above (although real estate is sometimes included under this umbrella), including private markets (i.e. companies that are not publicly traded), as well as funds with investment strategies that make extensive use of derivatives (which are sometimes referred to as hedge fund strategies), which are discussed below. Here it is worth noting that alternative investment funds (AIFs) and alternative investment fund managers (AIFMs) are European regulatory terms for entities that fall within the scope of the Alternative Investment Fund Managers Directive (AIFMD). AIFs are essentially any European funds that are not UCITS funds, which are broadly mutual funds that are suitable for retail investors and fall under the EU’s Undertakings for Collective Investment in Transferable Securities regulations. These terms therefore offer regulatory distinctions between types of funds but they can be confusing because some UCITS funds adopt alternative investment strategies (discussed below), while not all AIFs have alternative investment strategies (for example, UK investment trusts as classified as AIFs). Alternative investments and hedge funds will also be addressed in Chapter 7. Derivatives are financial instruments that derive their value from other assets. They include forwards, futures, swaps, warrants and options. They are used as a means to make money from investors’ predictions on the future price movement of an underlying asset, without having to purchase the actual asset. They are also used to mitigate the risk of another investment position the investor has in the market, known as “hedging” the risk. A futures contract is an agreement between a buyer and seller that an asset will be bought or sold at a predetermined price on an agreed date. Futures contracts are standardized and traded on exchanges. A forward contract is also an agreement to buy or sell an asset at a predetermined price on an agreed date. The main difference is that forward contracts are not standardized and are not traded on an exchange (trading off-exchange is known as “over-the-counter”).

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Options give the holder the right – but not the obligation – to buy or sell an asset from/to another party at a predetermined price before an agreed date. The option to sell an asset is called a put option, while the option to buy an asset is called a call option. A warrant is a variation on this, giving the holder the right to purchase a company’s stock at a predetermined price on an agreed date. The warrant is issued directly by the company concerned. A swap is a contract whereby two parties exchange, or swap, a financial instrument’s cash flows for a specific period of time. The most common are interest rate swaps. Unlike futures and options, swaps are traded over-the-counter. Mutual funds are typically limited in the amount they can invest in private equity, i.e. companies that are not listed on a public market, or similar private assets. For example, UCITS rules are specifically structured around investments in transferable securities, so real estate and private equity are not permitted beyond a maximum 10 per cent investment in illiquid assets (known as the trash ratio). Other fund vehicles do invest in private markets, however, and traditional asset managers are increasingly looking to expand their business into these parts of the market, normally via the acquisition of specialist firms or dedicated investment teams. Private markets include not just private equity, but also private debt (acquiring the debt of private companies) and infrastructure projects (such as airports) or other physical assets (such as farmland, forestry or mines). Lastly, there are cryptocurrencies. These are digital assets or tokens, such as Bitcoin or Ethereum, that were first devised as a type of electronic cash, but are not currencies as normally understood. There is no central bank or government to support the system, which instead relies on technology to “mine” and transfer the tokens. Individual tokens that make up a cryptocurrency are encrypted strings of data. A discussion of the pros and cons of cryptocurrencies lies outside the scope of this book. However, some European funds and exchange-traded products do invest in these extraordinarily high risk (and potentially extraordinarily high return) tokens. In December 2021, there was more than €10 billion of assets in European mutual funds and exchange-traded products (technically not ETFs) investing in cryptocurrencies, according to Morningstar data. In addition, regulated mutual funds have made small allocations to cryptocurrencies either directly (notably UK asset manager Ruffer) or indirectly (for example, funds investing in electric car maker Tesla, which in turn has invested in cryptocurrencies). Initially the preserve of specialist 75

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cryptocurrency investment firms, Europe has recently seen well-known asset management brands entering the arena, for example, Invesco launched a Bitcoin exchange-traded product in Europe in November 2021 and Fidelity International followed in February the following year.

BOX 4.1  INVESTMENT RETURNS: PAST AND FUTURE

Fund managers’ investments can be brought to life more effectively by looking at the historical returns that clients have received. This is primarily an historical view and with the caveat that past performance is not a reliable guide to the future (as financial regulators require mutual funds to state when marketing their products).

Figure 4.2  Asset class returns (per cent) Source: JPMorgan Asset Management, Guide to the markets - UK. Note: Total return of indexes in GBP, unhedged. Cash: JP Morgan Cash UK (3m); Govt bonds: Bloomberg Barclays Global Aggregate Government Treasuries; IG bonds: Bloomberg Barclays Global Aggregate – Corporates; EM bonds: JPMorgan EMBI Global Diversified; Cmdty: Bloomberg Commodity; DM equs: MSCI World; EM equs: MSCI Emerging Markets; Hedge fds: HFRI Global Hedge Fund Index. Past performance is not a reliable indicator of current and future results.

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Figures prepared by JPMorgan Asset Management show how investment returns from different asset classes vary each, not just in percentage terms, but also in relation to one another. For example, commodities was the best-performing asset class in 2021, with a return of 28.3 per cent (based on Bloomberg’s Commodity index), but the average return for the same index has actually been negative (-1.5 per cent) over the past ten years. Also, hedge funds have an average return of 4 per cent per annum over the past decade, considerably less than development market equities (represented by MSCI’s World index), which have an average annual return of almost 15 per cent. While the above table gives a sense of how returns have varied over each of the past ten years, Elroy Dimson, Paul Marsh and Mike Staunton at the London Business School have built up a database of historical returns dating back to 1900. Drawing on this database, world equities can be seen to have generated average annual returns of 7.2 per cent for baby boomers born in 1950 (see Figure 4.3). Average equity returns have fallen for succeeding generations since then, the research shows. By contrast, bond returns have risen over the same three generations. The research findings also calculate an investment portfolio invested of 70 per cent in equities and 30 per cent in bonds over the three generations, rebalancing the investments at the beginning of each year (rather than kept fixed throughout). Interestingly, the negative stock– bond correlation since 1990 has meant that investors in this 70:30 portfolio would have obtained a higher return from a stock–bond blend (rebalanced 8

Equities

7.2

7

6.4

6

5.8 4.7

5 4

5.8

3.5

5.2 5.4

Bonds

70:30 blend

5.7 3.6 2.6

3 2 1 0

0.1 World since 1950 World since 1970 World since 1990 World in the future* Baby Boomers Generation X Millennials Generation Z

Figure 4.3  Past and future returns (per cent) Note: Annualized real returns in USD. * Projection for the next 30 years, from start of 2022. Source: Copyright © 2022. Dimson, Marsh & Staunton.

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annually) than on either stocks or bonds. The difficult outlook for investment managers is reflected in the projection of potential world equity and bond returns for the next generation. They estimate average annual equity returns of 3.6 per cent and bond returns of just 0.1 per cent over the next 30 years.

Investment strategies Beyond a fund’s objectives and policies, the fund manager will also have a strategy or style guiding the way they manage investments in order to deliver better returns than their competitors. Such investment strategies largely lie outside the scope of this book – and there are more books and research papers looking into the pros and cons of different investment strategies than could reasonably be covered here anyway. For now, it is enough to list some of the strategies that asset managers employ and note that different styles will work better or worse at different points in a market cycle and over different time periods. In addition, larger asset managers are likely to offer a range of funds with different strategies to cater to different client demands. Large cap vs small cap. The market capitalization of a company determines whether it is considered to be large-cap, mid-cap or small-cap (or even megacap or micro-cap). For example, data provider Morningstar defines large-cap companies as those that account for the top 70 per cent of the capitalization of a domestic stock market. Mid-cap stocks represent the next 20 per cent, and small-cap stocks make up the remainder. Some funds invest across the market cap spectrum, while others focus on a particular range in order to attract different clients. Funds investing in smaller cap stocks are normally considered more risky (more volatile), but with the potential for higher returns. Value vs growth. Value stocks are companies deemed by a fund manager to be valued below what they should be worth, and so have the potential for better long-term returns. Growth stocks are those companies that are expected to grow faster than the overall market. This distinction seems to be particularly hotly contested in the US funds industry. Many fund managers use a mix of both value and growth considerations when considering whether to invest in a company. Some also undertake this combined approach as a specific strategy, for example, growth at a reasonable price, or GARP.

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Quant. Quantitative analysis is used to drive investment decisions, which may include computer models, algorithms or other data-based systematic investment strategies. Still generally considered to be active management, it can be seen as a half-way house between relying solely on a human fund manager and relying on an index to determine a fund’s returns. Absolute return. The vast majority of equity funds are managed and compared in relation to a benchmark index. For a large cap UK equity fund this might be a comparison with the performance of the FTSE 100 index of the UK’s largest companies listed on the London Stock Exchange. These funds’ returns are then judged relative to the index and so are broadly referred to as relative return funds. Absolute return funds aim to deliver a positive, or absolute, return regardless of the direction in which market indices move over a multi-year period. To achieve these returns, absolute return funds will often adopt an alternative investment strategy (see below). Factors. Alongside market capitalization and valuation, there are other so-called investment factors that have been found by academics to generate better returns than the market over some time periods. The factors that have been used most often for mutual fund construction and investment strategies are dividends (generating an income for investors), low volatility (a stock’s range of returns) and momentum (stocks that have performed well in the past tend to maintain that performance for certain periods). A fund manager will weight their portfolio more heavily to a factor to take advantage of the factor’s perceived superior performance. Index-tracking vs active management. The difference between index-tracking and actively managed funds has been explained earlier, but awareness of active and passive fund management also belongs in a consideration of investment strategies. Alongside traditional index-tracking mutual funds, exchange-traded funds are another vehicle that offers index-based strategies (while rarer, ETFs can be actively managed too). Passive funds and ETFs will also be considered in Chapters 7 and 9. Both active and passive managers can take advantage of investment factors noted above. Investing in an index based on a particular factor is often referred to as “smart beta”. In addition, while index-tracking funds traditionally weight stocks based on their market capitalization, so larger stocks make up a larger proportion of the index, an alternative approach is to equally weight

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the universe of stocks, effectively giving more weight to medium-sized and smaller companies. Traditionally index funds and ETFs would try and replicate an index by investing in the same basket of securities, or a sample of these that would generate a return similar to the index. This is known as physical replication. Some ETFs choose to replicate the returns of an index synthetically, using derivatives such as swaps instead of directly holding the underlying securities. The ETF provider enters into a swap contract with a counterparty (such as an investment bank) that agrees to return the value of the index the ETF is tracking, for which the counterparty receives a fee. When done successfully, this process can be particularly effective at minimizing tracking difference (the difference between the return of the fund and that of the index it tracks), potentially reducing it to zero. A decade ago, European ETF providers switched many of their products from synthetic replication to physically holding the assets of the indices replicated. These changes were partly the result of investors’ concerns about counterparty risk in synthetic products, stoked by warnings on the topic from the Financial Stability Board in 2011. Disclosures and understanding have improved since then and more firms now offer synthetic ETFs. BlackRock, one of the earlier critics of the practice, launched a swap-based S&P 500 UCITS ETF in 2020. Alternative investment strategies make extensive use of derivatives and are typically not restricted to one underlying asset class. These include eventdriven strategies, which attempt to profit from securities’ price changes in response to corporate actions, such as bankruptcies or mergers and acquisitions, and global macro funds, which primarily make investment decisions based on their analysis of the broad macroeconomic and political environment. The best-known alternative investment strategies are long/short funds, which are so-called because they take long and short positions in companies. This approach was the strategy of the first hedge fund. Most conventional funds invest by taking a so-called long position in a company: investing capital with the expectation that the value of the company will rise. A fund manager will take a short position if they expect the value of a company to fall. To do this, the investor borrows shares of the company, then sells them in the expectation that the share price will fall. When the fund manager needs to return the borrowed shares, he or she buys them from the market and returns them to the lender. If the shares have fallen in price during this period, the 80

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fund manager will have made money, but there is also the risk of losing money if the shares have risen in price. Regulators place restrictions on the extent to which mutual funds sold to retail investors can take short positions. This is partly because of the risk involved. For a long position, there is a limit to the downside of an investment: the capital invested. However, when taking a short position, it is possible to lose more than the capital originally used to borrow shares because there is theoretically no limit to the amount the share price might rise – and when the price rises above the level at which the shares were originally borrowed, this translates into losses for the short-selling investor. Hedge funds are also discussed later in Chapter 7.

Technology and data science As this book is not intended to provide an in-depth look at different approaches to investing, an in-depth look at the different uses of technology by portfolio managers lies outside its scope. However, this is not to minimize the ways in which technology has been used by some asset managers or, more importantly, its potential for shaping the future of active fund management. Indefi, an asset management consultancy, is not alone in suggesting that technology’s impact on investment management activities has so far been limited (Celeghin 2022). This contrasts with much more significant technological changes in areas such as trading, settlement, custody and fund administration. “An equity [portfolio manager] or an institutional sales professional teleported to 2022 from twenty years ago would find merely superficial changes to how they fulfilled their primary responsibilities. We expect this will not be the case for today’s professional being teleported to 2030”, Indefi predicts. Blockchain (see Chapter 2) and cryptocurrencies (earlier in this chapter) have been touched on previously. So this section will focus on data science, machine learning and algorithmic trading. Within asset management, the related areas of data science and machine learning probably overlap more than they might in a pure, academic setting. Data science – combining computer programming with knowledge of statistics to find new insights from data – is being established more as a standalone team within asset managers’ investment departments, and is feeding 81

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into different investment processes. Data science involves analysing not only structured data (numbers in a spreadsheet) but also unstructured data (text, audio, video). Machine learning refers more specifically to the techniques used to enable or teach computers to learn from data. In this way, machine learning is a subset of artificial intelligence. For example, a computer can be programmed to recognize similarities in existing data and then try to infer similarities in new data to enable it to come to a judgement (Van Egghen 2017a). Over time the computer refines its problem-solving capabilities by evaluating the robustness and usefulness of different data sources. The availability and reliability of different data is therefore particularly important for a computer’s learning to be valuable. Schroders has attributed some of the success of its actively managed funds to the firm’s data science team, particularly during pandemic-hit 2020.2 The firm says the outperformance of its investment teams was “particularly significant” and “demonstrates the benefits of the integration of data science into [the firm’s] investment process”. Schroders’ Data Insights Unit, set up in 2014, has more than 30 employees, including data scientists, engineers and analysts drawn from different industries, drawing on traditional and alternative sources of information. BlackRock’s use of data science and machine learning has shown where asset managers are still learning about how to integrate computer-generated insights into the management of funds. For example, despite data science correctly predicting political election results, a senior executive at BlackRock has said its investment team did not trust its computers’ judgement. Michael Gruener, former head of retail sales for Europe, the Middle East and Africa at BlackRock, has said the firm mines data from “every single Twitter feed” to gain investment insights, which are among the information sources that are used for “spotting trends [and] making predictions” (Van Egghen 2017b). Based on sentiment from social media, BlackRock’s algorithms concluded that UK prime minister Theresa May would lose her parliamentary majority in 2017 and Donald Trump would become US president in 2016. Both predictions would have been contrary to most polling data and conventional 2. Schroders, 2020 full-year results, 4 March 2021.

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political wisdom at the time. “The problem [with big data] is you have this information but do you trust the prediction or not? Within BlackRock we did not trust either of these predictions”, Gruener has said.

BOX 4.2  HOW PIMCO USES BIG DATA

PIMCO, a US-headquartered asset manager that specializes in bond investments, has been developing its use of alternative sets of data for many years. Ravi Mattu, global head of analytics at PIMCO, says: “We have now reached a place where the price of data is low and the amount of data has exploded.” The firm uses big data and machine learning to make predictions about the future value of assets, rather than for automating investment decisions. PIMCO is able to analyse different data on 200 million individual mortgages thanks to increases in computing power and the “explosion” of alternative data sources (Moisson 2018a). For example, the firm uses crime statistics and school ratings to help forecast default risk in relation to investments in mortgage-backed securities. A mortgage-backed security is similar to a bond and is made up of a group of mortgages that are packaged together, or securitized, by a bank or other organization into a security that can be bought by investors. Mortgage securities and other asset-backed securities are used in the firm’s Mortgage Opportunities fund, as well as accounting for 40 per cent of the $70 billion PIMCO GIS Income fund’s assets, Europe’s largest UCITS fund. PIMCO, which has more than 60 analysts in its analytics team (as at mid2018), has also developed text-reading algorithms to help the firm’s investment analysts. The algorithms can analyse nuances in the language used in the minutes of meetings of the US Federal Reserve. This can help to determine whether the board has become more hawkish on interest rates policy for example. Text-reading techniques are also used to spot changes in the language used in companies’ quarterly reports. Significant changes are flagged with investment analysts to help direct them to companies where their work may be put to best use. Data analytics and machine learning techniques also mean the firm can adapt more quickly as potential opportunities arise. The asset manager estimates that it now takes one week to be able to cover a new asset class, while using traditional analytics would previously take two months to do so.

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Algorithmic trading Machine learning is also put to work for algorithmic trading, whereby a computer programme follows a defined set of instructions (an algorithm) to place a trade, thus limiting human intervention in any given trade. This increases the speed and efficiency of executing these trades. However, the International Organization of Securities Commissions (IOSCO) has identified that machine learning, including algorithmic trading, may also “create or amplify certain risks”, including governance and oversight (IOSCO 2021). Having said this, much as data science and machine learning is primarily used in conjunction with humans in portfolio management, so using algorithms to execute a trading strategy is undertaken largely to augment decisions by humans rather than having computers effectively managing funds on their own. This is also reflected in IOSCO’s findings and its resulting recommendations for financial regulators to set standards of conduct by asset managers and market intermediaries. For mutual fund managers, algorithmic trading can be used as a means to execute an investment strategy, such as pairs trading. Pairs trading is a long/ short investment strategy that identifies two companies with similar characteristics that are trading at prices relative to each other that are outside their historical trading range.3 The strategy entails buying the security that is perceived to be undervalued, while short-selling the overvalued security. Algorithms can be used to swiftly take advantage of transient discrepancies in the value of the two securities. High-frequency algorithmic trading (HFT) takes this process once step further. Here the computer programme executes a large number, potentially thousands, of trades in fractions of a second to take advantage of a range of discrepancies similar to those described above. As the scale and speed of these processes are much larger than single trades, the computing power needed is much larger and so is much more likely to be undertaken by larger firms. Some hedge fund managers, most notably Citadel, founded by Kenneth Griffin, are among the world’s largest proponents of high-frequency trading. This practice has come under attack for some more recent stock market 3. See trading.

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crashes (such as the so-called “Flash Crash” of 2010) and for threatening the integrity of stock markets (see also Sornette & von der Becke 2011).

Fund analysis Fund managers are held accountable both for their ability to deliver on their funds’ investment objectives, as well as for how they compare to the rest of the market. As noted earlier, a fund’s investment objectives can be broad and normally describe how the fund will be invested, rather than how successful its investments will be. Because asset management is ultimately a commercial activity, it is the latter – how a fund compares to the market – that determines much of how good a fund manager is deemed to be at their job and, consequently, helps to drive demand for the products they manage. If it were possible to determine objectively which fund manager was better than others, then the number of funds in the industry would likely be very much smaller than it is. Instead, much time, energy and resources are spent in trying to establish which funds have performed best over previous years, even before the question of which funds will perform well in future is tackled. The issue is made more complicated by the fact that different investors have different investment objectives and there are different ways to judge which fund has best succeeded in delivering on those objectives. The demand for analysis of fund performance is reflected in the fact that both fund selection and fund data have become well-established subindustries within asset management. And much of fund analysis and research is based on the idea that past performance, as well as taking into account related factors, offers some guidance as to how well a fund will perform in future. This is despite the fact that regulators require mutual funds to state in their marketing documents that past performance is not a reliable indicator of future returns. Part of the challenge of comparing funds is resolved by comparing similar funds with one another. For example, there are more than 4,300 funds available to UK investors that the Investment Association groups into different sectors, with each sector having an average of 85 funds. These range from 460 global equity funds and 260 UK equity funds, to just eight funds investing in 85

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Japanese smaller companies. The number of funds in different categories, and holding similar types of investment, also largely reflects the level of demand for different types of fund, i.e. there is much more demand in the UK for global equity funds than for Japanese smaller companies funds. Statistical analysis of funds is based around a range of metrics. It is worth briefly highlighting some of these metrics as they are frequently referred to by fund managers. First, “beta”, which is the extent to which a fund’s returns fluctuate with the market. A beta of 1 reflects that the volatility of a fund’s returns exactly matches the market it follows. By contrast, “alpha” is the extent to which a fund has outperformed the market. This can be used as the basis for establishing whether a fund manager has skill. It is little wonder that “high alpha” funds are often trumpeted by asset management marketing departments. Other measures aimed at assessing how actively a fund is being managed include “tracking error”, sometimes called “active risk”, which shows the volatility of a fund’s excess returns relative to a benchmark, with a lower figure suggesting that the fund is not being actively managed. This measure is also used for index-tracking funds, where low tracking error is an advantage and may suggest a fund is tracking its index appropriately. “Active share” is also increasingly used by fund managers to try and show they are investing differently from a benchmark (or reference) index by calculating the degree to which their fund’s portfolio of investments overlaps with its benchmark. Among other measures used to evaluate fund returns and to try to glean whether the fund manager stands out from his/her peers, two are worth mentioning here. The “Sharpe ratio”, which shows a fund’s risk-adjusted performance by dividing a fund’s annualized returns above a so-called risk-free (cash) rate by its annualized standard deviation (measuring the volatility of a fund’s returns). The second is the “information ratio”, which is used to assess the potential for an active manager to outperform a benchmark by calculating the fund’s returns above the benchmark relative to the volatility of the fund’s returns (using its tracking error). The fund selection process is also covered in Chapter 8. Time periods are also important when assessing fund performance. One year is normally considered the minimum period needed to assess whether a fund is performing well (although ongoing monitoring for existing clients will often be over much shorter periods). But three years is the most common 86

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period used when comparing performance and normally deemed the most significant for attracting clients. Five years is also commonly used, but not as prominently as three years. And, taking this one step further, ten-year performance will also be assessed, but the number of funds with this track record length is much smaller and research suggests this time period is much less influential in determining demand for a fund. However, many fund managers suggest that investors need to stay invested in actively managed funds for the long term and endure periods of underperformance. Assessing skill The extent to which fund managers can demonstrate skill is one of the most hotly contested topics in the industry. It is also the area where much of the academic literature in investment management is focused. As this book is concerned with asset management as a business, rather than investing as a pursuit in itself, this conundrum does not need to be resolved here. But it is worth referring to this debate due to its importance in underpinning decisions on whether to invest in higher charging actively managed funds or low-cost index-tracking funds. There is a consensus in academic research that fund managers do not outperform their index benchmarks in aggregate after fees. In addition, any aggregate outperformance tends to be absorbed by funds’ fees and expenses, or it does not persist over time. For example, Mark Carhart found that “although the top-decile mutual funds earn back their investment costs, most funds underperform by about the magnitude of their investment expenses … The results do not support the existence of skilled or informed mutual fund portfolio managers” (Carhart 1997). Michael Jensen found that there was “very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance … These conclusions hold even when we measure the fund returns gross of management expenses” (Jensen 1968). Meanwhile Burton Malkiel found that “in the aggregate, funds have underperformed benchmark portfolios both after management expenses and even gross of expenses. Survivorship bias appears to be more important than other studies have estimated” (Malkiel 1995). This consensus has clearly strengthened the appeal of index-tracking funds and ETFs. 87

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“Survivorship bias” is a potentially significant factor when assessing historical returns across a group of funds. The term refers to the fact that over any given time period, some funds will be closed (or merged into other funds). As a result of this change in the size of the data sample, average returns may be inflated and reflect only those funds that survive throughout the period. As funds that close are more likely to have below average historical returns, survivorship bias therefore has the potential to make average returns look better than the historical reality experience by investors. (Although this is not always the case, for example, sub-scale funds with above-average returns are also liable to be closed). While it is not possible to examine the hypothetical returns of funds after they close, it is possible to look at the historical returns of these funds when they did exist, as this data is retained by fund data providers. For example, by looking at returns of funds over rolling time periods and capturing the data for funds that were in existence over each period. This approach also ensures that funds not in existence at the start of a period are included in the analysis. Having said this, academics and investors cannot escape the fact that fund closures and launches are a significant feature of the European funds landscape. This is addressed in the later section on launching new funds, which shows that over the past 20 years there have been more than 50,000 mutual fund launches and a slightly smaller number of closures. While survivorship bias is the most commonly identified bias in research into historical fund returns, it is not the only one. “Look-ahead bias” occurs when information is included in historical analysis of fund returns that could not have been known or was not available at the time when the returns were being generated. This bias is particularly relevant for asset managers looking to launch a new fund. A portfolio is managed before launch and models of the same portfolio are back-tested to see how they would have performed in the past. Commonly – it is tempting to say invariably – back-tested portfolios perform well and thus support the case for launching a new fund that follows the same investment strategy. The academic consensus on the aggregate underperformance of active managers has not stopped some researchers from coming to different conclusions. The authors of a recent paper admit their findings “stand in stark contrast with those in the prior literature” (Sheng, Simutin & Zhang 2021). Their research concludes that “high-fee funds significantly outperform low-fee funds before 88

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deducting expenses, and do equally well net of fees”. And even when academics conclude that funds in aggregate do not outperform, this does not mean they conclude that it is not possible for some investment strategies to do this. Most notably, the work of Eugene Fama (Fama & French 1993, 2010), a Nobel laureate in economics, inspired the founding of Dimensional Fund Advisors and was himself a founding shareholder of the firm, which today manages more than $675 billion in assets.4 One does not need to dispute the general agreement among academics on investment management to point out the commercial reality of the continued demand for active fund managers. All of the world’s largest passive fund managers also offer actively managed strategies, be it US firms such as BlackRock/ iShares, Vanguard or State Street Global Advisors, or the European firms of Amundi, DWS and UBS. There is also considerable research showing that it is more difficult for an active fund manager to outperform in a large, developed equity market, such as the US or UK. This also means there is the potential for a form of sample selection bias in academic research into funds’ returns. Reflecting this finding, professional fund selectors are more likely to allocate to index-tracking funds investing in US large cap equities than any other sector. Other research shows that it is difficult to make sense of the data, with “investors underestimat[ing] the probability that a track record was generated by pure chance, especially in large fund populations and when fund managers take excessive risks” (Heuer, Merkle & Webber 2017). The authors also show that “investors associate alpha with fund manager skill and are likely to invest in funds with high past alpha”. Related research contends that high performance levels are “rationally interpreted by investors as evidence of the manager’s superior ability” (Green & Berk 2002). This last research paper is also relevant as it found a “strong relationship” between past performance and fund flows. This finding from the US has also been found in the UK. For the latter, research has looked at the relationship between fund performance over prior one, three, five and 10-year periods and compared this with subsequent net fund flows (Moisson 2012). Most client money was found to flow to those funds with first quartile performance over prior one- and three-year periods, although this relationship deteriorated 4. See https://us.dimensional.com/about-us/our-company.

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when looking at longer performance periods. In addition, funds outside the first quartile generally have net outflows, which increase as their performance worsens (i.e. the largest outflows are suffered by fourth quartile funds). This is why asset managers are particularly focused on trumpeting the performance of actively managed funds relative to their peers: it drives client inflows. While a fund’s performance track record cannot be underestimated, the way in which it is achieved can vary considerably between rival fund managers. For example, the level of volatility may differ between two funds with the same total return over a three-year period. This, in turn, may give an indication of the likelihood of a fund manager being able to deliver good performance over future years. It is this type of detailed analysis in trying to understand the way a fund is managed that professional fund selectors undertake. An important related aspect is whether a fund is performing in the way a fund selector expects, for example, a manager that invests in undervalued companies may reasonably be expected to have prolonged periods of underperforming rival funds that invest in growth-oriented companies. Going beyond investment metrics, a fund selector will try to understand the way a fund’s investment process works, including points at which an 170 160 150

Fund A Fund B

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Figure 4.4  Same return, different volatility 90

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investment team would decide to buy or sell a particular stock. The repeatability of the investment process is particularly important if a fund selector is to have confidence that past performance is likely to be repeated. Fund charges tend to be an important selection criteria for index-tracking funds, but are normally deemed a relatively unimportant one for selecting actively managed funds (with a selector working on the basis that the active manager they invest in is able to out-perform the charges their fund bears). Fund size will also be assessed, partly because larger investors will be conscious that their holding should not form too large a portion of the fund’s assets, and partly because some funds’ performance suffers once they exceed a particular size (this varies widely depending on the type of fund). These criteria are accompanied by understanding and analysing aspects including the personnel in a fund management team (such as the size and experience of team members), the investment team’s access to information and resources outside its immediate circle (for example, being part of a larger organization), the robustness of the risk management process, the fund manager’s parent company (its scale and resources and the way it interacts with the fund management team), client support (including asset managers helping the selector or intermediary to help their clients), and the culture of the firm (including hiring practices and the extent to which a fund manager is constrained in their investment style). This inevitably leads to the question of whether professional fund selectors are any good at selecting funds or investment managers. There is much less academic research on this topic to review compared to that examining fund managers’ performance, so some caution in drawing a conclusion is needed. However, in three separate US studies examining pension scheme sponsors, institutional investment consultants and fund of funds managers, the findings are negative. Research into the returns generated by investment management firms hired by pension scheme sponsors concludes that “the post-hiring returns of chosen [investment management] firms are significantly lower than those for unchosen firms” (Goyal, Wahal & Yavuz 2021). Analysis of investment consultants’ advice to institutional investors on their choice of fund manager finds that there is “no evidence that these recommendations add value, suggesting that the search for winners, encouraged and guided by investment consultants, is fruitless” (Jenkinson, Jones & Martinez 2015). The third paper concludes that “managers of fund of funds, despite access to 91

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non-public information, select individual funds that underperform random selection” (Elton, Gruber & de Souza 2018).

Outsourcing investing Discussing the role of the investment manager would not be complete without recognizing instances where this role may be outsourced to a third party. This outsourcing arrangement may change over time, creating an opportunity for a rival asset manager to win business. The first example of this is an investment trust, which is a UK closed-ended fund (differences between closed-ended and open-ended funds will be covered in Chapter 7). One of the features of investment trusts is that they are public limited companies (Plcs), listed on the London Stock Exchange and with an independent board of directors. Being independent, and with a duty to uphold investors’ interests, investment trusts’ boards sometimes decide to kick out the manager of the fund and appoint a new investment manager. Ten years ago this was rare, but the willingness of boards to change manager has increased more recently. Changes include Witan Pacific dropping Witan for Baillie Gifford and renaming itself Baillie Gifford China Growth, Genesis Emerging Markets swapping for Fidelity and renamed as Fidelity Emerging Markets, and Jupiter US Smaller Companies becoming Brown Advisory US Smaller Companies. The board of the Perpetual Income & Growth investment trust took this one step further and decided to merge with Murray Income Trust, managed by Aberdeen Asset Management, when it ended its relationship with Invesco. The awarding or termination of a contract to manage an institutional mandate or segregated account can be seen in a similar way. The investment manager can change if a firm fails to meet the terms agreed with an institutional client, which the latter regularly reviews. While the management does not relate to a regulated fund, the need for the investment manager to continue to deliver on its objectives presents a similar situation and a related business risk (or opportunity). Investment managers can also gain business managing mutual (openended) funds for other firms, known as sub-advising (derived from the fund 92

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manager sometimes being referred to as the investment advisor, most notably in the US). This practice is more common among funds that are offered by banks or wealth managers with direct relationships with end clients. So, a bank in Italy might offer its own-branded products to its customers, but the investment manager selecting the fund’s investments works for another firm, typically an independent asset manager not working at a rival bank. Fund assets managed in this way are estimated to total €1 trillion at the end of March 2021, according to estimates from instiHub Analytics. In the UK, the best example of this is St James’s Place Wealth Management, which offers SJPbranded products with £154 billion in assets under management, but where the investment management is carried out by more than 30 other firms.5 Investment consultants have also been making greater use of sub-advised mutual funds (rather than mandates) in this way for their institutional clients, with Mercer Global Investments managing €100 billion of assets in Irelandbased funds.6 A variation on this approach is asset managers offering so-called multi-manager products. These can be divided into two groups of products: managers of managers (or manager of mandates) and funds of funds (see Figure 4.5). The manager of a multi-manager product (of either type) has a role more akin to a fund selector, in other words having to assess the performance of other investment managers, although he or she must also manage the fund’s investment strategy in response to macroeconomic factors and market changes in a similar way to a regular mutual fund (which will vary depending on the stated investment objectives of a fund). A manager of managers product is an individual fund that is sub-advised by a range of external investment managers. For example, a fund that invests globally but one third of its assets are managed by a US equities specialist, one third by a European equities specialist, and one third by an Asia specialist, with each manager agreeing to their role via an individual mandate. The second type of multi-manager product is a fund of funds: a fund that invests into a range of already existing funds. While the investment policies of funds of funds are as varied as the wider funds industry, most of them will 5. Company figures at 31 December 2021; https://www.sjp.co.uk/products-and-services/ investment-management-approach. 6. Morningstar data.

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Multi-manager products

Manager B

Manager A

Manager C

Figure 4.5a  Manager of Managers: a fund with three sub-advisers

Fund of Funds

Fund A

Fund C Fund B

Figure 4.5b  Fund of funds: a fund investing in three funds

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offer diversification across different types of underlying funds, not just geographically, but also into funds that have different levels of risk, such as those investing in government or corporate bonds, in addition to equity funds. In this way, managers of multi-manager products retain some or all aspects of asset allocation, but stock selection is outsourced to a different investment manager.

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5

S TA R S A N D S C A N D A L S

Many investors and fund management companies are united in their desire to find a particularly elusive individual: the star fund manager. So elusive is their quarry that a sub-industry of researchers and analysts has developed over the years to support this quest. Investors that choose actively managed funds want to find an individual who can generate better returns than the market over prolonged periods of time, while asset managers understand this desire and want to attract the money that follows it by promoting their fund managers and key members of their investment teams. “We are a people business” and “it is our people that sets us apart” are popular refrains from fund companies. The desire to find a star fund manager is understandable, both commercially (it makes money for fund companies and, if one is found, investors) and philosophically (if active managers are able to consistently outperform the market, then this must involve skill). It is worth pointing out that, at a basic level, over any given time period some fund managers outperform the market average (either the average returns offered by replicating an index or the average returns across a range of fund managers with a similar investment focus). This is not just a theoretical view, it is reality. Some stocks will rise more than others over a certain period, and so some fund managers investing in companies listed in the same stock market will perform better than the average. The difficulty for fund investors is identifying if, and when, a particular fund manager (via a fund) will outperform the average. Star managers are those that are deemed to have the skill to be able to outperform over prolonged

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periods of time, or who have built up a following of clients in the belief that the manager can do this. Client following is a particular feature supporting the status of star fund managers because their performance alone does not make their star shine, but instead it is their ability – and that of the sales and marketing team supporting them – to translate this into inflows and therefore to build increased scale in a fund that boosts their reputation. Crucially, a fund’s scale also builds greater influence with the companies in which a fund manager invests. As explained earlier, increasing a fund’s assets will also in principle increase revenues for a fund company, whether that increase is achieved through generating positive returns or by garnering client inflows. So the attraction of having a star fund manager is clear to an asset management company. This is amplified by the fact that in Europe annual percentage management fees for open-ended funds are not reduced as assets increase. The commercial benefits are clear: a fund manager who performs consistently well also increases the market tolerance of charging higher fees. Alongside the direct commercial incentive of cultivating the profile of individual fund managers who may develop a star profile, this process also has an indirect benefit of building a relationship between the fund manager and the end client, even if they never meet or speak. For active management to prosper, investors must believe that their fund manager has particular skills and abilities that are worth paying for. Such a relationship and belief help to cultivate investors’ trust, which is vital if they are to stay invested for the long term – as mutual funds are intended and to which asset managers aspire. The importance of trust is also one reason why a star manager who falls to earth can be so traumatic and why their experiences are worth exploring. While the attractions for employers of promoting star managers within their ranks are clear, there are also downsides. Just as the money can roll in when a manager with a high public profile joins with good fund performance, so the tide can turn all the more dramatically for high profile managers whose performance drops. And for an asset manager whose business has become overly focused on the success of one or two funds, this can have a damaging effect on the whole business. This business-wide impact is most apparent at small firms that only manage a very small number of funds, but it can also have serious consequences for medium-sized firms too. For example, Baring Asset Management lost three leading members of its multi-asset investment 98

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in August 2014, including the team’s head, Percival Stanion, leading to massive outflows from affected mutual funds and the loss of institutional client mandates. Within two years the firm was merged with three other subsidiaries of its parent company, Massachusetts Mutual Life Insurance Company. The Barings name was preserved, thanks largely to its long history, but the leadership team of the resulting firm was dominated by those from another US subsidiary. The multi-asset division’s losses were clearly not the sole reason for the restructuring, but it is hard to imagine this would have taken place without the knock-on effects of a star manager’s departure. It is worth noting that while knowing the identity of the individual or individuals managing a fund is important to retail and professional investors alike, UK and EU regulators do not require funds to disclose which individuals actually manage a fund or, perhaps more importantly, when this changes. This contrasts with the US, where the identity of who is managing a fund must be disclosed. The rule requiring firms to reveal this information came about at a time when a growing number of funds simply stated that a fund was “team managed” with no further information given in public documents. The regulation has had the effect of encouraging firms to announce manager changes too, although this goes beyond the annual update that is required. Having said this, if any of the managers of firms’ large or high-profile funds are due to leave, then the firm will announce this early to avoid shocks and calm clients’ nerves by explaining the transition process to a new manager (or managers). Firms will also typically make clear that the investment process (if still successful) will remain the same. All of this is done to try and avoid clients rushing for the exit, particularly clients with large investments in a fund. Clearly this is not always successful. The potential downside to promoting a star manager is one reason why more UK and European firms are promoting their adoption of a team culture in the management of their funds. This tends to mean that co-managers are identified as running individual funds, although team management is also becoming more common – despite the US experience referred to above. More broadly, emphasizing a team culture among investment managers can also help to develop longer term relationships with professional fund selectors and institutional clients, who place significant emphasis on the investment process used to manage a fund and deliver on its objectives. In other words, these clients seek to understand what the fund manager or team looks for 99

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when investing in a company, the buy, hold and sell signals that they monitor and react to in different market conditions. This approach recognizes that success in investment is repeatable due to a distinct and disciplined investment process, and not the result of a fund manager’s gut instincts or hunches. Professional fund buyers are still likely to want to build a direct relationship with an individual fund manager, but this is as a means to better understand their investment process, rather than as a way to get close enough to touch the hem of the star’s robes. Perhaps for this reason some fund managers that are deemed to be stars have seemed uncomfortable with the soubriquet. Richard Buxton, in an interview with the Financial Times, said: “I don’t see myself as a star fund manager. The stock market is a mechanism for humility. If you think you are a star, then you fail. You are only as good as your last game and only the paranoid survive” (Oakley 2014). Of course, this humility also helps to make Buxton more appealing to his clients and potential clients. His comments are also illuminating in showing that a person in his position has clout even beyond the companies he invests in. “The only thing nice, in inverted commas, about being a so-called star is that it opens doors, not just to the management of companies but to, for example, the Treasury or the Bank of England”, he said. Some of Europe’s largest firms, including the likes of BlackRock, Fidelity International and JPMorgan Asset Management, make clear that the benefits of their scale include access to rafts of research analysts, and that they make extensive use of co-managers of their funds, as well as a range of client support services. They are far from alone. It has become increasingly hard to think of star fund managers at firms of this scale. By contrast, small asset managers – often known as investment boutiques – are much more likely to promote one or two individual fund managers as representing the firm itself, tying their fortunes to the performance of their star managers. A significant impetus for this has come from the number of founders of these firms being fund managers, so the fortunes of their firms follow their own fortunes as investors. This link has often been reinforced by the naming of firms, such as Nick Train and Michael Lindsell of Lindsell Train, Terry Smith of Fundsmith, Bert Flossbach and Kurt von Storch of German firm Flossbach von Storch, as well as George Muzinich of New York-headquartered Muzinich & Co. Famously, or perhaps infamously, Neil 100

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Woodford also set up Woodford Investment Management in 2014. Some have predicted the demise of the star manager since Woodford’s firm collapsed, yet Blue Whale Capital, led by Stephen Yiu, has found much success – both in investing and in gaining clients – since launching in 2017. Mentioning Woodford opens up this discussion to the times when stars have exploded, often leaving mayhem in their wake. This look at several former star managers is not intended to be exhaustive, but reveals some common themes, as well as showing how the industry has evolved in some areas. It is also restricted to an exploration of fund managers alone, rather than those involved in other financial products or the exploits of investment bankers, both of which lie outside the scope of this book. Rogue traders such as Barings’ Nick Leeson, who ultimately brought down the bank in 1995, as well as Société Générale’s Jérôme Kerviel in 2008, UBS’s Kweku Adoboli in 2011, and JPMorgan’s Bruno Iksil, known as the London Whale, were all banking scandals and are intentionally omitted. Instead, this chapter will look at Woodford, BlackRock’s Mark Lyttleton and GAM’s Tim Haywood, as well as the older cases of Peter Young of Morgan Grenfell and Bernie Cornfeld’s Investors Overseas Service. Each highlight that alongside regulatory failures these scandals revolve around individuals and the way they respond to pressure. In addition to these cases, one notorious fraudster who is worth touching on is Bernie Madoff, who was arrested by US authorities in December 2008. This was not at its heart a mutual fund fraud, although some European mutual funds did invest in his business. The highest profile UK investor in Madoff was Nicola Horlick, popularly known as “superwoman” for her ability to combine holding down a high-powered job in the City with a large family – no mean feat at a time when employers were notoriously inflexible in helping women to do so. After stints at Mercury Asset Management, Morgan Grenfell and SG Asset Management, Horlick headed Bramdean Asset Management, which managed a closed-ended fund established in Guernsey, Bramdean Alternatives, which had a significant investment with Madoff. Madoff ’s fraud was based on fabricating trades and relying on new money coming in from new clients to pay out any withdrawals from existing clients in what was the largest so-called Ponzi scheme of all time. Horlick was not alone in failing to spot the fraud, but she lost control of the Bramdean Alternatives fund as a result of her losses and it was taken over by Aberdeen Asset Management. 101

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Madoff pleaded guilty and was sentenced to 150 years in prison in June 2009, where he died in April 2021.

Bernie Cornfeld and Investors Overseas Services Europe’s greatest scandal involving mutual funds was centred on Bernie Cornfeld’s Investors Overseas Services (IOS) business. Cornfeld himself was not a fund manager, but a salesman, and the success of the firm lay in its ability to attract clients’ savings (Friedrich 1971; Kerr 2018). “At the peak of his success, he seemed to combine the qualities of Billy Graham and Hugh Hefner: an evangelist in the cause of capitalism”, as the Financial Times’ obituary put it (Financial Times 1995). Together with Edward Cowett and sales head Allen Cantor they built a firm that barely seems possible even for a firm today targeting individual customers (rather than intermediaries). The sales were real, even if the structure of the firm and its sales practices ultimately defied reality. Cornfeld learned about mutual funds in the US, where he sold the products door-to-door in New York after the Second World War for Jack Dreyfus, founder of the Dreyfus Funds. It was here that Cornfeld met Cowett, who was an external lawyer advising the firm. Cornfeld then took the business to Paris in 1956, initially targeting US servicemen around Europe, as well as hiring salesmen from among the ranks of expatriates. Cornfeld later said he started the business with capital of just $300 (Raw, Page & Hodgson 1971). His experience in the US showed him the advantage of open-ended mutual funds, managing a pool of capital that expanded and contracted as client money moved in and out, rather than longer-established closed-end funds that have a fixed pool of capital. As a result, sales boosted funds’ assets, generating higher revenues. Cornfeld’s sales techniques became a hallmark of his firm, most notably his catchphrase used when trying to hire a new salesman: do you sincerely want to be rich? IOS used a pyramid scheme for its salesforce, with the more recruits drawn in, the more profitable it became for the original salesmen. At its peak the firm employed 16,000 of these footsoldiers – the same number of people that BlackRock now employs overall, 50 years later. To fund this ever-expanding sales army the firm’s products charged high fees and layered 102

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these within a structure that he called the fund of funds, in order words a fund that invested in other funds managed by the firm. One variation of these products sold in the UK was a version of a unit-linked insurance policy, which also opened opportunities for further charges that the client ultimately paid. The charges reportedly included taking 20 per cent of the money initially invested and included paying 8.5 per cent in commissions to salespeople. Rising stock markets helped the funds make money for clients despite these charges, but the firm set targets for fund managers as well as salespeople, encouraging the former to make riskier investments in the hope of generating higher returns. IOS operated and invested internationally, including maintaining Cornfeld’s links to the US as well as establishing an entity in Panama, and the firm used this approach to test how far the boundaries of national regulations would stretch. At the time, mutual funds based locally were tightly regulated, but foreign or “offshore” funds were far less so. But his business drew the attention of the US financial regulator, the Securities and Exchange Commission, forcing him to limit the size of his investments in US mutual funds. Moving from Paris to Geneva, he eventually settled his expanding empire in the small town of Ferney-Voltaire, which lies between the Jura mountains and the Swiss border. By the end of the 1960s IOS was managing about $2.5 billion of assets (around $19 billion today), making it arguably the largest fund management group in the world at the time. But the firm’s growth peaked in 1970. As it did so, the truth was exposed that beneath IOS’s web of international companies, there was very little of value holding the company afloat. Cornfeld was forced out of IOS the same year, with the company’s directors mistakenly embracing fraudster Robert Vesco as their saviour. Vesco negotiated a supposed rescue loan, which he had borrowed. Before long the company collapsed and Vesco fled. Cornfeld was prosecuted for fraud and spent time in a Swiss jail, although he was later acquitted of the charges. He undertook various smaller ventures in the years that followed and maintained an expensive, if less ostentatious, lifestyle. He died in London in February 1995. Cornfeld made a lasting impression in the annals of financial history not only because of the size of the business he built, but also the journey he took to achieve his success and the vast numbers of salespeople he was able to bring along with him. At IOS’s height, Cornfeld’s journey had seemed set to conclude at the castle where he lived surrounded by an array of young women, 103

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who included Victoria Principal (later a star of television soap opera Dallas) and Heidi Fleiss (who later ran an upmarket prostitution ring in Los Angeles). This seemed to help build the image of Cornfeld as a lovable rogue who was able to help the man in the street make money from the stock market, which had previously been the sole preserve of the wealthy. But many of those views were likely to have changed when investors’ savings disappeared or hundreds of staff lost their jobs. The scandal had profound consequences for the nascent European mutual funds industry. Exposure to stock markets had left investors with their fingers burned and many continental Europeans returned to investing in government bonds as a result. Meanwhile direct (mis)selling to retail investors, as well as the ease of selling funds across national borders, had spooked regulators so much that it was not until the creation of funds governed by EU regulations in the 1980s – following the Undertakings for Collective Investments in Transferable Securities Directive – that a truly European funds industry began to emerge once more. And it was years after that before funds of funds would be permitted by European regulators.

Peter Young and Morgan Grenfell The Morgan Grenfell scandal surrounding fund manager Peter Young gained notoriety more for the resulting court case than the crimes themselves. Young appeared in court in November 1998 dressed as a woman and saying he preferred to be called Elizabeth (Reuters 1998). Young had joined Morgan Grenfell, then owned by Deutsche Bank, in 1992 in his early 30s and earned a reputation as a skilled stock picker ultimately overseeing three funds investing in companies across Europe: MG European Growth Trust, MG Europa Fund and MG European Capital Growth Fund. While not huge funds by today’s standards, they were significant at the time and were coupled with Young’s star fund manager credentials. This came amid the first wave of successful fund managers being marketed, with accompanying advertising spend, as stars in the UK and gaining a resulting public profile beyond City insiders (Denton & Rich 1996; Olins 1996; Manning 1996).

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In September 1996, with fund assets totalling £1.4 billion, dealing was suspended by the company following its discovery of irregularities in the valuation of some of the funds’ unlisted securities (companies not listed on a recognized stock exchange). There were also questions relating to the funds breaching a 10 per cent limit of their assets being invested in unlisted companies. Young was subsequently fired for gross misconduct. The Serious Fraud Office then investigated and two years later Young was charged with several offences including conspiracy to defraud. After appearing in court dressed as a woman, Young’s lawyers said he was unfit to stand trial. The SFO disputed this and speculation mounted that Young’s appearance was simply a ruse to avoid prison. However, in the court proceedings it emerged that Young had made several attempts at self-castration after voices in his head said to do so, as well as suffering near-fatal blood poisoning after further instances of self-mutilation. Young’s wife revealed his increasingly bizarre behaviour at home, including buying 30 jars of pickled gherkins when she asked him to go shopping. In December 2000, a second jury sided with the defendant’s lawyers that Young had a schizophrenic condition, after the initial jury was unable to agree on the matter, and so he did not have to stand trial (BBC 1998; Calian & Steinmetz 1999; Clark & Treanor 2000; Finch 2002). The SFO then pursued a “hearing of the facts” that revealed the nature of Young’s fraud. To get around regulations limiting the size of investment in any one security, he created Luxembourg-based holding companies to replicate, or mirror, the investment and so enable Young to build a larger position in the security by holding a 10 per cent stake in both the original security and the holding company. He used a similar method to get around the size of holdings in unlisted companies. The subterfuge was carried out not only to enhance his funds’ returns, but also for personal gain, with other holding companies used to funnel money to himself. One example of the fraud was Solv-Ex, a company whose technology claiming to extract oil from the oil sands was revealed to be a sham by US authorities. The company was one for which Young set up unauthorized accounts to increase the size of his investment position. Solv-Ex came under scrutiny from the US financial regulator, triggering Morgan Grenfell’s investigation into Young’s activities. His fate was sealed when caught referring to his illegal activities on routinely recorded telephone calls in his office. “The important

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thing is that you know what the lies are, so you do not contradict them”, Young was recorded as saying (Bowers 2002, 2003). Four other employees were fired by Morgan Grenfell for their part in the affair. Each of them was subsequently suspended by the Investment Management Regulatory Organization (IMRO) for their failings, although in each case their conduct was not deemed to be dishonest or lacking integrity. IMRO also reprimanded former Morgan Grenfell chief executive Keith Percy for four breaches of its rules and he paid costs of more £80,000. Young’s fellow Morgan Grenfell fund manager, Stuart Armer, and two stockbrokers were taken to court by the SFO, although none of the prosecutions were successful. In May 1998, the regulator fined the funds’ trustees, Royal Bank of Scotland and General Accident, a combined £800,000 for their part in failing to spot Young’s activities (Paterson 1998). In June 2003 Young was found to have conspired to steal more than £350,000, despite earning a reported salary of around £300,000 a year. He was granted an absolute discharge by the judge following his earlier dismissal from court proceedings under the 1964 Insanity Act. Three other employees were dismissed and separately charged by the SFO, although none were found guilty (Bowers 2003). Alongside his horrific self-inflicted injuries, defence lawyer Clare Mont­ gomery told the court that Young had “gone from being a man of the highest intellectual achievement to living the life of a mental patient. Now he sits at home staring at the ceiling unless instructed by his mother or brother to get up and perform some menial task.” (Clark & Treanor 2000). Morgan Grenfell was fined £2 million by IMRO in 1997, which was reported as the largest fine handed down by the UK financial watchdog at the time. The firm had to pay an additional £1 million in costs. The cost to the firm’s parent company was far larger, however. Deutsche Bank invested almost £180 million covering losses from some of the funds’ unlisted securities. It also set up an investor compensation scheme estimated at more than £200 million to make good the losses suffered by some 90,000 investors (Hilsenrath & Spindle 1998). The firm remained in the spotlight throughout this period when it suspended Nicola Horlick from her role as a managing director at the firm in January 1997, prompting her to resign, after it was alleged that she was moving to a new firm and attempting to bring colleagues with her. Horlick’s flight to 106

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Germany to make her case to the firm’s owners was widely covered in the press and it was at this time that her superhero sobriquet was bestowed on her. In November 1998 Morgan Grenfell sacked a further 18 senior staff in an internal “reorganization”, with the firm denying the redundancies were to do with any underlying problems at the business (Bonte-Friedheim 1997; Garfield 1998). The Young case was a major reason for Deutsche Bank’s decision to assert more control over its asset management subsidiary, initially changing the firm’s name to Deutsche Morgan Grenfell before discontinuing the name altogether when Morgan Grenfell was merged with Bankers Trust to form Deutsche Asset Management in June 1999. Deutsche later sold most of its UK asset management business to Aberdeen Asset Management in 2005. While the case made the front pages of newspapers at the time, and has been best remembered since, for the appearance of Young in a dress outside court, it is for the revelations inside the courtroom that it is worth recalling today. As Anne McMeehan, a former manager director of asset manager Framlington and later director at the UK fund management trade body, said at the time: “This is by far and away the biggest scandal that’s hit the unit trust industry and the repercussions for the entire fund management business are likely to last for many years yet” (Blythe 1996).

Mark Lyttleton and BlackRock By the time the dust was settling on the Young case, a new investor was staking a claim to be considered a star in the fund manager firmament.1 Mark Lyttleton had joined UK firm Mercury Asset Management straight out of university in 1992, just a few months after Peter Young had left the firm to join Morgan Grenfell. Lyttleton moved up the investment ladder even as the firm was acquired by two US giants, first by Merrill Lynch and then BlackRock. By the end of 1999 he was managing the firm’s UK equity fund and took on the UK Dynamic fund in 2003.

1. This section uses Ignites Europe’s coverage of the events relating to the Lyttleton affair.

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Lyttleton’s reputation was such that in early 2005 Merrill Lynch launched its UK Absolute Alpha fund specifically for him to manage. The fund was at the forefront of a new wave of investment strategies aiming to deliver positive absolute returns regardless of market conditions, a strategy more akin to hedge funds – traditionally the preserve of the wealthiest investors, rather than an open-ended mutual fund available to all. Investors even had to pay a performance-related fee for the privilege, a feature the UK regulator had only recently allowed mutual funds to use. Assets in the three funds Lyttleton managed tripled over the following three years, reaching £3 billion in 2008 and peaking at £4.4 billion in March 2010. This growth was not just the result of the returns Lyttleton generated for the funds, with inflows from clients totalling more than £1.5 billion in 2008 alone. But even as the funds’ assets reached new highs, their performance had already begun to slip and “went from bad to worse” between 2009 and 2010, as Lyttleton’s barrister would later tell a court at his client’s trial, adding further pressure on the manager as he juggled his responsibilities across the three funds. In an apparent move to ease this pressure, BlackRock added Nick Osborne as co-manager on the UK Absolute Alpha fund in 2008 and Nick Little became co-manager of the BlackRock UK fund from 2011. Little took sole charge of the fund in February 2012. It was around this time that Lyttleton began to engage in “suspicious” trading activities, which BlackRock’s internal monitoring identified and raised with the UK regulator, which opened an investigation in 2012. From here the situation unravelled over the following months, with Lyttleton taking a sabbatical from the firm in June 2012 “to resolve family issues”. He returned to BlackRock in September but left the firm altogether in March 2013. Assets in the three funds had since fallen precipitously to £1.5 billion. Lyttleton was arrested on suspicion of insider dealing in April 2013. At his subsequent trial in 2016 it emerged that Lyttleton had purchased a Panamanian registered company in 2010, placing the beneficial ownership of this company in his wife’s maiden name. Personnel from Swiss financial advisory firm Caldwell and Partners were then instructed by Lyttleton to trade in stocks on behalf of the Panamanian company. He tried to further hide these activities with the use of unregistered mobile phones. The specific charges brought against Lyttleton related to trading in two stocks in late 2011. He acted on insider information related to a proposed 108

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takeover of securities issued by Encore Oil and also to the discovery of oil in Greenland by Cairn Energy, despite the two stocks being on BlackRock’s “stop list”, which signalled that they could not be traded. Ironically, despite this elaborate subterfuge, Lyttleton made a gain of just £45,000 on the first stock and actually suffered a loss of £10,000 on the second trade. In December 2016, he was sentenced to 12 months in prison, with the judge telling the court that the judgement took into account mitigating factors such as Lyttleton’s good character and the pressures that the portfolio manager faced. Lyttleton also had £149,000 confiscated from him and paid £83,000 in prosecution costs. In his defence, Lyttleton’s barrister said his client was once “one of the golden boys” in the fund management industry, but the decline in his performance resulted in a “mental freefall” in 2011. The lawyer said Lyttleton’s fall “from hero … to liability” put huge pressure on the star manager in the “macho environment” at BlackRock, which he described as a “huge American financial machine”. The culture in the firm was that “if everything gets too much for you, it’s up to you to get your own treatment … Weakness is not to be acknowledged as it is bad for business”. Underneath the “veneer of success and confidence”, Lyttleton suffered from depression and exhaustion, yet “completely failed to seek mainstream medical advice”, the court was told. BlackRock was quick to emphasize that Lyttleton’s actions were carried out “for his personal gain while off our premises” and there was no impact on its clients. The prosecution lawyer said in court that BlackRock’s procedures in relation to the case were “entirely appropriate”. At the time of his departure, several other fund managers left BlackRock, adding to speculation that Lyttleton’s fall from grace might have a larger impact on the firm. UK equity fund manager Hugo Tudor and co-head of global multi-asset strategies Colin Graham left the firm in 2013. Nick McLeod-Clarke, also a UK equity fund manager, went on extended sick leave in 2013 before leaving BlackRock altogether in 2018. Another UK fund manager, Richard Plackett, took a sabbatical in 2014 before retiring the following year. Meanwhile James Charrington, BlackRock’s European chairman, stepped back from running the firm’s day-to-day business in March 2013. This last move pointed to these departures being part of wider changes that BlackRock was undertaking at the time, with the firm announcing plans to scrap some 300 jobs.

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It transpired that the business impact was largely limited to Lyttleton’s former funds. With the regulator having found BlackRock blameless following its early steps to involve the financial watchdog in examining Lyttleton’s actions, this likely helped maintain its credibility with large clients and dampen potential reputational harm. The firm merged its UK and UK Dynamic funds in September 2013. However, even today the two remaining funds have assets of around £800 million, having made no headway in increasing their size since Lyttleton’s departure. But the impact on the business was limited to these funds. Lyttleton has kept a relatively low profile since his release from prison, although he has offered a few glimpses into his views of his experiences. Having retrained as a pranic energy healer, which he builds into the advice he gives to start-up companies in his role as an angel investor, he made his first public appearance in 2018 to discuss stress in high pressure workplaces, office culture and mental health, alongside regulation and compliance.

Tim Haywood and GAM It is perhaps counterintuitive to include Tim Haywood in this chapter as there is a strong case to say he was not really a star fund manager at all. Haywood was successful as a fixed income manager but he could hardly be described as a household name until his alleged misconduct at GAM hit the headlines in the summer of 2018.2 Haywood joined GAM via its acquisition of Augustus Asset Managers in 2009, where he was chief executive officer. His LinkedIn profile indicates that he had joined Augustus in 1998, although at that time the firm was a unit within Julius Baer. The Augustus brand was created when the unit set up on its own through a management buyout with the aim of sourcing fixed income and foreign exchange business from clients in addition to that which it retained with Julius Baer. But in a move that signalled “an embarrassing end of a bid for independence”, Augustus was taken back into the fold of the Swiss 2. This section also uses Ignites Europe’s coverage of the events relating to the Haywood affair; see also Mackintosh (2009) and Fletcher et al. (2019).

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private bank via GAM, then a subsidiary of Julius Baer, having failed to gain any significant third-party business. It took ten years to build the unit, headed by Haywood, to CHF11 billion (around £9 billion), which by that stage were labelled as GAM’s Absolute Return Bond Fund (ARBF) range. In this way, Haywood led a team managing fixed income funds with the aim of delivering absolute returns to clients, while Lyttleton had managed an equity-based fund with similar objectives. GAM suspended the fund manager in July 2018 due to flaws in “some of his risk management procedures”, which were understood to have included failing to conduct sufficient due diligence on some investments as well as not following the firm’s signatory policy by signing contracts alone where two signatures were required. His suspension was swiftly followed by dealing in the affected funds being halted and within weeks plans to liquidate the nine ARB funds were announced. But the lack of information related to these decisions led to significant investor withdrawals from other funds that GAM managed. As the months passed investors in the listed asset manager became increasingly frustrated by the apparent lack of direction at the firm, with the firm being only slightly more communicative despite outflows growing to levels far larger than were originally expected from an apparently limited problem. As a result, the firm’s US chief executive, Alexander Friedman, resigned in November, with his interim replacement announcing a strategy far more wide-ranging than simply cleaning up the Haywood mess and included a restructuring plan to cut 10 per cent of the firm’s workforce. GAM dismissed Haywood in February 2019 for gross misconduct, following its investigation and disciplinary proceedings, noting there was a “serious failure to achieve the standard of skill and care which were to be expected of someone in his position”. Haywood immediately announced he intended to appeal against his dismissal, saying he had been made a “scapegoat” and that the process leading to his dismissal has been flawed and “discriminatory”. He travelled to GAM’s annual general meeting in Zurich in May 2019, but was blocked from entering. Just as a lengthy standoff between Haywood and his former employer looked to be on the cards, GAM hired a replacement CEO from BlackRock, Peter Sanderson, and announced in July 2019 that it had agreed with its former fund manager “that neither party will pursue the other based on current 111

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facts”. Haywood pointed to the expected size of legal costs as a reason why he had agreed not to take the matter further. It had taken a year to draw a line under the affair, but during this time the firm’s assets under management fell from CHF84.4 billion in June 2018 to CHF52.1 billion a year later. Assets continued to fall, however, and reached CHF35.5 billion in June 2020. While that figure was affected by the market falls in March 2020 due to the coronavirus pandemic, GAM struggled to subsequently grow its business, even as rivals did so, and its assets slipped to CHF34.8 billion by June 2021, although the impact was softened somewhat by the firm’s separate private labelling business, where fund operations are outsourced leaving GAM’s clients to manage investments. Nevertheless, for the firm’s core business the apparently outsized reaction to one fund manager’s actions does suggest that investors in both GAM (as a publicly listed firm) and in other GAM-managed funds have been spooked by aspects such as risk management, which affects the business as a whole. Only limited details of the scandal have come to light. But journalists’ investigations into the case have shown that Haywood’s relationship with Sanjeev Gupta, an Indian-born British steel magnate, and Lex Greensill, the disgraced Australian boss of the eponymous supply chain finance firm, had led to a colleague raising complaints internally and then with the FCA and bringing the affair into the open. These relationships involved not just buying hundreds of millions of pounds’ worth of bonds linked to the two businessmen, but also accepting entertainment offered by Greensill. That the two sides of the dispute agreed to draw a line under the affair was at least partly due to GAM finding “no material client detriment” as a result of Haywood’s activities. No evidence was found to suggest that Haywood had actually breached the funds’ rules by holding Gupta and Greensill investments. As a result it is hard to draw clear conclusions as to Haywood’s activities beyond the pressure to meet client demands for returns in a low-yield market environment. In this, GAM’s investment managers were not alone in struggling to deliver absolute, positive returns through different market environments. However, in December 2021 the UK’s Financial Conduct Authority fined GAM £9.1 million for failing to ensure “that its systems and controls for the identification, management and prevention of conflicts of interest operated effectively”. It also fined Haywood £230,000 over conflicts of interest and 112

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failure to comply with GAM’s gifts and entertainment policy. These fines included a 30 per cent discount as both the company and Haywood “agreed to resolve all issue of fact and liability”. In March 2022, the regulator expanded on its decisions, revealing that two of the transactions on which GAM failed to manage conflicts of interest were linked to Greensill Capital. The FCA added that Haywood received gifts and entertainment, including travelling on a Greensill private aircraft, but failed to record them in a timely manner with his employer.

Neil Woodford Neil Woodford had little direct experience managing funds when he joined Perpetual in the late 1980s, but he quickly took charge of two funds investing in UK equities, the Perpetual Income and High Income funds.3 Over the following 25 years he built an impressive reputation as a fund manager. His standing was severely tested when he shunned high-flying stocks through the technology boom of the late 1990s, with questions raised in the press and by clients. But the subsequent collapse in many technology stocks’ prices served to enhance his reputation as a star manager, a position strengthened by his performance through the financial crisis in 2008. Martyn Arbib, Perpetual’s founder, sold his firm to US asset manager Invesco (then officially known as Amvescap) in 2001. With Woodford’s star shining, the growth of the Henley-on-Thames-based firm continued and Invesco Perpetual ranked as the UK’s largest retail fund house well into 2013. The importance of Woodford to Invesco’s UK business became apparent when the fund manager announced his decision to leave in October 2013. At the time, Woodford managed the £13.9 billion High Income Fund and £10.6 billion Income Fund as well as a further £9 billion in other mandates. Invesco managed assets in retail and institutional funds in the UK of almost £45 billion

3. This section uses Ignites Europe’s and the Financial Times’ coverage of the events relating to Neil Woodford’s rise and fall and the collapse of Woodford Investment Management.

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when Woodford departed, putting almost three quarters of its funds business under threat. Woodford set up on his own, launched his first fund in June 2014 and quickly attracted significant inflows from investors switching from his former Invesco funds, as well as other investors wanting to catch some of the stardust. The Woodford Equity Income fund peaked in size at £10 billion in 2017, with other funds and mandates taking the total size of his business to around £15 billion. Those first three years were also a period of good returns for clients, particularly in the first year when his flagship fund returned 17 per cent, compared to less than 3 per cent from the FTSE All Share index. But mid-2017 also marked the point at which performance began to head south. It never recovered. By the end of June 2019, the fund had incurred a loss of 21 per cent over the past 12 months, dragging down its prior gains so that it had managed to build a cumulative loss of 5 per cent over five years. By contrast, the FTSE All Share had risen by 35 per cent over that five-year period (with dividends reinvested). Client outflows increased as returns dropped, so that assets in the Equity Income fund stood at £3.7 billion in size when the firm’s authorized corporate director (ACD), whose role is to oversee an investment manager’s activities, decided to suspend trading in the fund. By late October the ACD, Link Fund Solutions, announced that it would wind down Woodford’s flagship fund and seek a new manager for the fund manager’s second, smaller fund. Woodford remained defiant, saying he could not “accept, nor believe” that Link’s decision was in clients’ interests, but he still pulled the plug on his firm the same day and stepped down from managing the Patient Capital Trust. The board of this latter fund swiftly selected Schroders to take over the management of the fund, while Link was later to select Aberdeen Asset Management (now rebranded as abrdn) to manage the former Income Plus fund. Intriguingly, Financial News’ David Ricketts has revealed that Aberdeen had earlier attempted to take over the running of the two other Woodford funds, but the firm’s bid was rejected by Link (Ricketts 2021). Beyond the headlines of a star fund manager who fell to earth, bringing customers with him, there was a more complex story relating to the types of investments that Woodford had made, whether these were within the rules, and the extent to which Link managed the situation correctly. Much of this relates to Woodford’s desire to invest in less liquid stocks. The liquidity of 114

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a security relates to how easy it is to be bought or sold. Larger companies listed on the main US, UK or western European stock exchanges can be quickly bought and sold, for example. At the other end of the spectrum, it can be a lengthy process to buy or sell direct property investments. Unlisted, or unquoted, companies are also far less liquid than quoted stocks, which became a feature of Woodford’s Equity Income fund. Meanwhile smaller companies – such as those listed on the London Stock Exchange’s Alternative Investment Market (AIM) – are typically less liquid than larger companies, but more easily traded than unlisted stocks. To understand how problems relating to Woodford’s illiquid investments exploded, it is worth returning to Woodford’s time at Invesco. As his time at the firm entered its later years, it became increasingly clear that the fund manager was frustrated with the limits placed on him when it came to investing in small and unlisted stocks. While it can be risky to invest in such companies – start-ups are more likely to fail than large companies – the potential rewards can be great if they succeed. Invesco made Woodford’s views known to the Investment Association’s Sectors Committee, which oversees the trade body’s scheme by which funds sold in the UK are classified, including investment parameters that funds should follow. More importantly, sensitivity around less liquid holdings is also guided by regulations. UK and EU rules state that an open-ended fund must limit holdings of unlisted securities to 10 per cent of its assets. The fund can invest a further 10 per cent in recently issued transferable securities as long as the companies have made an undertaking to be admitted to a recognized exchange within one year. With hindsight, it is possible to see Woodford’s intention to make significant investments in small and early-stage companies as he announced his departure from Invesco. “My decision to leave is a personal one based on my views about where I see long-term opportunities in the fund management industry”, he said in October 2013. Much was subsequently made about the resulting investments he made, although one respected fund of funds manager, Jupiter Asset Management’s John Chatfeild-Roberts, was not surprised, saying that Woodford had “significant unquoted exposure” throughout his time at Invesco Perpetual and so his investments when at his eponymous firm were “not something new”. Early on these start-up investments performed well for Woodford, making clients happy as a result. It also gave him the confidence to launch the Patient 115

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Capital Trust, a closed-ended fund dedicated to early-stage unquoted and quoted companies, which raised £800 million at launch in April 2015, making it the UK’s largest-ever investment trust launch. However, the Equity Income fund’s more liquid stocks dropped in value as they went through a period of poor performance, resulting in the unquoted stocks taking up a larger proportion of the fund’s assets. In March 2017 Woodford launched the Income Focus fund, which aimed to provide a high level of income but without investing in unquoted securities. It was at that stage that the performance of Woodford’s favoured larger companies was stalling and soon fell. The new fund struggled to generate positive returns just as the performance of the Equity Income fund began to fall and before long investors were withdrawing from both funds. For the Equity Income fund this meant having to sell down some holdings to meet redemption requests, again pushing up the proportion of the fund’s assets in unlisted and small cap stocks, which were less easy to sell. The fund’s holdings in unlisted securities were just over 10 per cent by April 2018, with holdings in AIM-listed securities adding a further 20 per cent of the fund’s portfolio. To deal with this problem, and as outflows mounted, the fund offloaded five holdings to the firm’s Patient Capital Trust in March 2019 and then, more controversially, listed four previously unlisted securities on Guernsey’s International Stock Exchange in April. The fund thus managed to move back within EU regulations, at least nominally. But these steps were intended to keep the Equity Income fund within the rules, they did nothing to help it perform better and revelations about the fund’s lack of liquidity did nothing to give confidence to investors, who continued to head for the door. The most significant of these nervous clients was Kent County Council, whose pension scheme had around £250 million invested in Woodford’s flagship fund. Having put its investment in Woodford under review in March 2019, the pension fund took the decision to withdraw at the end of May. In an extraordinary turn of events, as Financial Times journalist Owen Walker has revealed, the council’s intended phased withdrawal – a common approach for large institutional investors – was shot out of the water when a holiday absence and an over-zealous stand-in resulted in a request for a single redemption being made on Monday 3 June (Walker 2021). Link, despite being aware of the original plan, took the request at face value and, as a consequence, took the decision to suspend trading in the fund the same day because it had insufficient cash to meet Kent’s request. So the council did not get its money 116

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back and neither did the fund’s other investors. In October Link announced that it would be winding-up the fund, a process that has continued for more than two years. Woodford’s reputation as a fund manager had been used to draw in around 300,000 retail investors. Now they were trapped in a fund not knowing how much of their savings they would get back, or when. This in itself is a classic example of the dangers of relying on a star manager, both for clients and for the business. However, the Woodford saga goes far beyond being a sad tale of the consequences of a fund manager’s poor stock selections. It raises questions about mutual funds being allowed to invest in illiquid and less liquid companies, the appropriateness of rules allowing such investments, the robustness of the challenge that Link offered to Woodford, the legal structure of UK funds that made Link (rather than Woodford) responsible to the regulator, as well as the role of the FCA and whether it acted soon enough, if at all, in tackling the unfolding problem. This is even before the outsized role that a pension fund came to play in the whole affair is considered, or the shortcomings of financial advisers – most notably Hargreaves Lansdown, the UK’s largest financial advisory firm – who continued to back Woodford to the end. The FCA opened an investigation into the suspension of Woodford’s fund in June 2019, but after three years it had still not published its findings. The regulator’s CEO wrote to the House of Commons Treasury Select Committee in December 2021 that it was finalizing its legal analysis, all key evidence had been gathered and an expert witness had been instructed to provide an opinion.4

Conclusions – and the importance of corporate culture These five cases show how business practices, sales strategies and individual traits can have disastrous consequences for individual managers, as well as for their businesses and sometimes for their clients. The reasons to focus on these cases in particular is not to show where fund managers’ success turns to 4. See https://www.fca.org.uk/publication/correspondence/woodford-tsc-december2021-update.pdf.

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failure. The asset management industry is littered with fund managers whose performance drops or who were pushed out of their firm for not being as good as first thought. There are many more that continue in mediocrity, saved by inert investors who fail to notice their funds’ poor returns. Each case here has features that keep re-emerging at fund companies. This does not mean there is a fundamental problem with corruption or wrongdoing in the industry. But equally the cases cannot be dismissed as examples of rare “bad apples”, not least because it can be argued that some of the fund managers featured were not bad apples at all. And, perhaps more importantly, these cases have helped to frame many people’s perceptions of the fund management industry. Even if these are misperceptions, they remain a problem for an industry that increasingly wants to engage with end-investors and not just investment consultants or wholesale intermediaries. While these latter groups remain the gatekeepers to the vast majority of client assets, responsibility for long-term investment decisions increasingly sits in the hands of end-clients, most notably with the shift from defined benefit (DB) to defined contribution (DC) pension schemes (see Chapter 8). This shift would seem to warrant asset managers being more conscious of how their firms are perceived by the investing public. Leading from this, any reluctance to grapple with the (mis)perceptions noted above suggests that firms are not yet ready to change some aspects of their corporate culture. The need for portfolio managers to have a high degree of self-confidence, the extraordinary rewards on offer, and the pressure to perform combine for a heady mix that can be difficult to manage. This difficulty is likely to be accentuated by the behaviour of peers, as well as by what behaviour is acceptable within a company. Part of the problem for asset managers is that a large part of the popular perception of their industry is focused on high levels of pay. Yet there seems very little appetite to rein this in, it is not viewed as a cultural flaw, and indeed the general view is that restraining pay would harm competition and hinder the best fund managers from rising to the top of their profession. In a European industry with an over-abundance of funds (and therefore opportunities for fund managers), this view seems optimistic, at best. So pay remains a significant feature of the industry, but one that is rarely seen as a problem by practitioners. This is not to say that the excesses that came to light during Bernie Cornfeld’s rise to fame and fortune are prevalent today. However, his story ought to be 118

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borne in mind as the industry evolves and older events move into the annals of history. As this process happens then the institutional (or industry-wide) memory of Cornfeld’s exploits disappears (Tinline 2016). So including short accounts of these five fund managers’ activities is also intended to be a small contribution to preventing them from being forgotten. As an aside, the cases of Woodford, Lyttleton and Haywood also show that the financial consequences of fund managers’ actions are primarily borne by others, rather than themselves. Having said this, asset management companies, as with other professions, increasingly recognize that their corporate culture not only has the power to help grow their businesses, but can also nurture behaviours and attitudes that can undermine them. As a result, some firms have tried to implement policies that place an emphasis on employees’ well-being, the importance of a diverse workforce and creating an inclusive workplace with respect for all colleagues. The rewards remain great, however, and the pressure is hard to avoid when there is such a close relationship between fund performance, inflows from clients and resulting business growth. It is striking that asset managers trumpet their firms as being “people businesses” and that their success is thanks to the people they hire. Yet until relatively recently their hiring practices focused on a relatively small proportion of the population. A 2017 study carried out in the UK found that 77 per cent of investment managers were men (compared to roughly half the population at large) and 38 per cent were privately educated (compared to 7 per cent of the population) (Diversity Project 2017). It may well take years to change these proportions and draw a greater diversity of talented individuals, likely leading to better outcomes for clients. What is surprising is that it has taken so long for asset managers to have recognized there was a problem or, at the very least, that they were missing out on such a large part of the talent pool. Perhaps the greatest test will come with whether firms are ready to think differently, to really listen to diverse points of views – however uncomfortable those views might. Asset management’s comfortable profitability is likely to act as a hindrance to shaking things up too much, or to doing so more quickly than is absolutely necessary. The UK’s fund management industry still finds it difficult to shake off the image of being dominated by alpha males and run by an old boys’ network. This has certainly been apparent in the UK, but variations on the theme are 119

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evident in many countries. Portfolio managers across Europe, in the US and beyond remain overwhelmingly male. It is hard to miss the preponderance of fund managers with healthy egos and brimming with outward self-confidence. There is a case to be made that such a mindset is useful or even essential when bearing responsibility for delivering financial returns to clients and, as a consequence, for being a key factor in attracting new clients to a business. It is not possible to consider this aspect without also considering the potential rewards for fund managers. As shown in Chapter 1, fund assets of £1 billion can generate £10 million in revenues each year, giving plenty of scope for paying hefty salaries to successful managers. Greed, to a greater or lesser extent, played its part in each of these scandals. For example, for all of Woodford’s protestations about investors’ interests when trying to keep control of his funds, his firm continued to charge clients the full level of fees while the Equity Income fund was suspended, despite the protestations of both the financial regulator and members of parliament. While revenues are needed to keep the management of the funds going, offering no discount at all was widely seen as a slap in the face to clients who were cut off from their savings. This was exacerbated by Woodford and his business partner Craig Newman having received £1.5 million in dividends just weeks before the Equity Income fund was suspended. The pair had previously received a dividend of £36.5 million for 2018, despite poor fund performance and large outflows over the year (White 2021; Burton 2019). This situation might be called the “L’Oréal delusion”, after the cosmetics company’s advertising strapline (“Because I’m Worth It”), whereby an asset management executive believes they are worth a high salary because their fund generates a level of revenues that enables such compensation. They must be worth a salary because the money is available to be paid. But it is rare to find a UK or European fund that cuts percentage management fees as assets rise to better reflect the operating costs of managing a fund and to reduce overcharging of clients. It is little wonder that headlines surrounding Woodford’s fall are dominated by accusations of hubris. He is far from alone. In September 2021, a fund manager at Union Investment in Germany was sentenced to jail having made €8 million in profits from illegal transactions the year before. Tellingly, the unnamed fund manager began the illegal trades after he felt “offended” at having received only half the pay rise he had hoped for and decided to recoup the rest himself (Storbeck 2021a, 2021b). A not dissimilar mentality 120

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seems evident in the other fund managers covered in this chapter, such as the spectacularly misjudged close association of Haywood with Greensill Capital, including trips on private jets. Having said this, Union’s disgraced fund manager has also cited other issues as contributing to his actions, including losses from investments in collapsed German payments firm Wirecard and the ill health of his wife and children. The cases of Young and Lyttleton also show where fund managers can struggle and fail to manage the pressures placed on them at work. Academic research has shown the stress that outwardly confident fund managers feel and the difficulty they have in finding an outlet where they can discuss their feelings without either feeling threatened by their organization’s macho culture or fearing their career will be put at risk (Taffler, Spence & Eshraghi 2017). This does not mean that fund managers in this situation inevitably resort to criminal or unethical behaviour. A Fidelity fund manager, Sanjeev Shah, stepped down from managing the £2.8 billion Special Situations fund in 2013, having taken over the fund five years earlier from star manager Anthony Bolton. Shah cited his desire to avoid the “intensity” of the role as his reason for moving to another position at the firm (Asian Voice 2015). Despite external organizations such as the City Mental Health Alliance and the initiatives some asset managers have taken to address these issues, the pressures remain real. A positive corporate culture that can accept and help individuals under pressure, as well as one that is willing to act decisively to stop potential wrongdoing, is important. While an individual’s life and health are more important than those of a business, it is clear that a company looking after the former will also help the latter. BlackRock’s early intervention in the Lyttleton case ensured that fallout from the case was limited. By contrast, GAM’s apparently indecisive actions and unclear oversight of the Haywood case created far more damage than might have been expected from problems with just one fund manager. In addition, the governance shortcomings in Link’s relationship with Woodford must have contributed to the collapse of his flagship fund and, consequently, the winding-up of his eponymous firm. This has raised fundamental questions about the governance structure of UK open-ended funds and the use of authorized corporate directors, whereby the ACD is paid by the firm that it then oversees. While UCITS funds’ third-party management companies are similar in some respects, no other jurisdiction has the same arrangement as the UK’s. Fund governance experts are among those 121

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calling for an overhaul of this structure and of bringing the UK funds regime in line with widely accepted corporate governance structures and practices elsewhere (Barker 2021; Barker & Chiu 2021). Whether this structure will change, and whether UK asset managers are better able to manage potential conflicts of interest and the negative side-effects of high levels of remuneration, remain open questions. Just as Cornfeld’s misdeeds prompted a change in regulatory mindset across Europe that lasted decades, it will be interesting to see how far the changes prompted by the Woodford scandal will go.

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By now the purpose of fund management might seem to be clear. But this is sometimes confused with the role and function of fund managers (and their colleagues). The distinction is worth considering to better understand the nature of the industry, and as a means to identify potential challenges for firms and resulting flaws in the way they behave. At a basic level, there is a clear difference between the function of each role at an asset management company and the purpose of the industry as a whole. When defining an asset management company’s role, elements of the former – the various functions – are often highlighted, rather than the objectives of the latter that should influence all roles within a fund company. This may appear to be more of a technical clarification rather than a broader comment on the industry. However, the distinction is a useful way to check whether a fund company actually considers the industry’s purpose and its place within it. Most firms are focused on the way their business functions and the roles within it, and often they only fleetingly or obliquely appear to have a conception of their purpose and to use that understanding to influence the way their business is run. The purpose of fund management is to grow clients’ wealth over the long term. This purpose may have beneficial by-products, but the industry’s existence cannot be justified by such by-products because of the primacy of the relationship between fund manager and client. It may well be that some clients invest to make a positive impact on aspects such as the environment (which will be discussed later in this chapter), but even asset managers that manage money in this way are still focused on long-term returns for their investors 123

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– the primary purpose of the business remains the same. At the same time, an asset management company may offer products, such as short-term investment strategies, or services, such as an online investment platform, that help the growth of its business by attracting clients, but these do not change the industry’s raison d’être. I would contend that the same is true for smaller parts of the overall funds industry, such as hedge funds, which often argue that their purpose is to offer differentiated returns from their more conventional rivals. But ultimately hedge funds offer a variety of investment strategies, some of which have been adopted by mutual funds, that continue to fit within the broader fund management industry. Awareness of the industry’s purpose matters as it shows there are inherent tensions within each firm between different objectives that it is trying to achieve. These objectives include growing clients’ wealth over the long term, generating fees from clients, and the need to deliver shorter-term fund returns to attract and retain clients. Many firms will have additional objectives. Needless to say, the way that fund managers buy, hold or sell stocks varies massively across the industry: the long-term rationale of fund management certainly does not mean that stocks are always held for the long term. The level of risk fund managers aim to include in their portfolios varies widely, be that through the size of companies they invest in, the number of stocks they hold, the robustness of an investee company’s management, the jurisdiction in which a company operates, and so on. None of these aspects are necessarily right or wrong in investment terms, they are simply different ways of a fund manager building a portfolio for clients. These are aspects that reflect a fund manager’s investing style, or the way he/she interprets their investment role, but they do not alter the rationale of fund management. Similarly, some, or even many, clients invest in mutual funds for relatively short-term holding periods of less than three years. Evidence from the UK’s investment management trade body suggests that retail investors’ fund holding period averaged 3.4 years in 2020.1 This is down from 4.5 years in 2010 and was over 7 years in 1999 (see Figure 6.1). This is not solely investors’ fault. The 1. The Investment Association’s annual surveys, Investment Management in the UK. The IA calculates investor average holding periods as the average retail funds under management between two years, minus net sales over the period and dividing the result by repurchases.

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liquidity of daily dealing mutual funds, the ease of online investing, including via fund platforms, and monthly updates comparing performance between funds are all benefits that asset managers promote, but none of these encourage longer term investing. In turn, clients’ buying and selling sensitivities may affect the way an asset manager behaves as a business but, again, none of this changes a fund business’s rationale. As mentioned, understanding this dynamic matters as it reveals the tensions inherent within an asset management company, which leads to a better understanding of the way any of these businesses are run. For example, this can provide a barometer against which the actions or claims of an asset manager can be measured by prompting the question: in what way does this help the long-term growth of client assets? Asset managers are well-aware of the criticisms they receive for paying relatively large salaries and achieving high profit margins while many actively managed funds fail to outperform market indexes or their passively managed peers. It is often for this reason that firms or their representatives are keen to point out other roles that asset managers play in a capitalist economy, often linked to the role of active managers in particular. This was shown in one investment analyst’s paper that compared passive funds unfavourably to an economy run on Marxist principles, while making the case for active managers being “a force for social good” (Fraser-Jenkins 2016). 125

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It may well be that fund managers, via mutual funds or institutional mandates, serve a role in a capitalist economy by supporting companies, perhaps most influentially smaller companies, in this way. But it does seem to be a rationale based on hindsight: retrospectively fitting a purpose onto the investment industry that is a by-product rather than its reason for existing. Some, even many, asset managers see their role as allocating clients’ capital to companies that they believe will grow over the long term and where their involvement will help make that growth sustainable (i.e. investing), rather than solely picking stocks that they think will rise in the near future (i.e. more akin to gambling), but that does not mean this is the reason why clients give asset managers their money. And this is before any discussion of whether the fund management industry is really the most efficient way to allocate capital to companies if it was not for these firms’ primary, overriding purpose. This distinction between investing and gambling underlines the need for asset managers’ effective engagement with investee companies in order to deliver on their obligations to clients. Engaging with companies goes beyond simply providing capital and involves interacting with their management teams and ultimately holding them to account. In this way, the rationale for an emphasis on engagement does not come from an abstract social purpose or an extra justification for charging fees. Instead it comes from asset managers’ obligations to clients and to secure their long-term goals, effectively acting as stewards of their clients’ assets. Stewardship and engagement are thus interlinked and sometimes referred to interchangeably. Seen in this light, the increased push for asset managers to consider the environmental and social impact of the companies in which they invest are entirely logical and suggests an evolutionary step in the management of investments that some firms took up many years ago. These two factors (the environment and society) are often accompanied by a consideration of the governance of companies – together abbreviated to ESG – underlining that the initial consideration of these aspects was not purely in terms of their impact externally, but as potential risks for a fund manager to consider when investing in a company. Poor governance, poor treatment of employees and a disregard for the environment can each be a danger sign in the prospects for a company’s growth. None of this is to deny that an asset management business aims to make a profit. But disengaging this objective from the purpose of fund management 126

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is surely a sign of a company that is not acting in its clients’ best interests. Not acting in this way might be a feasible business strategy in some industries, but the investment management industry has developed with obligations to act in clients’ interests theoretically enshrined within it and these obligations are intended to underpin the way firms act. This is most commonly known as a fiduciary duty. Without this, the purpose of the industry would matter less as firms could disregard it without fear of reprisal or reputational damage. For example, by charging much higher fees. But the industry, in principle, aspires to do more than “getting away” with charging higher fees and firms have obligations to do more than this – even if they are sometimes ignored. How the fiduciary duty fits into firms’ responsibilities and how clients’ best interests are defined will be explored in the next chapter.

Sustainable investing While a detailed look at the ways in which non-financial considerations can be integrated into portfolios lies outside the scope of this book, the business reality of such considerations cannot be ignored. Proponents of integrating ESG considerations into the investment process contend that by doing so long-term outcomes are improved. The demands of clients, regulators and governments, are pushing firms to be seen to encompass this wider set of considerations, and fundamental questions for the industry, with Europe (beyond the US or Asia) at the forefront of these changes. By focusing on ESG factors, in addition to financial aspects, it is hoped (or expected) that asset managers’ investments will be more sustainable and long term. However, there is not a single, clearly defined way in which to invest sustainably, although the recent rise in demand for sustainable investment funds sometimes gives the impression that this is all one homogenous movement. Indeed, some would contend that integrating ESG into investing is not necessarily the same as investing sustainably, as explained below. It is worth considering, therefore, some of the different ways in which sustainable investing can be separated out. The four approaches below can be easily distinguished and are widely used: ESG integration, screening, thematic investing and impact investing. Engagement might be considered as a fifth 127

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approach, but this rightfully belongs in all investment approaches and so is covered separately. ESG integration reflects the most widespread change among asset managers over the past two or three years. Here ESG factors are considered alongside financial aspects when evaluating investment (or divestment) in companies. In this way ESG factors are risks that a fund manager needs to evaluate. The way in which these factors are integrated varies between firms, depending on the way in which “consideration” is interpreted. At one extreme it might be that a fund manager notes what an ESG analyst reports and then makes a decision based on their original financial analysis with no need to justify this decision further. At the other extreme, ESG analysts might effectively block an investment by flagging a climate-related failing at the prospective investee company. Screening can, technically, be divided into two categories of investment strategy, negative and positive screening. However, both primarily use quantitative based screens to select companies in which to invest and so the principles behind the strategies are not dissimilar. Exclusionary screening avoids investment in particular companies based on analysis of their ESG credentials, or companies in certain sectors (such as weapons or tobacco), or companies that undertake certain business practices (such as employing staff on zerohours contracts). This is now often seen as a slightly old-fashioned approach to sustainable investing, with new funds more likely to use positive screening. The latter, also known as “best-in-class”, select companies that have the highest ESG scores in a particular sector or geographic universe. Thematic investing relates, in principle, to a much wider universe than sustainable investment funds. Thematic funds can invest across sectors in companies that are expected to benefit most from a perceived long-term trend, such as emerging technology. But a growing number of thematic funds are dedicated to environmental themes, such as clean/renewable energy or the transition to net zero carbon emissions. Impact investing aims to create a positive, measurable social or environmental impact alongside financial returns. In order to maximize impact, fund managers consider aspects such as the intentionality of the underlying company’s impact, i.e. that a positive environmental impact is not accidental, and the materiality or scale of the impact. Because of these aims, impact funds are also more likely to invest in private companies or other entities not listed on public markets. 128

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Greenwashing Growing demand for sustainable investment funds has been accompanied by growing scrutiny of whether funds are engaging in so-called “greenwashing” – talking the talk but not walking the walk on sustainability. It is a sign of how rapidly the industry has evolved on sustainable investing that accusations of greenwashing now have serious business consequences. For example, in August 2021 the former group sustainability officer at DWS accused the asset manager of greenwashing, prompting German and US financial regulators to reportedly open investigations. The firm’s share price fell almost 14 per cent on the day and it barely recovered over the following two months.2 While the firm has rejected the allegations and inflows to the firm’s funds do not appear to have suffered over this period, investors in DWS itself have clearly been spooked and their fears not easily assuaged. Sensitivities around greenwashing have made fertile ground for ESG experts to point the finger at various asset managers for not being sufficiently robust in their analysis of, and subsequent holdings in, companies that have flawed ESG practices, or for funds not being willing to divest from such companies. Fund managers have often been similarly willing to burnish their own ESG credentials by trying to distinguish their practices from those of rival firms. The ease with which accusations are thrown around reflects the fact that establishing whether a fund can be definitively described as greenwashing is far from easy. Analysis of the policies and practices of investee companies are often subjective, even if the judgements made can be presented as data. For example, whether a company board is sufficiently diverse, whether a company’s net zero goals are sufficiently ambitious, or whether treatment of staff is sufficiently enlightened. Getting to the bottom of whether funds are greenwashing is made trickier by the fact there are two bases from which these accusations stem (see also Bioy 2021). The first, and more serious, is intentional greenwashing, where an asset manager’s claims are not matched by its actions. But there is also unintentional greenwashing, where an investor has a particular expectation of how a sustainable fund should invest that is not the same as the views of an individual fund manager. This need not even be the result of a client failing to 2. See https://markets.ft.com/data/equities/tearsheet/summary?s=DWSX:GER.

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read the detailed investment policies of a particular fund, but instead might reflect either what is practical for the fund manager or the way in which the manager is engaging with an investee company to resolve ESG issues. This can even be seen when referring to the United Nations’ Sustainable Development Goals (SDGs), against which some funds benchmark their investment objectives. There are 17 SDGs that include 169 targets. Yet taking steps to address one SDG target might run counter to another of the targets, particularly when the goals cover both people and the planet. This is not to criticize the SDGs, but to reflect the balancing act that is sometimes needed as companies push to make progress on sustainable development. In response to growing demand from clients for sustainable investments and ESG-integrated funds it is little wonder that asset managers have ramped up their offering of products that try to meet such demand. This has been accelerated by regulations and government policies that have encouraged more disclosures and targets in these areas. Yet a large wave of firms rushing to launch new products has never been a good sign in the asset management industry with at least some firms likely to cut corners – even if not actually breaking the rules – in order to keep up with their peers in an effort to catch client inflows. Slightly worryingly, one asset manager has suggested that launching sustainable funds is part of its definition of sustainable investing.3 They are far from alone in thinking of sustainable investing as, at least partly, a new product development opportunity. In addition, the FCA has been quick to challenge firms’ planned sustainable fund launches that cannot back up their ESG claims.

Engagement and stewardship One particularly contentious area of debate within sustainable investing is the relative merits of divestment and engagement. As mentioned above and explained more fully in Chapter 4, stewardship and engagement are interlinked. Engagement is particularly important within the context of sustainable 3. Abrdn, “Test your ESG knowledge, Question 1: what is responsible investing?” Company website, (accessed October 2021).

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investing because it offers a rationale for investing in a company that might be flawed in some of its ESG policies and practices, but where a fund manager’s investment and resulting influence can help to improve those practices if he/ she thinks their holding is justified on other grounds, not least his/her clients’ best long-term interests. Divestment in the context of ESG investing reflects concerns with aspects of an investee company in relation to one or more of these three considerations (E, S or G) that cannot be resolved by engagement or are positively excluded by a fund’s investment policy. With this in mind, it can be argued that the ultimate failure of engagement results in a fund manager’s decision to disinvest from a stock. Furthermore, as more funds have adapted to growing demand – from policymakers and clients – for sustainable investments, particularly in Europe, then many have adjusted their investment policies accordingly. This, in turn, has led to some funds reducing their stakes or divesting fully from some companies or sectors. In this way, divestment has had a similar effect as an ESG exclusion policy. An example of the challenges of engagement and the potential for a tension between long-term financial returns and ESG considerations emerged in 2021 when electric car maker Tesla revealed that it had invested in energy-hungry cryptocurrency Bitcoin. The controversy reignited earlier concerns about the governance of Tesla, with the firm dominated by chairman and CEO Elon Musk. A large investor in Tesla, James Anderson, manager of the £18 billion Scottish Mortgage Investment Trust, later revealed that he “painfully clashed” with Musk. But he concluded: “I do not believe that Tesla would have changed the world for the better if it had been a normal company paying heed to the standard governance codes”. Anderson went on to criticize fund managers’ over-reliance on quantitative metrics to assess companies’ ESG credentials and not allow sufficient room for judgement. “ESG frameworks are not just gestures, not just ill-thought through metrics and distractions, but that in aggregate they are profoundly damaging to the prospect of changing the corporate sector – even the world – for the better”, he wrote (Anderson 2021). Pressure to divest from fossil fuel companies – crude oil, natural gas, coal – has come most vocally from climate change campaign groups, such as Extinction Rebellion, but also from more moderate environmental think tanks. Asset managers generally have stood their ground in saying that divesting from public companies in many of these situations has no effect in the 131

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real economy. A publicly traded company needs a buyer for every seller. And, taken to an extreme, a profitable company that is shunned by the stock market can ultimately be taken private, where disclosure of ESG activities need not be made public and so become far harder to track. But many ESG-related issues reveal differing views between asset managers. For example, in 2022 Schroders backed supermarket Sainsbury’s in a vote at the latter’s annual general meeting on its living wage policy, while firms including Legal & General Investment Management pushed for the UK retailer to pay third-party contractors, such as cleaners and security staff, the living wage (Lewis 2022). The emphasis on stewardship is no longer an abstract concept or one left to the whims of individual fund managers. The UK Stewardship Code, managed by accountancy regulator the Financial Reporting Council, was established in 2010 and updated in 2020, setting a higher bar for asset managers and asset owners (institutional investors such as pension funds that own companies’ shares and debt either directly or via an external fund manager) for stewardship standards. While it is a UK code, the international nature of both the UK stock market and asset managers means that its ramifications will be felt far more widely than in this country alone. In the latest version of its code, the FRC defines stewardship as “the responsible allocation, management and oversight of capital to create long-term value for clients and beneficiaries leading to sustainable benefits for the economy, the environment and society”. Reflecting the way that stewardship has evolved over recent years, the FRC notes that environmental and social factors, in addition to governance, “have become material issues for investors to consider when making investment decisions and undertaking stewardship”. Without going into the details of the code, as these considerations ultimately relate to investment managers’ activities, which lie outside the scope of this book, it is worth detailing the FRC’s principles below, against which potential signatories are assessed and for which they must provide sufficient evidence to support their application. The high bar for asset managers to be accepted as signatories was made clear when the code was launched with one third of asset managers failing to meet the required standards, or 64 of the 189 firms that applied, although more have subsequently been accepted (Mooney 2021). The 12 principles are as follows:

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  1. Signatories’ purpose, investment beliefs, strategy, and culture enable stewardship that creates long-term value for clients and beneficiaries leading to sustainable benefits for the economy, the environment and society.   2. Signatories’ governance, resources and incentives support stewardship.   3. Signatories manage conflicts of interest to put the best interests of clients and beneficiaries first.   4. Signatories identify and respond to market-wide and systemic risks to promote a well-functioning financial system.   5. Signatories review their policies, assure their processes and assess the effectiveness of their activities.   6. Signatories take account of client and beneficiary needs and communicate the activities and outcomes of their stewardship and investment to them.   7. Signatories systematically integrate stewardship and investment, including material environmental, social and governance issues, and climate change, to fulfil their responsibilities.  8. Signatories monitor and hold to account managers and/or service providers.   9. Signatories engage with issuers to maintain or enhance the value of assets. 10. Signatories, where necessary, participate in collaborative engagement to influence issuers. 11. Signatories, where necessary, escalate stewardship activities to influence issuers. 12. Signatories actively exercise their rights and responsibilities.

Politicians getting involved The sheer number and range of government and intergovernmental initiatives that relate to different aspects of ESG and sustainable investing cannot all be covered here. But several initiatives, alongside that of the FRC above, have already driven significant change among asset managers considering their role as businesses and in wider society and so are worth touching on. The most significant government-level influence on asset managers’ approach to sustainable investing has come from the United Nations’ 133

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Principles for Responsible Investment (PRI). In 2005, then UN SecretaryGeneral Kofi Annan invited a group of institutional investors to develop a set of principles, which were formally launched a year later. The number of signatories to these voluntary principles has since grown from 100 to over 4,000, primarily investment managers, but also asset owners and related service providers.4 While still supported by the UN, the PRI is now funded primarily via an annual membership fee from its signatories, as well as grants from governments and other international organizations. Its six principles are: 1. We will incorporate ESG issues into investment analysis and decision-making processes. 2. We will be active owners and incorporate ESG issues into our ownership policies and practices. 3. We will seek appropriate disclosure on ESG issues by the entities in which we invest. 4. We will promote acceptance and implementation of the principles within the investment industry. 5. We will work together to enhance our effectiveness in implementing the principles. 6. We will each report on our activities and progress towards implementing the principles. The UN, as we have seen, is also responsible for its 17 Sustainable Development Goals, the origins of which date back to the Earth Summit in Rio de Janeiro in June 1992. The SDGs were launched in 2015 as part of the UN’s 2030 Agenda for Sustainable Development. For many asset managers, the SDGs play an important role in defining a common range of environmental and social considerations. In addition to their broad use as part of ESG integration, some funds also use one or more SDGs as benchmarks for their investment objectives. Trackinsight, an ETF research firm, has found that 266 ETFs with assets of $112.2 billion were linked to the SDG on climate action at the end of December 2021.5 By contrast, only one was focused on quality education, two ETFs were focused on the zero hunger SDG, and two on life 4. See https://www.unpri.org/signatories. 5. See https://www.trackinsight.com/en/esg-investing.

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below water. Altogether there are 456 SDG-focused ETFs with assets of $199.6 billion, the researchers found. While these UN initiatives are voluntary, the European Union is in the midst of rolling out regulations and other actions to make sustainability considerations an integral part of its financial policy and to support the European Green Deal, which aims to make Europe the first climate-neutral continent. These have had direct, practical implications for asset managers, as well as knock-on effects on client behaviour. For asset managers in the EU, the most significant parts of this sustainable finance action plan are the Sustainable Finance Disclosure Regulation (SFDR) and the EU’s taxonomy for sustainable activities. Starting in March 2021, SFDR requires asset managers in the EU to disclose whether they incorporate environmental or social characteristics among other investment objectives (article 8 of SFDR) or whether they have a specific sustainable investment objective (article 9), covering both for mutual funds and segregated mandates. If funds do not meet either of these criteria, then they must state this and are still required to consider sustainability risks (article 6). Asset managers’ wholesale clients in particular (such as wealth managers and banks) responded to the introduction of the rules by using articles 8 and 9 as a screen in their fund selection process, effectively pressuring fund houses to ensure their products meet the disclosure criteria under these two articles of SFDR – with many asset managers adjusting their products accordingly. While the European Commission has since scrambled to clarify that its disclosure rules were not meant to be used to promote the ESG characteristics of funds, but only to “ensure that the information presented to investors is more coherent, uniform and reliable when it comes to ESG” (Moisson 2021). Following Brexit, firms and funds in the UK are not caught by these EU rules, although the UK government has launched its Roadmap to Sustainable Investing in October 2021, which includes its own Sustainability Disclosure Requirements (SDR). The final form of these requirements will be closely watched by those in the industry. The EU Taxonomy for sustainable activities is a classification system, establishing a list of environmentally sustainable economic activities that provide fund managers and others with definitions for which economic activities can be considered environmentally sustainable and, therefore, where greenwashing

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might be taking place.6 The EU hopes that this will “help shift investments where they are most needed”. The Taxonomy Regulation entered into force in July 2020, establishing a range of environmental objectives, with the first raft of obligations on firms coming into force in January 2022. Government pressure on financial firms to help global efforts to cut greenhouse gas emissions increased in November 2021 with the 26th UN Climate Change Conference (COP26), held in Glasgow. Asset managers joined the Glasgow Financial Alliance for Net Zero, led by former Bank of England governor Mark Carney, by establishing the Net Zero Asset Managers Initiative, with 220 signatories committing to the goal of net zero by 2050 or sooner, in line with global efforts to limit warming to 1.5°C.

BOX 6.1  INVESTING IN SDGS

Candriam, a responsible investment manager owned by New York Life, and Rize, a specialist provider of thematic ETFs, manage two funds that show different ways in which some asset managers aim to support the UN’s Sustainable Development Goals. The Rize Education Tech and Digital Learning UCITS ETF seeks to invest in companies that have the potential to benefit from the increased adoption of digital and lifelong learning technologies that are changing the way people learn, such as personalization and adaptive learning, video content, gamification and immersion technology. The fund could therefore be used by a client seeking to align their investments to UN SDG 4 – ensuring inclusive and equitable quality education and promoting lifelong learning opportunities for all. The fund is classified as article 8 within the SFDR. In other words, the fund incorporates social characteristics among other investment objectives. The ETF is passively managed, in other words it tracks an index of companies. To create the list of companies in the index, Rize works with HolonIQ, a global education market intelligence firm, and uses its classification system of companies to establish what it deems to be “market leaders” in digital and lifelong learning technologies. Index provider Foxberry then uses this information to create an index of companies that the ETF tracks. The proportion of the index 6. See https://ec.europa.eu/info/business-economy-euro/banking-and-finance/ sustainable-finance/eu-taxonomy-sustainable-activities_en.

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that each company makes is weighted by each company’s liquidity, whereby companies with higher liquidity achieve a larger weight in the index. Candriam’s Sustainable Bond Impact Fund aims to reconcile financial returns alongside a positive social and environmental impact by investing in corporate and sovereign bonds based on their ability to address societal challenges and generate a positive contribution across the UN SDGs framework. The fund is classified as article 9 within the SFDR, meaning that it has a specific sustainable investment objective. The actively managed fund uses an in-house screening approach to assess the ESG quality of the issuer of each bond and examines how proceeds from the issuance of these bonds will finance underlying projects that are aligned with the UN SDGs. Financing sustainable debt must be linked to both issuer credibility on ESG commitments as well as its solvency profile. The fund seeks to include a minimum 75 per cent ratio of sustainable bonds. In addition, 10 per cent of the fund’s management fee will be donated to specific organisations supporting environmental or social projects.

Putting a price on the environment While the pricing of environmental assets is primarily relevant for portfolio managers rather than asset management businesses as a whole, the potential impact of changes in this area are so significant in the way funds select and hold their investments that initiatives in this area are worth picking up on. The first is the Dasgupta Review, which was commissioned by the UK government in 2019 and published in 2021; it is a report on “The Economics of Biodiversity” led by Partha Dasgupta, professor emeritus of economics at the University of Cambridge.7 Part of the rationale for the review is to put a price on biodiversity – nature in all its forms – that is not captured by market prices “because much of [nature] is open to all at no monetary charge”. Dasgupta writes that “we are all asset managers. Individuals, businesses, governments and international organizations all manage assets through our spending and investment decisions. Collectively, however, we have failed to manage our global portfolio of assets sustainably”. The Review challenges business and 7. See https://www.gov.uk/government/publications/final-report-the-economics-ofbiodiversity-the-dasgupta-review.

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governments in three areas to: (1) ensure that our demands on nature do not exceed its supply, and that we increase nature’s supply relative to its current level; (2) change our measures of economic success to guide us on a more sustainable path; and (3) transform our institutions and systems – in particular our finance and education systems – to enable these changes and sustain them for future generations. The UN has also tried to tackle the pricing of natural assets with its System of Environmental Economic Accounting (SEEA), a framework that “integrates economic and environmental data to provide a more comprehensive and multipurpose view of the interrelationships between the economy and the environment and the stocks and changes in stocks of environmental assets”.8 The SEEA is a guide to integrating economic and environmental data into a single, coherent framework of internationally agreed concepts, definitions, classifications, accounting rules. Both of these initiatives are not an end in themselves, but a sign of the changes that a growing number of asset managers are signing up to, conscious that changing the way to value an investment or asset could have a significant impact on the environment. In a similar vein, a raft of asset managers have come out in favour of governments levying a “carbon tax” and generally acknowledging the limits to what capital markets (and therefore fund managers) can do in tackling the climate crisis. The loudest voice in favour of government action here is that of Tariq Fancy, former chief investment officer for sustainable investing at BlackRock. Fancy published an essay titled “The Secret Diary of a Sustainable Investor” in August 2021 that challenged asset managers’ claims about their ability to bring about change in investee companies’ environmental and social practices.9 But more than this, he used this platform to emphasize the need for government-led change, most notably on a carbon tax, as the only effective way to bring about changes in behaviour from participants in capital markets, such as asset managers. “If you want less of something, make it less profitable. That’s the whole idea behind a carbon tax”, Fancy has said.

8. See https://seea.un.org/. 9. See https://medium.com/@sosofancy/the-secret-diary-of-a-sustainable-investorpart-1-70b6987fa139.

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Passive conundrums Dedicated active fund managers are normally only too happy to criticize index-based funds for their apparent flaws or drawbacks. These arguments will continue as more client money flows to passive funds (although that shift has been much more pronounced in the US than in Europe). Regardless of these arguments, the growth in demand for sustainable investments does pose a challenge to passive products in at least two ways. First, index-based funds have enjoyed growth on the back of the proposition that they do not take active investment decisions, but instead rely on objective, quantitative measures to define the universe of companies in which they invest. The most common of these is market capitalization of companies within a certain index, such as the FTSE 100, so that a fund invests in 100 stocks in relation to their market weightings. But for a passive fund with a sustainable investment objective, the set-up is subtly, but significantly, different. To assess the ESG-ness of companies, or the extent to which a company follows a UN SDG, an assessment must be made of each potential company. As much as this assessment is intended to be objective, human involvement inevitably means there is a subjective element. Furthermore, these active decisions are typically taken not by an asset manager but delegated to an index provider or to a research firm whose data is used by the index provider. There is nothing inherently wrong with this, although the management of this delegation adds an additional layer of oversight not present in a traditional index fund. A knock-on effect of the growth of ostensibly passive ESG funds has therefore been the growing importance and influence of ESG analytics firms, which are often part of index providers, most notably MSCI. Indeed if MSCI were treated as an asset manager, rather than an index provider through its selection of stocks for index-tracking ESG funds and ETFs, then it would be the largest sustainable fund manager in Europe – more than four times larger than the next largest fund house.10 A second challenge for passive funds is the practicality of integrating ESG policies. Actively managed funds have been able to tweak their investment strategies to meet investor demand for sustainable funds, as the discretion of 10. Author’s analysis of Morningstar European mutual fund and ETF data, as at 31 December 2021.

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an active manager normally allows. But more significant changes are needed for passive funds to make a similar change, such as aligning with the EU’s SFDR articles 8 or 9. If a passive fund changes the rules on which it is based, such as changing the index it tracks, then its investment objectives change and shareholder approval is needed, running the risk that investors may withdraw from the fund. In a similar way, a passive fund is severely restricted in its ability to disinvest from a company included in the index it tracks. For a fund or fund company that has an effective engagement division, then there is an argument that this is not a significant problem, and clients invest in the fund knowing the fund’s index rules. However, if divestment is the final threat for an asset manager engaging with an underlying company, then passive funds would seem to be lacking this particular arrow in their quiver of ESG tools.

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R E G U L AT I O N S A N D R E S P O N S I B I L I T I E S

The aim of this chapter is to give an overview of the main fund structures used by UK and European asset managers, as well as the evolution of product regulations that have supported the growth of mutual funds across Europe. It is not intended as a detailed primer on fund regulation. There is an ongoing tension between asset managers’ desire for less regulation (and its associated costs) and regulators’ instinct to regulate (to safeguard investors’ interests). Despite this, the European asset management industry can thank supportive fund regulation as part of the reason for its impressive growth over the past 30 years.

Fund structures The first fund in the UK was set up in 1868, the Foreign & Colonial Govern­ ment Trust, which is now the £5.6 billion F&C Investment Trust. Originally established with a trust structure, the fund is now a closed-ended investment company, also known as an investment trust. The UK had to wait until 1931 for its first open-ended fund, the Municipal & General First British Fixed Trust, which had a fixed term of 20 years and so was then replaced by the M&G General Trust, which in turn has had several reincarnations, latterly as the M&G Blue Chip fund, which merged into the M&G UK Growth fund in 2006. In turn, this fund was renamed M&G UK Select in 2015 and had assets of £500 million in May 2022. M&G had originally been inspired by the first 141

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US open-ended fund, the Massachusetts Investors’ Trust that launched in 1924. This US-based fund has fared better than M&G’s UK product and now manages assets of $7.1 billion (£5.3 billion). While tracking an index is an investment strategy, rather than a distinct fund structure, it is worth noting that after some false starts by other firms, the first index fund open to retail investors was launched by John Bogle in 1975, the First Index Investment Trust. Today it is the Vanguard 500 Index Fund, with assets of $770 billion in May 2022. Developing index-based products further, the first exchange traded fund was established in Canada in 1990, Toronto 35 Index Participation units. Today this is the iShares S&P/TSX 60 Index ETF, which had assets totalling CA$12.6 billion (£8.1 billion) in May 2022. The first US product was launched in 1993 by State Street Global Advisors, the S&P 500 Trust ETF, which manages $346 billion (in June 2022). It was not until April 2000 that the first ETFs came to Europe, with Merrill Lynch launching German-based funds tracking the Euro Stoxx 50 and the Stoxx Europe 50, which are now managed by BlackRock’s iShares business (Glow 2020). In this very brief history lesson several basic fund types are covered that form the basis for much of the funds industry as it stands today: open-ended funds, closed-ended funds and exchange-traded funds. There is a wide variety of legal structures for funds internationally (see St Giles & Buxton 2003), but for simplicity’s sake, covering these three types establishes the main funds sold to retail investors that UK and European asset managers are likely to have in their armoury. Also, as has been established throughout this book, the focus here is on mutual funds, rather than dedicated mandates, which are contracts entered into directly between an institutional investor and an asset manager with the investment objectives agreed between the two. The legal structure that is most used for funds in the EU is the Société d’Investissement à Capital Variable (Sicav), on which the UK open-ended investment company (OEIC) was based. The term OEIC is also used interchangeably with investment company with variable capital (ICVC), although it is not a specifically UK structure, with ICVCs also established in Ireland. While these are all company-based fund structures, the most common fund structure in the UK used to be the unit trust, which is a trust-based structure. The OEIC structure was launched in 1997 to take advantage of the EU’s UCITS rules that did not allow trust-based funds (or closed-ended funds), in turn starting the shift by UK asset managers to convert their unit 142

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Table 7.1  Open-ended funds vs closed-ended funds Open-ended funds

Closed-ended funds

Open-Ended Investment Companies (OEICs) in the UK, which have largely replaced Unit Trusts.

Investment companies in the UK, which are also known as investment trusts.

The most common mutual fund structure in the world is the open-ended fund. This term refers to the fact that the fund expands or contracts as investors move their money in or out of the fund, with the asset manager creating new shares when investors buy and cancelling shares when investors sell. Openended funds therefore have a variable capital structure.

These funds have a fixed number of shares in issue at any one time. Investors buy and sell shares in a closed-ended fund from one another on the stock market. Closedended funds must issue new shares if they wish to increase the pool of money they manage (beyond that resulting from their returns). Closed-ended funds therefore have a fixed capital structure.

The open-ended fund’s structure means that the value of its shares directly reflects the value (net asset value) of its underlying investments.

Because a closed-ended fund’s shares are bought and sold on an exchange, its share price is affected by the demand for those shares. So its share price might be higher (known as trading at a premium) or lower (discount) than the net asset value.

Partly because of this aspect of an openended fund’s structure, and partly because of regulations on what assets the fund can hold, an open-ended fund’s investments have to be sufficiently liquid so as to enable swift redemptions by clients.

The fixed capital structure means a fund manager is not forced to sell holdings to meet redemptions, giving more flexibility to invest in less liquid assets, such as private companies and real estate.

Open-ended funds available to retail investors are not permitted to borrow on a permanent basis (gearing). There are exceptions for temporary borrowing on a limited basis, while non-retail funds are likely to have greater leeway for borrowing.

Closed-ended funds can borrow, or gear, giving the fund more money to invest and so offering the potential for higher returns. Over shorter periods this borrowing can increase the riskiness of a fund.

OEICs all choose to appoint an authorised corporate director, rather than individual directors. At least one quarter of the ACD board is required to be made of independent directors.

Investment trusts have a board of directors, with a majority required to be independent of the investment manager. Many boards are entirely made up of independent directors.

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trusts to OEICs, which now dominate the market. Another important benefit of the OEIC to asset managers is the ability to offer different share classes with different fee levels for different client types. It is worth noting that until the UK’s RDR reforms came into effect open-ended funds also had an advantage (for firms selling them) over investment trusts in being able to pay commission to intermediaries. In the EU, contract-based funds are also common, most notably Fonds Commun de Placement (FCP), which can also comply with UCITS rules. Contractual funds are so-called as they are established by a standardized contract between investors and the fund management company. This means that the fund is not a legal entity, which can weaken the voting rights of investors, but offer tax advantages, adding to their popularity. While FCPs are found in French-speaking countries, similar structures can be found elsewhere in Europe, such as Fonds voor Gemene Rekening (FGR) in the Netherlands.

Exchange-traded funds Exchange-traded funds (ETFs) offer a combination of features found in both open-ended and closed-ended products. They are open-ended funds but are bought and sold on an exchange. Trading on an exchange means their price varies through the day, although ETFs typically trade at net asset value, or very close to it. Their accessibility is one reason for their growing popularity, although demand has been much stronger in the US than Europe. (The clear tax advantages of ETFs, notably on capital gains, for US retail investors do not apply in Europe). In the UK, trading on exchange like company shares means that potential clients accessing funds via online investment platforms have sometimes found it harder to buy ETFs because they are treated as companies, rather than funds, with some of the larger platforms only recently offering access to the products as a result. And long-term investors have not always been won over by the tradability of ETFs, with Vanguard’s Bogle among those to make this argument most forcefully (Tuckwell 2019). The growth of ETFs has largely been on the back of demand for low-cost passive investments. As a result, ETFs have become synonymous with indexbased investing, even though the products can be actively managed (and there 144

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is a significant minority that are). However, regulatory requirements for ETFs to disclose their full holdings mean that active equity fund managers are reluctant to use them, although active bond ETFs are more common as these managers tend to be less concerned about revealing their holdings. A middle ground between active and passive are so-called “smart beta”, or factor-based, investment strategies, which are often structured as ETFs. These funds track alternative indexes from traditional market capitalization weighted indexes (i.e. weighting each stock in an index based on its market cap), with the factors commonly used instead of companies’ size are their momentum, volatility or dividends. But, to be clear, smart beta is an investment strategy and funds following these approaches need not be structured as ETFs. Exchange-traded funds are sometimes referred to as exchange-traded products (ETPs). However, while ETFs are collective investment schemes, and in Europe will be eligible to comply with UCITS rules, there are other ETPs that are not ETFs. Non-fund ETPs are exchange-traded notes (ETNs) and exchange-traded commodities (ETCs), which are debt instruments (notes and certificates). ETNs are issued by institutions that bear what is called the counterparty risk. If the issuer of the ETN goes bust, investors can potentially lose all their investment. In an ETF, as with other funds, if the fund provider goes bust then investors still own the underlying assets and so the fund’s shares would be liquidated at their market value. While the various vehicles above are what customers invest their money in to gain access to a fund manager’s services, and so an understanding of the different types is useful, the rules governing these products in Europe over the past 30 or so years have largely been shaped by common standards across the EU (and beyond).

EU’s UCITS At the heart of Europe’s product-related regulation lies the EU’s Directive on Undertakings for Collective Investment in Transferable Securities. This set down the legal fund structures that UCITS could take, their permitted investments, liquidity requirements, prospectus disclosures, and the duties of related functions, such as custodians or depositaries. In this way UCITS is a 145

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fund label, rather than a legal structure. With these ground rules established, UCITS has since established itself as an international standard of robust, retail investor-friendly fund regulation. In the UK, the FCA’s rules derived from this regulation are laid down in the Collective Investment Schemes sourcebook, known as COLL. Brexit has opened up the potential for the UK to diverge from the EU on fund regulation, and the UK government has indicated areas where it plans to do so, but the UK’s fund rules still primarily reflect EU rules. This is not to ignore other countries’ local fund regimes, but these pan-European rules largely shape regulatory fund regimes across the continent, including for non-EU countries. The original UCITS Directive was launched in 1985 and provided the basis of agreed rules for the operation and management of open-ended mutual funds, as well as enshrining investor protection safeguards, which together enabled their distribution across the EU. While various European countries had well-established local fund industries, the idea of selling funds cross-border had been dealt a severe blow by the exploits of Bernie Cornfeld and IOS (see Chapter 5), which had made national regulators nervous about losing direct control of permitted activities in their jurisdiction. Over the intervening years, albeit slowly over the first 10 years, UCITS established itself as the passport for EU funds to be sold internationally, primarily across Europe, but also in many Asian and Latin American markets. Luxembourg’s prominent position within the European mutual funds landscape was established early on in the history of UCITS, with the Grand Duchy becoming the first country to implement the UCITS Directive in 1988. Ireland was among the other early adopters and, significantly, this was accompanied by the Irish government’s decision to offer favourable tax rates for companies setting up in Dublin’s newly established International Financial Services Centre (IFSC). But it was Luxembourg, helped by its geography and long-­ established private banking sector, that made the early running in expanding as a base for funds sold into different neighbouring countries, initially Belgium and Germany. Soon Swiss asset managers saw the potential to set up fund businesses in Luxembourg in order to more easily reach an international client base within the EU. Early growth in these funds reflected existing client demands in these countries, with fixed income products dominating. It was only in the later 1990s that US and UK asset managers began to establish Luxembourg funds and to offer an international client base actively managed 146

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equity funds, which then benefited from the technology boom at the end of that decade. As investor appetite opened up to these more adventurous products, Anglo-Saxon firms in particular had funds available to take advantage of this opportunity. UCITS required funds to be corporate entities, such as the Société d’Investissement à Capital Variable (Sicav). Luxembourg’s recognition of these funds’ ability to adopt an umbrella fund structure found particular success with firms. After a fund (umbrella) was authorized by an EU regulator, then sub-funds of this initial entity could be added much more easily than having to go through the entire authorization process again, reducing costs for fund companies and enabling them to bring new funds to market much more quickly. For example, Franklin Templeton Investment Funds Sicav contains the firm’s flagship Luxembourg fund range, consisting of 89 sub-funds at the end of 2021, including the Templeton Global Bond Fund and the Franklin Income Fund. The corporate fund structure also enables a sub-fund to offer multiple share classes, which UK unit trusts, among others, were not allowed to do. Share classes enable different types of client to invest in the same, single portfolio but with different terms. Different share classes can have different fee levels, for example, charging an institutional investor 0.6 per cent if they invest €1 million but charging a retail investor 1.25 per cent if they invest €1,000. Share classes can also be denominated in different currencies to cater to different client geographies, which in turn may be unhedged or hedged (to reduce fluctuations between the fund’s base currency and the currency of the share class). Ireland has also benefited from the growth of UCITS funds. While Luxembourg’s asset manager client base is particularly international, Ireland’s is more dominated by US and UK firms. While PIMCO and Vanguard selected Ireland as their EU funds base, one of the most significant drivers of Ireland’s growth has been its success in attracting ETFs. An early reason for this success was Ireland’s double taxation treaty with the US. The US charges a withholding tax on American companies’ dividend payments to international investors at 30 per cent. Ireland’s tax treaty means that its funds and ETFs only pay 15 per cent tax on the dividends they receive. As ETFs are particularly cost sensitive and keen to minimize any divergence in their performance from their benchmark indexes, this advantage proved decisive early on in many 147

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international firms’ choice of ETF domicile. The issue was accentuated by the fact that US stocks make up a significant portion of many passive funds’ holdings.

The UK and the European Union The success of Luxembourg, and the attractiveness of the UCITS features noted above, made some UK asset managers and policymakers look on enviously. While most took the step of setting up in Luxembourg to enable their expansion in the EU, others sought to make the UK a base for pan-European fund sales. At the time the established open-ended fund structure in the UK was the unit trust, based on trust law, rather than a corporate fund structure. The UK responded by launching the open-ended investment company (OEIC) in January 1997. Asset managers in the UK converted most, or all, of their unit trusts to OEICs over the succeeding years, at least partly due to the attraction of using multiple share classes. Success in creating the UK into a hub for EU funds was much more limited, although M&G Investments and Threadneedle Investments were the most successful in building significant assets in UK-domiciled funds from EU-based clients. Brexit serves as a postscript for the UK’s foray into cross-border fund distribution, effectively ending UK-based funds’ ability to be sold in the EU using the UCITS passport. M&G and Threadneedle transferred around €60 billion of assets from their UK funds to Luxembourg to protect their EU clients from the impact of Brexit. A host of other UK firms with a small number of EU-based clients were effectively forced to move UK-based funds to the EU (primarily in Luxembourg and Ireland) as a result. This included some smaller firms establishing funds outside the UK for the first time, such as Artemis Investment Management, Crux Asset Management and Somerset Capital Management, the last of which was co-founded by Brexiteer Jacob Rees-Mogg. As the Luxembourg government imposes an annual tax (taxe d’abonnement) on these funds, borne by investors, then Brexit has also delivered more than €50 million over the past three years to the country’s coffers. One major concern for UK-based asset managers was, and is, the possibility of restrictions being placed on investment management being provided by 148

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non-EU firms to EU-based funds. This delegation of a fund’s management to an investment manager outside the EU had been an unquestioned feature of the UCITS regime until the Brexit referendum. Potentially affected delegation arrangements relate not only to UK-based investment managers, but also to any others based outside the EU, such as those in the US or Asia. While some sabre rattling was heard following the referendum relating to delegation, in the end EU regulators have steered clear of making any significant changes in this area, conscious of the global implications of any such changes. However, regulators have made smaller changes, such as ensuring that asset managers’ operational presence in the EU is made up of more than a so-called letterbox entity. Alongside these investment management and operational issues, perhaps the most significant post-Brexit change for UK asset managers has been on their sales teams. Many firms, particularly smaller ones, had previously used a “fly in, fly out” approach to sales, with UK-based sales personnel travelling into EU countries to meet potential clients. But even UK firms with EU-based funds need relevant permissions – established under the Markets in Financial Instruments Directive – to actively market and sell within the bloc. For example, a senior executive at Somerset Capital Management, having set up funds in the EU, admitted that “it was only really at the beginning of [2021], when Brexit occurred, that the gravity of the situation properly hit us” and the firm was blocked from sending marketing material to prospective EU clients, some of which Somerset has had relationships with for over 20 years (Devine 2021).

Setting limits on investments One important feature of UCITS has been its definition of which transferable securities are eligible to be invested into – and the willingness of authorities to adjust these restrictions over time. With the aim of spreading investment risk in a UCITS fund, the original directive had a so-called 5/10/40 rule, whereby a fund could not invest more than 10 per cent of its net assets in transferable securities or issued by the same body, but also that the total value of investments in issuers in which the fund invests more than 5 per cent of its assets is capped at 40 per cent. 149

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In a sign of the development of UCITS, firms sought an expansion in investment restrictions and this came to fruition with UCITS III in December 2001. (UCITS II was only ever a draft directive and was ultimately abandoned when agreement could not be reached.) UCITS III included a Management Directive and a Product Directive. The former gave management companies, which have ultimate responsibility for the management and oversight of funds, a European passport to operate throughout the EU and widened the activities which they are allowed to undertake. (This was to prove limited, however, and only took off when further provisions were made in UCITS IV.) The Product Directive allowed funds to invest in a wider range of financial instruments, although its impact only took hold once the Eligible Assets Directive was agreed in 2007. Essentially this had the effect of expanding the UCITS product range to include money market funds, funds of funds, index-tracking funds and funds using derivatives for investment purposes. The last of these, the use of financial derivative instruments, was perhaps the element that created the most excitement at the time. UCITS funds that made extensive use of derivatives for investment purposes even gained their own nickname, “Newcits”, as a wave of asset managers launched products to take advantage of these new rules.1 This included firms taking existing nonUCITS investment strategies, such as some hedge funds managed in the US, and looking to structure them as UCITS. These funds can take short exposure to equities by investing in derivatives, such as forwards, futures, swaps and options, together with cash or liquid instruments, which are used as cover or collateral for the fund’s short positions. UCITS III also ignored the ghost of Bernie Cornfeld and permitted UCITS funds to invest in other funds – funds of funds. To reduce risk through diversification, restrictions include a maximum of 20 per cent of a fund’s net assets to be invested in any one open-ended fund. Coupled with this, a UCITS fund cannot own more than 25 per cent of the shares or units of another fund. In addition, a total of 30 per cent can be invested in non-UCITS funds. Also, to prevent funds of funds of funds being constructed, investee funds cannot have more than 10 per cent of their assets invested in other funds.

1. Thanks to Jonathan Miller, at the time head of research at Citywire and subsequently head of UK manager research at Morningstar.

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Index-tracking funds were not, on the face of it, banned under the original UCITS directive. However, the 5/10/40 rule created problems for passive UCITS funds where an index constituent exceeded the 5 per cent limit. The new rules meant that a fund tracking an index was now permitted to invest up to 20 per cent of its assets in shares or debt securities issued by the same body, with this limit raised to 35 per cent in exceptional market conditions.

Protecting investors The EU, and its national regulators, place great store on UCITS’ strong investor protection focus. However, this has developed most effectively through the structure and management of funds, which have resulted in their smooth running in most circumstances, rather than the active engagement of individual retail investors. This is partly a testament to UCITS: firms are fearful of damaging not only their own brands, but also that of the UCITS label itself. Evidence of policymakers struggles to engage individual investors were well-shown with the shortcomings of the so-called simplified prospectus, introduced in UCITS III. Asset managers, nervous of potential legal action, were reluctant to really simplify their full legal prospectus that details the formal structures, terms and relevant organizations involved in a UCITS fund. So the plans for a simplified prospectus ended up with a slightly shorter prospectus that was no more investor friendly than before. UCITS IV, implemented by member states in 2011, tried to change this by introducing the Key Investor Information Document (KIID). The KIID is a two-page summary document that provides a fund’s objectives and investment policy, its so-called risk and reward profile, charges, past performance, and a final section on practical information. This last section is a good example of how asset managers have shown they have little enthusiasm for KIIDs, making little or no attempt to provide useful information for retail investors or signposts to relevant webpages. The risk figures were (and are) the most contentious, presenting a fund’s risk as an historical measure of a fund’s volatility. This measure ranks a fund from 1, low volatility of returns over the past five years, to 7, high volatility of past returns. In practice these measures provide little useful insight to investors beyond the fact that certain 151

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asset classes are generally more volatile than others, while at the same time throwing up individual fund anomalies that give a misleading impression of how risky a fund really is. Asset managers were relieved that they are allowed to include past performance in the KIID, which irked some regulators that were keen to reiterate the well-established mantra that past performance is not a reliable indicator of future returns. Fund firms are well aware that funds are largely sold on the back of their performance. In the end, asset managers are still able to create their own fund factsheets, tailoring the presentation of past performance and other relevant information largely as they see fit (albeit within certain boundaries set by regulators, namely to not be misleading). Largely because of this, while retail investors are unlikely to be able to buy a fund without seeing its KIID first, they are far more likely to use factsheets to help them in their buying decision and for monitoring how their investment is faring. The KIID is a useful example of where UCITS has been effective and where it has struggled to make an impact. The document is far more accessible than the one it replaced, but it is still not much used. This reflects both that UCITS are primarily distributed via intermediaries and not direct to retail customers, and also that retail investors (and others) want to look at past performance when evaluating funds. Coupled to this, UCITS has worked best where asset managers’ interests align with those of policymakers and regulators. While firms have made the most of aspects of UCITS that are commercially beneficial for them, it is not surprising that less energy is spent in areas that are deemed to be a cost drag, which tend to be aspects that are designed to help retail investors. In the same vein, other parts of UCITS IV combined policymakers’ ambition to create a true single European market with asset managers’ desire to reduce costs and operational headaches. The best example of this were the changes related to notification procedures. This simplified the procedures for cross-border distribution of UCITS funds to minimize the ability of member states to impose their own local registration requirements. The changes aimed to allow a UCITS to be marketed almost immediately across borders once it has received its initial authorization.

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Alternative Investment Funds Under EU rules, any fund that is not caught by UCITS is classified as an Alternative Investment Fund (AIF). This can be slightly confusing as alternative investments is often used as a generic term for funds using non-traditional investment strategies (such as long/short equities and other strategies commonly used by hedge funds) or investing in less liquid asset classes (such as private equity, infrastructure or real estate). In addition, one slightly peculiar side effect of this approach is that closed-end funds, such as UK investment trusts, are classified as AIFs as they do not meet UCITS requirements. The Alternative Investment Fund Managers Directive (AIFMD), implemented in 2013, aimed to provide a common regulatory framework for the management and marketing, or distribution, of non-UCITS funds and thus formalized the classification of AIFs. In slightly simplistic terms, UCITS is a retail fund regime, while AIFMD brings institutional funds within EU rules. By catching all AIFs marketed in the EU, AIFMD also catches the activities of AIFMs based outside the EU. As the AIMFD was set in motion in response to the global financial crisis of 2008, part of its aim was to ensure the mitigation of risks associated with the management of alternative investments. In 2016, UCITS V came into force, which aimed to align the UCITS and AIFMD regimes’ remuneration and depositary rules.

Hedge funds Hedge funds have been referred to several times throughout this book, but it is worth trying to distinguish them from mutual funds. They are a standalone asset class for some investors, although this does not mean it is straightforward to define them as such. In Europe, the evolution of UCITS to allow hedge fund-type strategies, together with AIFMD encompassing a wide variety of alternative funds, mean that hedge funds are no longer a distinct regulatory category. Hedge funds bought in Europe are still often established in non-European jurisdictions, such as the Cayman Islands, but using this as a means to define hedge funds – for example, as funds subject to light touch regulations – is to miss that many hedge fund strategies are undertaken by 153

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EU-domiciled products using investment powers allowed by UCITS III, as well as missing that AIFMD catches non-European firms selling alternative products into Europe. So a clear distinction between hedge funds and mutual funds in Europe is much harder to make than in the past. Hedge funds frequently charge high fees, the best known of which is the “2 and 20” model. This involves charging a 2 per cent management fee (an annual charge based on a fund’s assets) plus a 20 per cent performance-related fee (taking a percentage of a fund’s net gains over different periods). Industry researchers suggest these fees have fallen over recent years, but it still provides a reference benchmark and in-demand funds remain willing to charge performance fees higher than 20 per cent. Other hedge fund features can include their client base (institutions and high net worth individuals), business or operational style (entrepreneurial boutiques), restrictive dealing terms (limiting the speed of withdrawals, which may include so-called gates), investment flexibility (more freedom allowed in the fund’s objectives). But each of these can frequently be found among other fund types and so do not, in themselves, define hedge funds. In addition to the features above, hedge fund is an umbrella term for an array of investment strategies that have evolved from Alfred Jones’ original “hedged” fund. Market neutral funds take long and short investment positions to hedge market factors. Event driven funds seek to exploit perceived mispricing of companies that may occur before or after corporate events, such as bankruptcies, mergers, or regular earnings calls. Macro funds aim to profit from market swings caused by political or economic events and will typically do this by investing across the spectrum of asset classes. Long/short credit funds take long and short positions in bonds. While hedge funds may no longer form a legal entity that can be distinguished from mutual funds, some of their features remain distinctive and commonly identified, even if not always found together. Mutual fund managers’ desire to adopt hedge fund strategies, and other features, serve as a demonstration of their appeal as a distinct part of the fund management universe. Hedge funds’ allure for asset managers also points to one ill-defined aspect – their image. For those working in and around hedge funds is a label to be worn with pride, a sign of sophisticated investing, of setting oneself apart from “traditional” managers. By contrast, those who see hedge funds as damaging to society with high fees and harming companies’ fortunes through 154

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short-selling, use the term as a criticism. Politicians or campaigners criticizing asset managers are quick to use “hedge fund” as a term of abuse even for those who have no such investment strategies. In this way, a hedge fund can be seen as reflecting a state of mind.

Offshore Hedge funds were traditionally synonymous with offshore jurisdictions and accompanying regulations being looser, or allowing greater investment freedom, and attracting an international client base, while mutual funds were established in the onshore jurisdiction where they were sold, with tighter regulations imposed by the national regulator to protect the country’s retail investors. As has been explained above, this simple distinction no longer holds true, which is not to say that there aren’t offshore jurisdictions with lower levels of protection for investors, for example, around required disclosures for investors. Bernie Cornfeld (see Chapter 5) knew very well that choosing an offshore jurisdiction in the 1960s could be particularly advantageous for a firm wanting to avoid the beady eyes of financial regulators and still be able to sell funds into onshore jurisdictions. Traditional British offshore centres include Guernsey, Jersey and the Isle of Man, while Caribbean offshore centres include the Bahamas, British Virgin Islands and Cayman Islands. These islands had originally gained their offshore moniker as shorthand for identifying them as tax havens. How this status has changed over time lies outside the scope of this book, although tax can play a part in a company choosing to set up a fund in a particular jurisdiction, alongside aspects such as the disclosure requirements referred to above. The development of Luxembourg and Ireland as bases for funds sold internationally have led to them being labelled as offshore centres – with the uncomfortable tax associations that label entails. But the development of both centres as domiciles for UCITS funds – with accompanying personnel, expertise and infrastructure – do not reflect the taxation of funds themselves, which falls within each national government’s domain. While UCITS reflects agreed standards across the EU, European citizens are not taxed on this basis. 155

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Throughout UCITS’ history, there have been periods when it has been tax advantageous for German and Italian investors, for example, to choose foreign-based (or offshore) UCITS funds, rather than funds set up locally. But these situations reflect tax rules in those countries (i.e. in Germany and Italy), and each time these emerge, national governments have normally stepped in to make it less advantageous to select foreign funds. Ironically, Luxembourg actually imposes an additional tax on some funds (taxe d’abonnement, mentioned above) that on the face of it make them less appealing to investors. This tax is borne by a fund’s investors, however, rather than the firm managing the fund. This is not to say that other forms of taxation have not played a part in helping Ireland and Luxembourg, in the early years of the development of their funds industries, to attract firms to set up in their countries. This was apparent when the Irish government established its International Financial Services Centre (IFSC) in Dublin, originally applying a 10 per cent corporate tax rate for designated financial services activities.

Oversight and fund governance Regulations have to be implemented and monitored within asset managers, while the actions of a firm’s employees are similarly subject to internal policies and ongoing checks. This is where a firm’s oversight functions – including legal, risk and compliance – come into play, ensuring that the rules are followed in an appropriate way (see Chapter 2). However, it is worth noting that employees in oversight functions are still employed by an asset manager. Just as the role of the human resources team is to help employees, but their ultimate loyalty and responsibility is to their employer, so the oversight team do not report to the regulator, they report to their employer. They have a responsibility to ensure rules are followed, both because this is what the regulations require and because to do otherwise is a risk to their employer. But the same rationale requires the oversight team to not restrict their employer’s activities beyond what they are obliged to do, or what is sensible to avoid unnecessary risks for the firm.

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Internal oversight covers not just corporate-level activities, but also the actions of a firm’s employees, most obviously in dealing with potential conflicts of interest. These can arise in various situations relating to managing investments, new sales, relations with third-party service providers, as well as with existing clients. In the first instance, asset managers put in place their own code of ethics or conduct, to which all employees must agree. These are detailed documents covering specific situations and activities, but underlying them are ethical and professional responsibilities similar to those that the CFA Institute lays out in its Asset Manager Code. To give a better sense of these codes, the CFA Institute’s general principles of conduct are as follows: (1) Act in a professional and ethical manner at all times; (2) Act for the benefit of clients; (3) Act with independence and objectivity; (4) Act with skill, competence, and diligence; (5) Communicate with clients in a timely and accurate manner; (6) Uphold the applicable rules governing capital markets. This, of course, is a voluntary code, not a regulation. There is also a distinct layer of oversight specific to asset managers’ funds, which again aims to ensure that conflicts of interest are avoided and clients’ best interests are upheld, while also bearing in mind the business interests of the fund’s manager, even if these interests should not supersede those of the client. Different fund governance structures have been referred to earlier. For example, in the UK OEICs (open-ended funds) and investment trusts (closedended funds) differ in the structure of their boards and the presence of independent directors. OEICs all choose to appoint an authorized corporate director, rather than individual directors. Since September 2019, at least one quarter of the ACD board is required to be made of independent directors. Investment trusts have a board of directors overseeing their activities, with a majority required to be independent of the investment manager. The latter is much more akin to what is found in the US, where mutual fund boards (under the Investment Company Act of 1940) are made up of a majority of independent directors. However, it is worth adding that a growing number of investment trust boards have been keen to demonstrate their independence and change the investment firm managing their funds, with 27 boards taking this action over the five years to mid-2021, around 10 per cent of the universe, according to figures from the Association of Investment Companies. Even

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with independent directors dominating US fund boards, such actions remain a rarity. In Europe, MiFID II’s product governance rules, which came into effect in 2018, are a useful sign of the way in which governance has become more prominent at asset managers as a result of regulations. These rules require fund providers to regularly review their products to assess whether they remain consistent with the needs of the users for whom the product is designed (known as the target market). Procedures must be in place to ensure conflicts of interest, including remuneration, are managed in relation to particular funds. Firms must also consider whether the fund’s charging structure is clear and appropriate for its clients.

Fiduciary duty Fund governance and the wider obligation to avoid conflicts of interest can be seen as crystallizing with a firm’s, or director’s, fiduciary duty. This is the obligation to act in shareholders’ best interests. This can be seen as a positive duty, an opportunity to take positive actions to help clients, but it also involves a negative obligation, namely to avoid acting in situations where there is a conflict between your own interests and those of your firm’s clients. However, this is worth exploring further as not all fund managers in Europe believe they have such an obligation, not least where commercial considerations are concerned, and legal experts in the industry also disagree on how, and in what ways, fiduciary duties apply. For example, one portfolio manager who works at a firm that manages more than £17 billion, told me that he does not have a fiduciary duty to his clients, but instead said his duty was to his company which, on a day-to-day basis, meant to his boss. It is worth noting that the company he works for is not a high charging business and offers a range of different investment products with varying fee levels. So the insights this manager provides are not fundamentally to do with the way that he in particular makes money, but shows both where some fund managers see where their duties lie, as well as how some interpret applicable rules and obligations. Another senior executive in the industry states that while a pension scheme has a legal fiduciary 158

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responsibility to its members, an asset manager does not have the same legal duty. Having said this, there remains a widespread acknowledgement of fiduciary responsibilities, as detailed in the codes of conduct referred to earlier. Jonathan Willcocks, then global head of distribution at M&G Investments, has said in an interview with me: “The fiduciary responsibility and the conflicts of interest policy means that we have to act in the best interests of our clients at all times. I wouldn’t have it any other way” (Moisson 2015b). And BlackRock’s public principles include one that states: “We are a fiduciary to our clients”. As noted earlier, the firm does not define how wide-ranging their view of fiduciary duty is, but states that “our clients’ interests come first”.2 Yet it is in defining the scope and limits of a fiduciary duty that this becomes thornier for asset managers. I would contend that most asset managers view their fiduciary duty in relation to the way they invest. The fact that their commercial interests have a direct impact on the returns their clients receive is treated separately. Attempts to turn the principle of a fiduciary duty into an obligation that includes a firm’s commercial interests have floundered in the UK over recent years. This can be illustrated with the salutary lesson from two city high-flyers who decided to test how far companies were willing to go to show their support for their clients. In 2012, Martin Wheatley, then head of the UK’s financial regulator, gave a speech in which he said he was “particularly interested in how asset managers respond to the idea of adopting a fiduciary duty to their investors, something that would offer an extra level of commitment beyond simply the letter of our rules”.3 Asset managers did not respond warmly to this suggestion at the time and the duty has never made its way into regulations. Wheatley was ultimately forced out of his job after George Osborne, then the Chancellor of the Exchequer, indicated he would not renew the regulatory boss’s contract in 2015. Wheatley’s readiness to stand up for consumer interests – he once said the regulator would “shoot first and ask questions later” – was not officially the reason for his being unceremoniously dumped, but 2. See https://www.blackrock.com/corporate/about-us/mission-and-principles. 3. FSA Asset Management Conference, 25 September 2012. https://www.actuarialpost. co.uk/article/martin-wheatley-speech:-my-vision-for-conduct-regulation-3507.htm.

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as this stance was often at the expense of asset managers and other financial institutions, many of these businesses heaved a sigh of relief when he left his job early. Some of these companies were willing to take more active steps to oust another senior industry figure with a similarly pro-consumer agenda at around the same time. Wheatley’s time at the regulator coincided with the leadership of Daniel Godfrey at the top of the UK asset management industry’s trade body, the Investment Association. Godfrey joined the trade body in 2012, not long after the FCA appointed its new boss, with a specific ambition to improve investor trust, partly in the wake of the financial crisis, by increasing transparency. But he was ultimately forced out when a number of asset managers decided the Investment Association (the IA) had overstretched its remit and was acting more like a regulator under his leadership. In particular, the IA introduced a statement of principles, akin to a code of conduct, aimed at setting out in clear terms what responsibilities asset managers had to their clients. Only 25 of around 200 members signed up to the principles, with Schroders, M&G, Fidelity, Aberdeen and Invesco among notable names absent from the list of signatories. Godfrey resigned after several of his organization’s member firms, including M&G and Schroders, then threatened to leave as a result of his pushing on with this pro-consumer agenda. Meanwhile the FCA has more recently sought to introduce a duty of care on asset managers, and other financial firms, although it has made clear that this is distinct from a fiduciary duty. In relation to commercial interests, it was telling that in a paper published in 2019 the FCA wrote that respondents in favour of a fiduciary duty said it would “create the necessary, explicit obligation to avoid conflicts of interest altogether” (FCA 2019). But those opposed to the idea said: “the concept of undivided loyalty to a customer is inconsistent with commercial enterprise”. After this initial phase of its work on customer duties it seemed the regulator had given up on the idea. However, it was revived with a new consultation paper in May 2021, titled “A New Consumer Duty”. This paper made it clear that the planned consumer duty “would not change the nature of a firm’s relationship with its customers. For example, it would not introduce a fiduciary duty”. Instead, the duty “would require firms to ask themselves what outcomes consumers should be able to expect from their products and services”. 160

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The FCA makes the somewhat surprising conclusion that “fiduciaries’ duties apply in much more limited circumstances than a duty of care. This makes it tempting to think of a fiduciary duty as being a stricter standard than a duty of care” (FCA 2018). There are others who would dispute this and contend that a fiduciary’s duty is more comprehensive, whereas a duty of care could be interpreted as ensuring the rules are obeyed and providing evidence for decisions related to this.4 For asset managers, as alluded to above, the real area of concern would be enshrining a fiduciary duty in law, or potentially a duty of care, that incorporates on commercial aspects. It seems unlikely that a duty of care, as so far outlined by the FCA, would extend this far. The FCA’s work in this area is ongoing (an updated consultation paper on the new consumer duty was published in December 2021), so asset managers will be monitoring its final form, although at the time of writing it seems that the FCA’s separate work requiring asset managers to assess the value their funds deliver to clients will require more detailed work. Assessments of value will be discussed in the next chapter.

4. With thanks to Mark St Giles of Cadogan Financial for his time in discussing these issues.

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To better understand how asset managers compete with one another, it is necessary to look at how firms sell funds and the development of new products. There are more than 4,580 fund management companies across Europe, although many of these manage tiny pools of money (EFAMA 2021a). This number fits with the industry narrative that there is intense competition and that a large number of firms are constantly vying with one another to show that their funds are better than others. However, taking Europe as a whole, many of these firms will not compete against one another. This is either because any given international firm is not necessarily active in every European market, or because a firm is a part of a larger group (such as a bank or insurer) and primarily provide funds to be used internally rather than competing with independent asset managers for a client’s business. Having said this, even when individual countries are singled out, the number of competitors is still large, with approximately 1,100 asset managers in the UK, 680 in France and 386 in Germany (EFAMA 2021a). In addition, there are 417 companies in Ireland and 268 in Luxembourg. And even if these latter two partly overlap with the lists for the three largest European fund markets, they still swell the numbers of competitors. These numbers also show that barriers to entry for establishing an asset management business in Europe are low. Getting a business off the ground has been made easier over recent years as service providers have made better use of technology, giving small investment management firms the ability to outsource more of their operations. The robustness of these small operations relying on large third-party providers was proven over the recent past as asset 163

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managers were forced to work from home through the pandemic. The regulatory burden in Europe has clearly increased over the past ten years, but this has not stopped the launch of fund management businesses, even if it has added to the cost burden, albeit for larger firms in particular. But establishing a firm is different from making it a successful business. The biggest challenge for a fund management company is to attract sufficient assets early on to keep the business going. Gaining seed investors is crucial for this process, not just for making the business viable, but also for attracting more clients. Of course, new clients will be attracted by a fund’s performance, although they are also likely to look at a portfolio manager’s track record at previous firms. Performance and sales go hand-in-hand for growing an asset management business, as larger fund buyers will normally only consider a fund once it reaches a certain size – often £100 million in assets under management. Professional fund buyers do this partly as they do not want to bear the risk of making up too large a proportion of a fund’s assets, and partly as they do not deem it worth investing client assets below a certain size. Getting a new firm up and running may be easier than before, but making it grow remains as hard as ever. While the numbers above show that Europe is awash with thousands of asset managers, other numbers reveal that far fewer firms have built their business to a significant scale. A firm with mutual fund assets of €10 billion would rank among the largest 200 in Europe, while reaching €20 billion would place a firm among the largest 100 firms, Morningstar data show. This is not to say that smaller firms are not viable, far from it, but these figures give an indication of the proportion of large firms that dominate the market: the largest 100 firms manage 85 per cent of European mutual fund assets. With so many firms and funds in the industry, competition is hard to escape. “As one investment manager said to me recently: ‘Every day is a competition’. Against your benchmark, against your peers and, very often, against your colleagues” (Armstrong 2021). But the competitive nature of the industry is not just a reflection of the sheer number of asset managers, or the culture in those companies, it is also a recognition of the importance of client inflows to increase assets under management – and the revenues that follow. While fund management companies are, not surprisingly, best known for their investing and their investors, these firms’ ability to sell is at least as important in driving overall growth in the European industry. It has grown 164

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from €5 trillion in assets under management to €15 trillion over the past 12 years since the financial crisis. Approximately half of this growth has come from inflows (more accurately, net inflows, i.e. also including client outflows over the period). Performance is crucial in growing fund businesses and is a key factor in a client’s decision to invest in a particular fund, as well as accounting for the other half of the industry’s growth over the past decade. But performance without recognition, without visibility among potential clients, without the ability to sell, is likely to result in an asset manager lagging the growth of rivals. Some firms are comfortable with such a situation and so do not feel the need to “chase” growth through sales, at least once their assets under management have reached a level to make the business viable. This feature of open-ended funds (mutual funds and ETFs) makes them more attractive from a commercial perspective to manage than closedended funds (investment trusts in the UK). Bernie Cornfeld realized this (see Chapter 5) more than 60 years ago, opting to use open-ended rather than closed-ended funds. As discussed earlier, the closed-ended structure means that assets under management do not increase when more clients invest, although if there is sufficient demand the fund can periodically issue new shares. Clearly this does not mean that selling of open-ended funds is the same as the abuses and excesses of Cornfeld’s IOS operation, but the commercial incentives and potential for conflicts of interest need to be managed by asset managers.

BOX 8.1  BLACKROCK: SALES MACHINE

Probably the best example of a firm that has boosted its asset growth through sales is BlackRock. The firm’s European funds business (including both mutual funds and ETFs, but excluding primarily institutional money market funds) has grown by more than €950 billion over the past ten years to the end of 2021 (Morningstar data). Over €560 billion of that growth has come from net inflows, 60 per cent of the total. The rest of the European funds industry has grown by €7.25 trillion over this period, equally split (50:50) between sales (net flows reflect the difference between inflows and outflows from clients) and performance (returns generated by funds). So BlackRock is becoming an ever more dominant player in the market not only by growing its larger pool

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Net flows

Markets and forex

3,500 3,000 2,500 2,000 1,500 1,000 500 0

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

a  Cumulative asset growth

1,200 1,000

Net flows

Markets and forex

800 600 400 200 0 (200) (400) (600)

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

b  Annual asset growth Figure 8.1  BlackRock’s growth since its acquisition of BGI ($bn) Source: BlackRock. Long-term products, excluding cash management. Markets reflect returns generated by funds and mandates.

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of assets through performance, but accentuating its growth through larger inflows. This has come at the same time as the firm’s ability to outgrow its rivals through superior fund performance has been reduced as its index-based funds have grown. Ten years ago, the firm’s European fund assets were split fairly evenly between active and passive funds. But that split has shifted decisively towards the latter over the intervening years, with passive funds now accounting for around three quarters of its assets. This does not mean the firm is struggling to grow its revenues. The firm’s global asset growth translates into faster growth in management fee revenues than the rest of the industry. BlackRock’s chief financial officer has trumpeted that its annual management fees grew by 5 percentage points more than the industry at large in 2021 (11 per cent compared to 6 per cent), a gap that is widening each year, according to the firm (Shedlin 2021). BlackRock’s own figures show how the firm’s sales globally across funds and institutional mandates have helped its overall growth. These figures start in 2009, when BlackRock acquired Barclays Global Investors, including its iShares ETF business. Figure 8.1 shows that net flows are a less significant factor than for the growth of the firm’s European mutual fund and ETF business. But the figures also show the reliability of client inflows compared to the much more variable effect of markets (returns generated by funds and mandates) and the impact of foreign exchange. Note particularly the years 2011, 2015 and 2018. The figures also reflect BlackRock’s uneven global footprint: approximately two-thirds of its assets relate to the Americas, one quarter to Europe and the Middle East, with less than 10 per cent from Asia Pacific (at the end of December 2021).

Fund buy lists The importance of performance in the sales process for asset managers should not be underestimated. Neither should its importance be underestimated in financial intermediaries’ fund selection process. Professional fund selectors use a range of quantitative and qualitative factors to determine the selection of individual funds, as discussed in Chapter 4. However, larger fund selection units, such as those supporting a bank, do not select funds in isolation but as part of a wider selection process to create a fund buy list. While the approach will vary from firm to firm, a team will likely have a list of preferred 167

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funds for a wide range of asset classes and investment strategies, such as US growth, European smaller companies, and emerging market local currency debt. Some of these asset classes might not be in favour at any given time, so a fund being on a firm’s buy list does not necessarily mean it will regularly see inflows. For any firm’s funds to feature on the list, the company will need to pass a separate due diligence process. While larger fund selection teams are generally keen to unearth smaller fund houses to include in their buy lists, partly to demonstrate their fund selection credentials, some smaller asset managers have complained that their size and limited offerings makes it more difficult to make it onto the buy list of larger fund selectors, partly to the lengthy due diligence process. The flipside to this is that larger asset managers are well-suited to the demands of large fund selectors, both on logistical aspects such as the due diligence process, as well as having a brand profile or reputation that can partially protect a fund if it does not demonstrate the very best performance. Taking this to one extreme, a very small number of the largest asset managers aim to offer a supermarket of funds, ranging across active and passive strategies, in order to meet any needs a selector might have. This scale also gives the largest asset managers the potential to swiftly develop new products that can be tailored to a particular (large) selector’s demands. With these aspects in mind, it is not inevitable that funds’ raw past performance will, in itself, drive flows over any given period. But analysis of quarterly fund flows in the UK (where independent financial advisers and wealth managers dominate distribution) suggests that funds’ one-year and three-year returns are a significant factor in determining which funds gain most net flows (aggregating client inflows and redemptions). This relationship between sales and performance weakens for five-year performance and deteriorates further for ten-year returns. Most money flows to those funds that have performed well over the recent past, seemingly flying in the face of regulatory warnings that “past performance is not a guide to future returns”. However, just as the industry’s assets are managed disproportionately by the largest firms, so flows do not spread evenly among funds with similar levels of performance. Along similar lines, the range of fund selection criteria mentioned above also play a significant role, with different selectors placing different emphasis on different criteria. As a result, good performance is often a prerequisite for selection, but not necessarily the determining factor (Moisson 2012). 168

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When considering an asset management business, it is sometimes easy to assume that fund performance and related factors are the primary determinants of what makes a fund a success, i.e. that its assets grow to a reasonable size and so have the potential to increase significantly over time. One cautionary note is worth adding, namely that many funds never reach a viable size to attract larger clients (who need a larger minimum fund size before investing their large pools of capital) and so their three-year performance figures may never be considered by potential clients. The majority of funds sold internationally across Europe never reach £50 million in assets, and most funds that reach this level do so within three years of their launch (i.e. before a longterm track record is established), according to Broadridge data. In addition, after three years it becomes rare for funds to then reach £50 million in size (Moisson 2015a). So a significant part of making a fund a commercial success lies outside the performance that it delivers. This can involve an asset managers’ parent company offering seed capital to launch the fund, and so encourage other larger investors early on. Or it can involve getting external clients on board at the time of a fund’s launch. This is most likely when the portfolio manager of the new fund has his/her own track record outside the new product, and so it is not viewed as a new fund. For example, when a portfolio manager moves company and sets up a fund with a similar investment strategy at his/her new employer, drawing clients to switch from their old firm to the new one. Neil Woodford’s move from Invesco to his eponymous firm is perhaps the bestknown example of this, although Richard Buxton’s move from Schroders to Old Mutual is among countless others. Product development and the industry’s approach to launching new funds will be examined later in this chapter.

Institutional clients The relative size of funds’ and mandates’ total assets vary between countries, as shown in Figure 8.2. This gives an indication of the relative size of institutional and retail/wholesale client assets around Europe as mutual funds are often seen as investment products used by retail clients, while institutions use mandates. However, in reality, there is not a clean divide between the two. 169

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7,000 6,000

Funds

Mandates

5,000 4,000 3,000 2,000 1,000 -

Figure 8.2  Size of European markets

Source: EFAMA, Asset Management in Europe, December 2021.

Institutional clients readily use funds to access certain investment strategies or because of a particular fund legal structure, such as Germany’s spezialfonds, which are funds dedicated to institutional clients, or France’s money market funds, which are used extensively by corporations for cash management purposes. EFAMA’s data also breaks down overall industry assets by client type, split between institutional clients (primarily pension funds and insurers but also charities and large companies) and retail clients (ranging from the smallest household savers to high-net-worth individuals). Institutional clients account for 72 per cent of total industry assets across mandates and funds. On the basis that the vast majority of mandates are used by institutional clients (a small number of UK wealth managers use mandates, and they are also used for some retail clients in Spain), one can estimate that institutions account for 54 per cent of European fund assets. Asset managers’ largest institutional clients are pensions and insurance companies. While figures vary on the exact proportion of assets that these two channels account for, their dominance is clear and account for somewhere between two-thirds and three-quarters of institutional assets over recent years. Pension funds here are defined benefit (DB) schemes, whereby 170

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the employer (private or public) manages a scheme’s assets in order to pay retired employees an income based on their length of service and salary. These schemes are generally being phased out and shifting responsibility onto employees by using defined contribution (DC) pension schemes, whereby employees decide how much to save from their salary and which funds to invest in through their employer’s scheme. Insurance company assets are those classified as the general account, which contains investments of an insurance company available to pay claims and benefits to which policyholders are entitled, including so-called with-profits policies, endowment policies and whole life insurance. The investment strategy in the general account is determined by the insurer and its investment return is a direct source of profit for the insurer. Analysis by Broadridge (calculated on a different basis to EFAMA’s figures above and so the two cannot be compared directly) suggests that insurers’ general accounts and pension schemes together managed more than $10 trillion of assets in 2020 across funds and mandates. However, this does not mean that all of these assets are available to be managed by external fund managers. Just 12 per cent of insurance assets are managed by external asset managers, totalling $1.27 trillion, with the vast majority managed by insurers’ in-house investment teams. Pension schemes are a much larger potential pool of clients for independent asset managers, with 59 per cent of assets outsourced to external managers, totalling $6.37 trillion (see Figure 8.3). Official institutions account for a large pool of institutional assets if the Middle East is included within an asset manager’s European business (many firms cluster these countries together as Europe, the Middle East and Africa, or EMEA). This group covers sovereign wealth funds (state-owned funds that manage money generated by governments) as well as central banks and finance ministries. In Europe the largest sovereign fund is the £1 trillion Norway Government Pension Fund Global, although this is largely managed by Norges Bank Investment Management, so is smaller as a potential client for other asset managers. Russia and Turkey also have sovereign wealth funds. If the Middle East is included, then the channel accounts for $5.8 trillion of assets across EMEA, of which almost $3 trillion is outsourced to external fund managers, according to analysis by Broadridge. The largest official institutions in the Middle East include the Abu Dhabi Investment Authority, the Kuwait Investment Authority and Saudi Arabia’s Public Investment Fund, which is 171

THE ECONOMICS OF FUND MANAGEMENT 3,000 2,500

In-house

Third party

In-house

Third party

2,000 1,500 1,000 500 -

A  Insurance assets 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 -

B  Pension assets Figure 8.3  European insurance and pension assets ($bn) Source: Broadridge Financial Solutions.

chaired by the Saudi crown prince and best known in the UK for recently becoming the joint owner of Newcastle United Football Club. Charities of various types form a significant minority of institutional investors in some markets, which includes endowments, foundations and other not-for-profit organizations. These groups invest to provide long-term 172

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support for their charitable causes. Some charities and religious organizations have created their own fund management businesses to manage their assets, which have often been trailblazers when it comes to ethical, socially responsible and environmentally conscious investing. Such investing principles have largely been overshadowed by larger firms that were more purely focused on financial returns in the past, but tackling ESG considerations has clearly come into the spotlight now (see Chapter 6). In the UK, these firms include CCLA, which manages investments for charities, religious organizations and the public sector and is owned by these clients. Epworth Investment Management only manages money for churches and charities and is owned by the Methodist Church. Meanwhile EdenTree Investment Management is ultimately owned by Benefact Trust, one of the UK’s largest grant-making charities, whose mission is to “make a positive difference to people’s lives by funding, guiding and celebrating the work of churches and Christian charities”.1 Investment consultants do not technically constitute an asset management client, although their influence is such that many firms will treat them this way. Consultants advise institutional investors, including pension schemes’ trustees, on how to invest, with their role ranging from strategic investment advice and assistance on asset allocation to specific guidance on fund manager selection. The world’s largest investments consultants are Mercer (with $15 trillion of advised assets), Aon ($3.5 trillion) and Willis Towers Watson ($2.6 trillion),2 while other firms such as Russell Investments and Cambridge Associates are also prominent in the field. In the UK, the same three global behemoths are the dominant investment consultants and together account for roughly half of the market. Annual revenues for these three firms totalled £486.5 million (Willis Towers Watson), £446 million (Mercer), and £286.1 million (Aon) in 2020. This was well above a following group of four consultants, each with revenues close to £100 million (Lane Clark & Peacock, XPS Pensions, Barnett Waddingham, Hymans Robertson) (Stapleton 2021). A longer tail of smaller consultants follows behind these.

1. See https://benefacttrust.co.uk/about-us/. 2. As at 30 June 2019. See Pensions & Investments, “The largest investment consultants ranked by total worldwide advisory assets”, 25 November 2019.

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Either internally or with the advice and assistance of consultants, institutional investors and fund managers must agree on the terms of a mandate, including aspects such as the investment policy and objectives, risk and return expectations, investment restrictions, fees and related terms, the client’s reporting requirements and ongoing service needs. The client (as with a wholesale client) will then monitor the success of the fund manager in delivering on these terms, and here investment consultants may also be employed. While this is presented as an agreement for establishing an investment mandate, a growing number of institutional investors use funds, with national regulators having established legal structures that are intended to be better suited to institutions, notably in relation to tax efficiency, such as the UK’s Authorized Contractual Scheme or Ireland’s Common Contractual Fund. Funds may be more suitable for smaller institutional investors as the pooling of assets with other investors creates scale, and so should reduce costs, which these investors might not be able to achieve if they invest alone. Scale is also relevant for smaller institutional investors from an operational perspective as establishing a mandate requires establishing direct relationships with not only the investment manager but also related service providers, such as the custodian – aspects that are built into a mutual fund.

Retail and wholesale clients The distinction between institutional and retail clients is not always clear-cut and asset managers view some client types differently from one another. This is particularly the case when referring to retail, as throughout this book, this also includes clients that are commonly referred to as wholesale. This reflects the fact that end-retail clients, including high-net-worth individuals, primarily invest in mutual funds via an intermediary. It is these intermediaries that are asset managers’ main non-institutional clients. By contrast, direct sales to retail clients (i.e. the man/woman in the street) make up a small fraction of fund companies’ overall business. The first group of clients that is generally considered to be wholesale (but which some consider institutional) is asset managers. This is primarily via 174

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firms’ funds of funds, in other words funds investing primarily into other funds. Funds of funds is one client type that is relatively easy to identify and estimate its size as the data is reported, as with other mutual funds, to external researchers and data providers. According to Morningstar data, at the end of December 2021 European funds of funds managed assets of more than €1.1 trillion. The vast majority of these funds invest into funds managed by other asset managers (sometimes known as unfettered funds of funds), although this does not prevent them from investing a portion of their assets in funds managed by fund managers within their own firm. A shrinking proportion of funds of funds only invest internally (so-called “fettered” funds of funds), which account for less than 15 per cent of funds of funds’ assets overall. Investing in other funds, rather than directly in securities or other assets, is not only done by funds of funds. Other funds sometimes choose to take an investment position by investing in a fund rather than an individual stock, for example, gaining exposure to the broad US equity market if the fund manager thinks this will rise by holding an S&P 500 ETF. ETFs have found this to be fertile ground for sales, with their high degree of liquidity offering fund managers a useful means to take short-term tactical positions in this way. Family offices are sometimes viewed as institutional clients. With some family offices overseeing multi-billion-pound pools of assets, this is perhaps understandable. However, within the broad term of family office there are a wide variety of different structures. An indication of this diversity is reflected in the fact that there are both single-family offices and multi-family offices. The former is a private organization set up to oversee the financial affairs of one family. Single family offices are sometimes created in reverse, for example, with a hedge fund manager deciding to no longer manage external clients and instead focus on his/her family’s wealth. Multi-family offices, as the name suggests, serve multiple families, perhaps by broadening over time to advise other wealthy families. In these cases, a multi-family office can approximate a private bank. Stonehage Fleming, which oversees more than $55 billion, is arguably Europe’s largest multi-family office. Stonehage was established in London in 1976 by a group of wealthy South African families. In 2015 it merged with Fleming Family & Partners, which was originally established to manage the family’s money in 1873. Family offices vary in the range of activities they undertake, which may include household organization, legal, tax and succession planning, as well as philanthropy. Therefore, investments are just 175

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one part of this, and funds may form only a small part of these. In particular, family offices’ long-term, multi-generational perspective means that less liquid investments, such as real estate and private assets, are far more commonly held than investors in general. Pension schemes can behave more like a wholesale client than an institutional one, depending on the type of scheme. Institutional assets described above primarily reflect investments through DB pension schemes. But defined contribution (DC) schemes are a different type of workplace pension. Here an employee’s contributions and their employer’s contributions are invested together by the employee in a fund or range of funds offered by the employer’s pension scheme provider. So the employer selects the range of funds on offer, but it does not invest in particular funds directly. Although the employer gets closer to this when it selects which fund, or combination of funds, are deemed to be the default investment for employees, i.e. the fund in which employees invest if they do not opt to select their own. Generally, most DC assets are invested in default funds. A similar situation applies to insurance companies. Insurers as institutional investors reflects the management of their general account assets, which is often done internally, as noted above. Insurers also offer unit-linked funds, or unit-linked insurance plans, which combine insurance and investments in one product for the insurer’s clients. Unit-linked products often invest directly into, or wrap, a single mutual fund, which in turn can be managed by an external asset manager. This approach makes insurers a particularly significant retail distribution channel in the UK in particular, with firms including Scottish Widows (part of Lloyds Bank), Aviva, Legal & General, Prudential (part of M&G), and Standard Life (which merged with Aberdeen Asset Management in 2017, but now part of Phoenix Group). Accurately estimating the size of retail channels is not easily done, but the best estimates suggest that retail banks are Europe’s largest distribution channel, including in Germany, Italy and Spain (see Figure 8.4). Offering funds to their customers is just one of a range of services, including current accounts, mortgages and personal loans. They are dominated by high street brands that are well-known in each country. In Italy these include Intesa Sanpaolo (owner of Eurizon Asset Management) and Unicredit (which sold Pioneer, its fund management unit, to Amundi in 2017, and with whom it now has a strategic partnership). In Spain the largest banks include Santander, BBVA and 176

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CaixaBank, each with its own asset management business. Deutsche Bank (owner of DWS) and DZ Bank, together with its network of cooperative banks and owner of Union Investment, dominate in Germany. In each of these three markets, retail banks are the largest distributor of mutual funds and often use their internally managed products to sell to their customers. In this way, funds are often sold to banking customers, rather than being proactively bought by them. Private banks cater to high-net-worth individuals by providing a more personalized service as well as including aspects such as tax planning. There is not a particularly clear distinction between wealth managers and private banks, and Broadridge’s analysis includes discretionary investment managers (firms that can make investment decisions on behalf of their clients) together with private banks. Swiss-headquartered private banks, including UBS and Credit Suisse, are the country’s largest distribution channel largely as a result of attracting an international client base through their global offices. It is worth adding that Swiss private banks have changed considerably from the days when Steve McQueen’s title character in the 1968 film The Thomas Crown Affair could hide his ill-gotten gains in Geneva. As noted above, funds of funds can be identified separately as a distribution channel. Within the broader picture of fund distribution across Europe, however, these products are generally distributed through proprietary channels, such as a retail bank selling to its customers. So France’s large funds of funds industry partly reflects the importance of its large banks, including BPCE (owner of Natixis Investment Managers), BNP Paribas (owner of its eponymous asset manager) and Crédit Agricole (owner of Amundi), selling funds to their retail customers. Taking these three channels together (retail banks, private banks and funds of funds), the dominance of banks in distributing funds across Europe is clear (see Figure 8.4). The UK stands apart from other large fund markets in Europe because, as we’ve discussed earlier, here the largest distribution channel is independent financial advisers, while retail banks are estimated to account for a relatively small proportion of total fund assets. Large financial advisory firms include Hargreaves Lansdown, Openwork Partnership, Quilter, St James’s Place and Tilney. While the importance of IFAs as a distribution channel have grown since the introduction of the Retail Distribution Review (RDR) at the end of 2012, the way IFAs select funds for their clients has changed significantly. 177

THE ECONOMICS OF FUND MANAGEMENT 6 France 5

Germany

4

Italy Spain

3

Switzerland

2

UK 1 0

Retail bank Private bank

Funds of funds

Insurance IFA-advised

Direct

Figure 8.4  Retail distribution channels Source: Broadridge, Fund Radar report, 2019.

Note: 1= smallest channel, 6 = largest channel.

In order to manage their businesses’ costs more effectively, and with commissions no longer built into the funds they sell, many IFAs have chosen to focus on financial planning and to outsource the selection of investments for clients, notably funds. This also moves that aspect of business risk to the third-party fund selector. Discretionary investment managers (referred to above) and firms offering model portfolios have grown as a result. Model portfolios are pre-constructed lists of funds with a specific investment objective or risk profile. They are not structured as a fund of funds, but offered on an investment platform from where the client, or their adviser, can invest in the selected funds and then adjust these investments over time. This shift to outsourcing has meant that the number of firms with the real power in making fund selection decisions has shrunk over the past decade as a result. For context, it is useful to compare the importance of different distribution channels with the US, although the patchwork nature of fund distribution across European markets does not make this straightforward. In the US, banks vie to be the largest channel with broker-dealers, which are firms that trade securities on behalf of clients, as well as for themselves. The latter 178

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accounts for 28 per cent of industry fund assets, while the former manages 26 per cent of the total, according to Broadridge data at the end of March 2021.3 The three other main retail channels are of similar sizes and encompass financial advisers (16 per cent), wirehouses (15 per cent) and online services (14 per cent). The first of these include registered investment advisors (RIAs) and independent financial advisers, so are not tied to selling the funds of any one firm. By contrast, wirehouses, which are otherwise similar to broker-dealers, sell funds run by the asset management arm of their parent companies. This channel encompasses four of the largest wealth management firms in the US, namely Morgan Stanley, Bank of America Merrill Lynch, UBS, and Wells Fargo (although the last of these sold its asset management business to private equity firms GTCR and Reverence Capital Partners in 2021). The smallest, albeit fast-growing channel in the US is online, which includes robo-advisers (see below). Online services include the likes of Charles Schwab, which manages more than 32 million accounts.

Direct-to-consumer Figure 8.4 shows that retail customers investing directly with asset managers, or via online investment platforms, account for the smallest share of European fund assets. This D2C segment is slightly larger in the UK, where until well into the 1990s asset managers had significant assets from direct clients, often investing by filling in coupons found in newspapers or personal finance magazines that accompanied advertisements. Many of the longer established asset managers in the UK still have sizeable legacy businesses based on clients that invested decades ago. So for these firms, sorting out how to effectively manage their direct retail clients is essential, even if they decide to sell these client assets to rival firms that are willing to bear the additional costs of servicing smaller clients directly. For example, Fidelity International acquired Legal & General Investment Management’s personal investing business, including

3. Banks operating their own broker-dealers are included in the latter category in Broadridge’s data.

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300,000 customers, in 2020.4 Other asset managers are ramping up their efforts to better serve these clients with their own online services. For example, Columbia Threadneedle offers mythreadneedle.com. Itself the result of a merger between US (Columbia) and UK (Threadneedle) companies, the latter was originally set up in 1994 from the merger of the fund management divisions of two insurers, Allied Dunbar and Eagle Star. Hargreaves Lansdown offers the UK’s largest fund platform with 1.6 million customers5 and its brand rivals other online investment services, but many other fund platforms have struggled to raise their profile sufficiently to attract clients. These platforms also have to compete with a new wave of online investment and trading services (such as Trading212 and eToro) that sometimes do not offer funds at all, or which focus on the high-risk world of cryptocurrencies (such as Coinbase and Binance). Digital wealth managers, or robo-advisers, compete in the same arena, typically offering a form of simplified, or guided, investment advice to customers in order to select from a range of investment portfolios, often made up of a selection of low-cost ETFs. Robos in the UK include Nutmeg, Moneybox, Wealthify and MoneyFarm. The last of these was set up in Italy, indicating that robo-advisers have tried to find clients across Europe, with assets also growing in Germany, Switzerland and particularly the Netherlands. However, European robos’ assets are a small fraction of those built up in the US (noted above), where both Betterment and Wealthfront have more than $20 billion in assets (Rosenbaum 2022). D2C platforms, including robo-advisers, are distinct business-to-business (B2B) platforms, with the latter used by intermediaries to administer the funds they use for clients (see Chapter 3’s section “Linking up the value chain”), although some firms offer services for both groups of clients (e.g. Fidelity offers both Personal Investing and Adviser Solutions platforms in the UK).

4. Legal & General press release, “L&G announces sale of a back-book of retail investment products to Fidelity International”, 26 October 2020. 5. See https://www.hl.co.uk/about-us.

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Launching new funds Many investment managers remain focused on running a small number of funds and grow their business on the back of the success of these investment strategies. Smaller firms’ tendency to limit the range of products they manage feeds into the perception that boutiques are more focused in their approach to investing. Having said this, the size of a firm’s assets under management is not the same as having a large product range, although it is relatively rare for firms to build a business with a limited number of funds (France’s Carmignac, Germany’s Flossbach von Storch and the UK’s Fundsmith are perhaps exceptions to prove this rule). To grab the attention of the various intermediaries outlined above, larger firms, which make up most of the industry’s assets, have a significant focus on growing their business by expanding their product range. And at the very largest end of the spectrum, some firms adopt a supermarket-style approach to product development and try to offer clients every conceivable fund, with fund giants such as BlackRock and Amundi the best examples of this approach (see also previous section on “Boutiques vs behemoths” in Chapter 3). This leaves a middle ground, which is commonly seen as being squeezed, as noted earlier in this book. However flawed that perception might be, it is based on an accurate view that there is significant pressure on firms to get the development of new products right. Figures from data provider Refinitiv Lipper, part of the London Stock Exchange Group, give an indication of the scale of product development activity across Europe. In the 2000s the funds industry launched more than 2,500 products each year on average, with closures and mergers resulting in a net increase of around 1,000 funds every year. To be clear, these new launches were not just products replacing those that are not performing well or not selling, but more than half were additions to the overall universe. The financial crisis of 2008 had a significant impact on product development. Initially the crisis prompted firms to try and reduce costs by rationalizing their fund ranges with more closures and, a few years later, a slowdown in the number of launches too. As a result, there was a net decrease in the number of mutual funds and ETFs between 2011 and 2017. However, the industry’s instincts could not be kept in check indefinitely and there has been a small increase in fund numbers over recent years. But looking back over the past 181

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20 years shows that product development departments have been kept busy with some 51,438 mutual fund launches and 46,519 closures and mergers (see Figure 8.5). Particularly over the past five years, these figures suggest there is certainly a degree of money being recycled and moving out of old funds and into new products with the net change in fund numbers closer to zero than over any prior period. Overall, the net increase in fund numbers has nudged up over recent years. A reduction in fund numbers of 556 in 2016 has been followed by a small reduction of 97 in 2017, an increase of 71 in 2018 and, most recently, a net increase in 209 in 2021. Just how frenetic an approach to fund launches firms take varies significantly between asset managers or countries. Asset managers that are part of larger financial groups (notably banks) and in countries where those institutions dominate fund distribution (such as France, Germany, Italy and Spain) are most prone to regularly launch products and it is into these new products that client assets are most commonly funnelled. By contrast, in the UK (where independent financial advisers and wealth managers are more important for Launches

4,000

Closures

Net Change

3,000 2,000 1,000 0 -1,000 -2,000 -3,000 -4,000

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

Figure 8.5  European fund launches and closures Source: Refinitiv Lipper.

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firms selling funds to retail clients) and for funds sold internationally by independent asset managers, then a performance track record is much more likely to attract inflows rather than new fund launches. When widening the focus to the world, in Asian markets where banks dominate distribution, then the sales pattern is similar to bank-dominated European markets. In the US, where bank-led distribution is a smaller channel, then the preference is for existing rather than new funds – although the ongoing shift from active to passive funds overrides many other fund sales trends there. The overall growth in the number of funds in Europe, which results from new launches outweighing closures, is in addition to an already bloated industry with more than 30,000 UCITS funds and almost as many AIFs.6 Why are firms so keen to bring new products to the market? Salespeople generally want a story to tell. Fund salespeople are no different, especially when selling directly to retail investors, such as a bank’s customers. Being able to tell a new story that chimes with current investor concerns or with sectors of the economy that are hot or growing is like gold dust. This gives a fund salesperson a foot in the door with a prospective client as well as a reason to get in touch with existing clients. New funds do not have mediocre or poor past performance to explain away. Instead the past performance created in research and tested within a firm is almost invariably good. And why wouldn’t it be? It shows why the fund is being launched.

Fads and fashions What happens when a previously successful investment trend fades? Or when more and more firms try and capitalize on the latest investment fashion? The technology boom and bust at the turn of the century offers a salutary lesson. One person’s opportunity to pile in is another person’s fear of a pile up. Some 245 technology funds were launched in Europe between 1997 and 2001, with half of these being launched in 2000 alone, according to data from Morningstar. Since the dot-com bubble burst in 2001, most of those funds have been closed. Just as with the stock market bubble itself, fund investors 6. EFAMA, quarterly statistical release, March 2021.

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moved in at the wrong time and then lost out as markets dropped. And it was investors rather than asset managers who really lost out: fund management fees are paid regardless of whether an investment is sensible or not. The question has to be asked as to why so many of these funds were launched in the first place. Quite simply, there was demand, or expected demand. If asset managers think they spot possible demand, they don’t hold back. So with new technologies on the rise again, a new wave of technology funds are being brought to the market. Firms have launched over 150 new tech funds between 2018 and 2021 (see Figure 8.6). Asset managers say this time it’s different, however, with the funds focused on new sectors, such as fintech, cyber security and sustainable technology. Arguably, this is where an asset manager’s fiduciary responsibility kicks in. Is encouraging retail customers to invest their money in a collection of the current hot stocks really in their best interests? And this need not look overtly reckless: setting up a well-managed mutual fund is not the same as suggesting an investor take a punt on a technology stock, be it Globix in 2000 or Zoom in 2020. 120 100 80 60 40

0

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

20

Figure 8.6  Number of technology funds launched in Europe Source: Morningstar.

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In creating a fund, an asset manager should be convinced that a theme makes sense as a robust investable theme, and not just as a broad economic development. For example, Barings Agriculture fund was launched in 2009. The importance of the theme was backed by the chief investment officer and other funds at the firm invested in the product, boosting its assets. The fund grew from £50 million when it launched to reach £250 million within four years. But its performance and interest peaked soon after it reached those heights and its assets under management steadily declined. It has slowly slipped to £60 million in assets with no sign of significant new inflows as its performance is mediocre. An underlying theme may be sound – companies that will benefit from the rising global population in Barings’ case – but that doesn’t mean that it is investable as a fund that has a reasonable potential to out-perform its benchmark index over the medium term. Yet firms keep launching new funds. Those that don’t build sufficient assets or where the performance isn’t good enough to attract customers are shut down or merged into new products. As a result, many firms stand accused of simply trying to catch fund fads and of launching so-called “me too” funds, offering their own versions of successful funds. A classic example of this was Standard Life Investments’ Global Absolute Return Strategies fund (now part of abrdn). Using a wide range of complex investments, including derivatives, the strategy aimed to deliver positive, absolute returns (rather than returns relative to a market index). The two mutual funds with the strategy appeared unstoppable and reached £38.6 billion in assets by the end of 2015. So popular was the strategy that members of the team were lured to other firms. Invesco launched its Global Targeted Returns strategies in 2013 and Aviva Investors launched its Multi-Strategy Target Return strategies a year later. Both initially fared well and peeled away some of Standard Life’s clients, reaching £18.4 billion and £9.2 billion in assets respectively by 2018. But delivering ongoing positive returns proved increasingly difficult for all three firms and as performance slipped away, so did the funds’ clients. By the end of 2021 the funds were managing a combined £10 billion with no sign that this would be turned around.7 A notable side-effect of the proliferation of funds in the industry is the disproportionately large number of small funds. There are 8,000 mutual funds 7. Fund data in this paragraph sourced from Morningstar.

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with less than €20 million in assets and a further 5,000 with less than €50 million. Together these small funds make up more than 40 per cent of the funds in Europe, but only 2 per cent of industry assets.8 On the face of it, this is a problem for the firms managing these funds, having to bear significant costs for little revenues. There are many, typically larger, firms that are effective at capping charges on smaller funds, so that costs borne by investors do not rise unchecked. But many European funds pass on additional costs to a fund’s investors, such as those for the services of an administrator, custodian or auditor. So while the asset manager may indeed receive low revenues from smaller funds, they can often avoid bearing higher costs. And the end-investor (normally a retail investor) can be hit particularly hard with many small funds charging more than 2 per cent a year, increased by some back-office costs being charged as absolute amounts, rather than as a percentage. So a £20,000 charge on a fund with £10 million of assets equates to a hit of 0.20 per cent on investors’ returns, which has a cumulative effect over time. The equivalent charge on a £100 million fund would be just 0.02 per cent. Consumer campaign groups have, not surprisingly, been quick to criticize regulators and firms for not taking action on this issue and noting the “illusion of competition” that allows such a situation to occur. For now, the situation encourages firms to keep many small funds alive and hope that, in time, they will grow.

8. Based on 31,000 mutual funds and ETFs with assets data available to Morningstar.

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With so many funds available, and new launches coming to market so regularly, one might expect intense price competition among funds in the UK and Europe. But the European fund management industry is different. Cutting fees to attract clients is barely, if ever, used by active fund managers. For most firms, to take this approach would be to tacitly admit that their performance, or expected future performance, is not as good as their rivals. Regardless of the reality, the possibility that this could be suggested is enough to stop most active firms from taking this step. Index-tracking funds, on the other hand, do compete on price, which in turn puts competitive pressure on active asset managers to demonstrate that it is worth paying more for potentially higher returns. Trying to unpick the reasons for the limits of price competition in the industry touches on both the way fee structures are determined for active funds and the way funds are distributed in Europe.

How funds ignore the law of demand As we briefly discussed in Chapter 1, the law of demand suggests that the higher the price of a product, the less will be demanded, all 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. The ways in which the funds industry does not abide by this law are explored below.

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Firstly, funds do not have a price tag that is distinct from a client’s investment. Clients’ investments in a fund are collectively used to pay for the costs the fund incurs. A fund pays these costs, such as those for its management, from its assets on a daily basis. These costs are then presented as an annualized percentage charge to investors. For example, if a fund manager’s investments generate an annual return of 7 per cent over one year and the fund incurs costs equivalent to 1 per cent of its assets over that year, then the fund’s investors receive a return of 6 per cent over the year (7 per cent less the 1 per cent costs). So a fund’s charge reduces the return it generates by that amount every year. For those in the industry, it seems straightforward that charges are paid out of the money invested in a fund on an ongoing basis, but this is far from clear to many retail investors. Research carried out by NMG Consulting found that only 49 per cent of UK consumers thought they paid charges for the fund in which they were invested (FCA 2016). The rest said no (29 per cent) or were not sure (22 per cent). It can reasonably be assumed that the cost of investing for many retail investors is the total sum of money they invest in a fund. This lack of understanding must inevitably play into the weight that retail investors place on a fund’s charges when choosing which product to invest in. With this backdrop it seems unlikely that retail investors in Europe are placing little, if any, downward pressure on levels of fund charges. It shouldn’t be overlooked that the European funds industry is an intermediated market. Be it through IFAs in the UK, private banks in Switzerland, or high street banks in Spain, as discussed earlier, the vast majority of retail investors do not invest directly with fund companies. As a result, it is these intermediaries that have the potential to influence fee levels. In large part cost sensitivity has shaped the industry by encouraging the growth of lower charging passive funds, rather than significantly lowering the fees of active funds, however. This is made more complicated by the fact that intermediaries, to varying degrees, receive commission (known as retrocessions or trail commission) that is part of the annual charges borne by a fund. This practice was largely banned in the UK under rules brought in by the Retail Distribution Review (RDR) at the end of 2012, with similar rules also applying in the Netherlands. MiFID II applied a looser version of these restrictions to the rest of Europe, with only independent financial intermediaries banned from accepting so-called inducements. With much of European fund 188

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distribution dominated by non-independent intermediaries, the impact of MiFID II on stopping retrocessions has been limited. In this way, regulation has been shown to have a potentially significant impact on asset managers’ revenues and for influencing which types of funds are favoured. Returning to the law of demand, it is worth picking up on the phrase “all other things being equal”. Active fund managers would contend that it is rare for this to be the case. They compete on attributes other than price, most obviously past performance and potential future performance, upsetting the dynamics at work in this economic law. Fund managers bring products to the market that, in limited circumstances, have no competitors, or the products are presented as though there are no genuine competitors. Either because a rival fund with a similar strategy is launched, or because a firm’s fund is launched precisely to rival an existing strategy, then the funds are typically compared on their quality – how well they are managed. This might include the experience of the portfolio manager, the size of the supporting research team, or the ability to demonstrate a repeatable investment process. For fund managers, it is only when two funds of comparable quality are compared that other factors might come into play, such as client support or, possibly, price. There may be exceptions to this, such as if a fund selector is developing a broader relationship with an asset manager and wants to use a range of the firm’s funds, in what asset managers’ sales teams refer to as a “long-term partnership”, one of the holy grails of fund distribution. The law of demand is also less applicable to asset management in that, ultimately, firms sell a service rather than a good or commodity. And even if this service is, as we’ve seen, wrapped in a product (a mutual fund) there is certainly no sign of a limit to its supply. Some argue that funds are indeed commodities, but this tends to be as part of an argument against the value actively managed funds claim to provide (instead valuing low-cost passive funds more highly). Besides, many funds have been able to attract significant assets from clients almost regardless of their (high) fee levels if they have a performance record that seems to set them apart from their peers (even if this advantage is only temporary). Furthermore, many active fund managers argue that their fees are justified as a result of the performance and quality of service provided, while others go further and suggest clients have to “pay more to get more” (setting fee levels will be discussed in more depth below).

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Famed “bond king” Bill Gross, founder of PIMCO, once discussed investors willingness to pay for an expectation of future performance, saying: “We sell hope, but very few are able to seal the deal with performance anywhere close to compensating for the generous fees we command. Hope has a legitimate price, of course, even if its promises are never fulfilled” (Gross 2009). Where the industry gets closer to selling goods or commodities is with passive funds that try to track market indexes as closely as possible. Charges are lower in these funds both as a result of lower costs involved in their running and also because of the fund manager’s desire to minimize tracking difference (the difference in the performance of the fund from that of the index it tracks). Passive funds’ charges are also lower by their not paying retrocessions to intermediaries. This has meant that in some countries intermediaries were reluctant or unwilling to offer these funds to their clients. Regulations such as RDR in the UK and, to a lesser extent, MiFID II in the EU have opened up the possibility of intermediated clients being advised to buy passive funds and further boosted demand. Coupled to this, research findings showing active managers’ inability (in aggregate) to outperform market indexes have become more widespread. Figure 9.1 shows the extent to which attitudes to passive funds have changed over the past ten years in different countries (fund domiciles) both across all funds in each country and separately for equity funds, where most price competition has been focused. The UK is separated from the rest of Europe to highlight the extent to which the changes brought in by RDR have had a particular impact (here the 2010 figures are largely the same as in 2013, when the regulatory changes began to come into effect). The figure shows that the proportion of assets invested in passive funds in the UK has overtaken the rest of Europe during this period. The US is included as a comparison. This is a market where cost sensitivity, encouraged by the regulator, has been a prominent feature of the funds landscape for much longer than in Europe. Crucially this awareness has been accompanied by US retirement savings schemes (known as 401k plans) that enable retail investors to feed money regularly into mutual funds or ETFs. In addition, distribution channels are more similar to the UK than continental Europe, with accompanying availability of intermediaries charging separate fees rather than retrocessions, thus enabling greater use of passive funds.

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60% Dec 2010

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Figure 9.1  Passive proportion of fund assets Source: Morningstar.

Here it is worth recognizing the use of one-off initial charges. These charges were explained in Chapter 3 in relation to the asset management value chain. If applied, these charges are clearly relevant to an investor, but they are levied to pay a financial intermediary rather than the asset manager, so are less directly relevant for the latter’s revenues. Initial charges are still commonly used across the EU through various distribution channels, although in the UK use of these charges linked to funds has been dramatically reduced following the arrival of the RDR reforms (although an individual financial adviser may separately choose to charge an initial fee to their client).

Fee trends The limited price competition in the industry does not mean that average fee levels are not falling. Research from the Investment Company Institute, a trade body for asset managers, shows that annual ongoing charges for all UCITS equity funds fell from 1.49 to 1.24 per cent between 2013 and 2020 191

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(ICI 2021b). The figures are asset-weighted averages, giving more weight to the fees of funds with larger assets, reflecting where most client money is invested. There are several factors at work in pushing down this average. The first is the increased range and use of different share classes with different fee levels, largely the result of regulatory changes. Both RDR and MiFID II have required and/or encouraged asset managers to offer share classes stripped of retrocession payments and so offering lower annual charges. In the UK, some of these classes were previously restricted to institutional clients and so were repurposed following RDR, with significant assets shifting to these classes as a result. Elsewhere new classes have been launched to meet demand from intermediaries that charge their clients separately for their services, rather than through retrocessions. Also, as referred to earlier on, institutional investors’ use of mutual funds, rather than segregated accounts, has increased over the past decade, increasing assets in share classes reserved for these clients with accompanying lower charges. To clarify, the ICI’s research includes all share class types, covering those with and without retrocessions, as well as institutional classes. The changes described above have altered the industry landscape, although the figures do not fully reflect the impact on end-clients as the figures reflect charges levied by funds, rather than other elements of the value chain (see Chapter 3). The way the industry has changed has been most significant in the UK, although MiFID II’s impact will have acted as a similar dynamic, if with a smaller quantum, in the rest of Europe. Research from Fitz Partners focused on funds in the UK shows both the decline in annual charges between 2013 and 2020 across different share class types and the shift in assets that have accompanied RDR’s changes (see Figure 9.2). Here “bundled” share classes are those that pay retrocessions (known as trail commission in the UK), “clean” classes are those where retrocessions are not charged, and discounted classes are those with additional discounts available on certain fund platforms. As this research focuses on mutual funds, it is worth adding some additional figures to give a sense of how low fees can go for institutional mandates. Figures from Broadridge suggest that institutional fees for actively managed equity strategies average 0.38 per cent. As with mutual funds, fee levels vary depending on the investment universe, with US global equities charging 0.33 per cent and global equities charging 0.41 per cent, but charges for emerging 192

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Figure 9.2  Impact of RDR on UK fund charges

Source: Fitz Partners. UK-domiciled actively managed equity funds.

markets averaging 0.57 per cent and Asia Pacific equities averaging 0.46 per cent. Institutional fees inevitably fall for passive strategies. Global equity index offerings average just 0.03 per cent, although this is lowered by the even smaller fees for the largest mandates. Mandates with assets of around $50 million charge 0.08 per cent, falling to 0.04 per cent for mandates with up to $500 million, Broadridge’s data shows. Interestingly, European retail investors can access index funds and ETFs at these low levels. At December 2021 Amundi’s Prime range of ETFs charged the lowest fees, giving exposure to Europe, Global, Japan, US and UK equities, each charging 0.05 per cent. Vanguard’s FTSE 100 Index and FTSE UK All Share Index index-tracking funds both charged 0.06 per cent, with its lowest charging equity ETFs also charging less than 0.10 per cent. BlackRock’s iShares has a range of Core ETFs including FTSE 100 and S&P 500 products that charge 0.07 per cent. Turning back to actively managed mutual funds, previous research focused solely on bundled share classes sold across Europe (relating to funds domiciled in Luxembourg and Ireland) found that annual charges for actively managed equity funds rose consistently through the decade to 2011, i.e. prior to the two sets of research above. It has not been possible to update this research, 193

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although separate analysis suggests that charges for a similar universe of bundled share classes have remained stable over the past five years. This would support the contention that the effects of regulatory changes and competitive pressure are playing out differently for different client types. Lower-cost passive funds’ influence in pulling down the average charges for UCITS equity funds is separated out in the ICI’s research. Charges for index-tracking funds (excluding ETFs) fell from 0.40 to 0.28 per cent between 2013 and 2020. This 30 per cent fall is more marked than the 14 per cent decline for actively managed funds, down from 1.56 to 1.34 per cent over the period. That passive funds’ average charges have not lowered the overall average for UCITS equity funds further (1.24 per cent in 2020) reflects that about 70 per cent of equity fund assets in Europe remain actively managed. Assets in UCITS funds have grown by 70 per cent over the period examined by the ICI, rising from €6.4 trillion to €10.9 trillion. This contrasts with a decline in annual charges over the period of 17 per cent. These figures enable the calculation of industry revenues, at least for equity fund managers, working on the basis that equity funds account for approximately half of UCITS fund assets. From this one can see that UCITS equity funds generated revenues of €47.7 billion in 2013, which rose to €67.6 billion in 2020. So despite the decline in average fees, the industry has still managed to increase revenues by more than 40 per cent over the period. The potential for the European industry to pass on more of the benefits derived from its scale to investors is addressed below. Digging deeper into the figures provides further evidence that asset managers may not be helping their clients as much as a first look at the historical trend suggests. Firstly, the decline in average charges has levelled off in recent years. The average charge across all equity funds and for actively managed equity funds has fallen by 3 basis points since 2018, and stayed the same for index-tracking funds. This raises a question as to whether fee levels have actually bottomed out, or if additional client (or regulatory) pressure will be brought to bear to push down the averages once more. Secondly, the ICI estimates that only 20 per cent of the decline in average charges is the result of individual funds actually lowering their charges. Instead, the change is primarily due to investors moving to lower-cost funds, firms closing smaller funds that tend to have higher charges, new fund launches not charging above average fees, as well as the rise in assets (referred to above). 194

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So there has clearly been change, but the impact on average fee levels for Europe as a whole has not been as dramatic as an external observer could have expected. While not directly comparable, similar ICI research into US mutual fund charges reveals that annual equity fund charges have fallen from 0.74 to 0.50 per cent between 2013 and 2020 (ICI 2021a). Actively managed equity fund charges have fallen from 0.89 to 0.71 per cent, while index funds’ charges have fallen from 0.12 to 0.06 per cent. These figures do not solely reflect funds in the US being more willing to cut fees, but include a range of other factors, such as retirement savings plans (401k plans), the preponderance of share classes used with no retrocessions (similar to the UK), and the larger assets of many funds (which is translated into lower accompanying fund charges). Lastly, a home bias among investors, which is common around the world, is particularly prominent in the US. US investors favour funds investing in US stocks that bear lower charges than funds investing internationally, let alone in emerging markets. Having said this, the various drivers behind lower average fees in Europe have had a significant impact in the way asset managers’ businesses are run and how they engage with clients, such as having to compete with passives to a degree that was far from the case ten years ago. A small number of firms have sought to bring some innovation around fee structures, mainly relating to fees linked to performance (see below). The shift towards passive funds has also resulted in active managers being more conscious of justifying their fees through performance, even if this does not lead to fee cuts. Despite these changes, the UK financial regulator is not satisfied that competition on charges is working as it should and recently decided to step in.

Assessing value The Financial Conduct Authority announced its intention to carry out an investigation into the UK’s £6.9 trillion asset management industry in 2015 “to ensure that the market works well and the investment products consumers use offer value for money”. The FCA pithily summarized the service asset managers provide to investors as comprising “a search for return, risk management and administration. The investor bears virtually all the risk”. 195

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The FCA’s interim findings in November 2016 put the industry on notice as the regulator announced the evidence it had found “suggests there is weak price competition in a number of areas of the asset management industry [which] has a material impact on the investment returns of investors through their payments for asset management services”. Coupled with this, the FCA wrote: “Funds which are available to retail investors underperform their benchmarks after costs – while products available to pension schemes and other institutional investors achieve returns that are not significantly above the benchmark”. “Investors may choose to invest in funds with higher charges in the expectation of achieving higher future returns. However, we find that there is no clear relationship between price and performance – the most expensive funds do not appear to perform better than other funds before or after costs”, the regulator added (FCA 2016). Despite asset managers disputing the FCA’s findings and fearing an intervention to encourage investors into passive funds, the regulator largely stuck to its initial findings in its final report in 2017 and in its policy statement detailing its final remedies a year later. Despite the damning nature of its findings, the FCA’s remedies seemed, on the surface, less radical than many in the industry had feared. Among several rule changes, the most striking was the requirement for UK asset managers (specifically for OEICs this would be the authorized corporate director) to undertake an annual assessment of the value the firm’s funds have delivered to their investors. The aim of the assessment is to determine whether a fund’s charges are justified in relation to the overall value delivered to investors. Value here is judged in relation to each of seven minimum criteria: performance, economies of scale, the asset manager’s costs, comparable market rates, comparable services, quality of service, and the appropriateness of share classes. Accompanying this assessment was a requirement for the board of the ACD to have a minimum of two independent directors, making up at least one quarter of their membership from September 2019, in an attempt to ensure that investors’ interests were properly reflected in board discussions. After the rules were introduced and assessments began to be published, it became clear that some directors thought the initiative was largely a waste of time and some boards made a superficial interpretation of the FCA’s minimum criteria. But there were also senior figures in the industry that were taken aback by the fact the regulator was willing to intervene and not leave 196

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it to the market to decide what charges were appropriate. Traditionally asset managers would contend that demand, as we’ve seen, would determine what price or charge is appropriate. But the FCA, while stating that it does not view its role as setting prices in the market, made it clear that the lack of competition on charges and high levels of profitability among UK asset managers (with an average profit margin of 36 per cent between 2010 and 2015) meant the market was not working as it should (FCA 2016). Indeed in 2021 the FCA clarified that it expected firms to assess their profitability as part of their value assessment in relation to the costs they incur. While the UK stands apart from the rest of Europe in requiring internal analysis of this kind – linking fund charges to the value provided to investors – speculation has grown that EU regulators are heading in the same direction, encouraged by the European Securities and Markets Authority publishing a supervisory briefing on fund fees, calling on asset management companies to create a detailed pricing process that lays out exactly what costs are being charged to investors (ESMA 2020a). The EU’s markets regulator also asked national regulators to increase their scrutiny of fund charges to ensure that costs are reasonable and appropriate. The EU’s regulatory authority for insurers and occupational pensions has gone further issuing a supervisory statement specifically on assessing value for money of unit-linked insurance products (EIOPA 2021). Several UK-headquartered asset managers now produce value assessment reports for their EU funds, similar to those required for their UK products, albeit that making this public remains rare. While primarily focused on the retail fund management industry, the FCA’s interim report also tackled the institutional industry, focusing its sights on investment consultants that advise pension funds on their investments and selection of asset managers. These include Aon, Mercer and Willis Towers Watson, which together account for almost half of the market. The FCA had “concerns about whether the interests of investment consultants are in line with investors’ interests”, prompting it to ask the Competition and Markets Authority to investigate. The CMA later decided that pension trustees selecting a fiduciary manager – a third-party provider appointed to make investment decisions on behalf of the pension scheme – must run a competitive tender. Around half of pension schemes choose the same provider for fiduciary management that they use for investment consultancy, and the incumbent 197

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investment consultant can steer them to do this, the CMA (2019) concluded, describing “significant competition concerns”.

Why fund charges matter Just as some in the industry were taken aback by the UK regulator’s willingness to intervene on product pricing, an area that would normally be determined by the market, so some readers may find the extent of the focus on this issue slightly surprising. Ultimately the different treatment of the issue than for other industries relates to the fact that charges have a direct and cumulative impact on the returns investors receive, i.e. the reason for investing, yet retail investors in the main do not understand the importance of charges and, even if they did, they lack influence in affecting change in this area. As a result, the FCA pushed ACD directors to examine the workings of this area further on the basis that they should be acting in fund investors’ interests. Fund charges are often ignored by investors as they seem relatively unimportant compared to potential returns. A useful analogy might be made with the character Gus Gorman (played by comedian Richard Pryor) in the film Superman III who notices that his pay cheque is rounded down from what he is actually due (being paid $143.80 rather than $143.805). Gorman discovers that all employees’ half cents are never paid, but instead are left “floating around” within the company’s computer system. He duly hacks into the system and ensures that these half cents are all paid into his next pay cheque, earning him more than $85,000.1 Just like Gorman’s half cents, annual fund charges have a cumulative effect over time, thanks to the effect of compounding. Figure 9.3 illustrates this effect over a 20-year period for two funds with different annual charges. For an original £50,000 investment, this results in a difference of £27,612 over the period, or a difference of £2,761 if £5,000 had been invested, or £276,116 if £500,000 had been invested. As the FCA put it: “Improvements in value for

1. See https://superman.fandom.com/wiki/Gus_Gorman and https://moneymovieclub. com/2021/03/26/superman-iii-1983/.

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money could have a significant impact on pension and saving pots. Even small differences in charges can have a significant impact over time” (FCA 2016). It is not just consumer advocates that have made this point. Bill Gross, in his “Investment Potions” note, said that paying 1 per cent a year for an equity fund and 0.75 per cent for a bond fund “during an era of asset appreciation with double-digit returns may have been tolerable, but if investment returns gravitate close to 6% … then 15% of your income will be extracted”. Or, as a senior German executive at Schroders has said, in justifying fee cuts at the firm: “Jeder Basispunkt zählt” (“Every basis point counts”).2 Higher charges hit investor returns but also boost asset managers’ recurring revenues, creating a conflict of interest that each firm needs to manage. This goes to the heart of the attraction of mutual funds as an attractive and profitable business to run. Estimated revenues for UCITS equity funds were 2. Achim Küssner, Schroders senkt Management-Gebühren für drei Rentenfonds, 29 April 2008.

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referred to above, but it is also possible to make a similar estimate across the €17.7 trillion of European fund assets.3 Applying a conservative estimated average charge of 0.6 per cent across these funds, the industry generates annual revenues of €106.4 billion per annum, or almost €1.8 billion for each basis point charge. Every basis point does indeed count.

Setting fee levels Asset managers have to bear in mind all of the above when setting fee levels for their new funds and, later, determining whether they remain appropriate. On the latter, the RDR and, more recently, assessments of value, have resulted in more funds in the UK lowering fees on selected share classes of existing funds where they are out of line with peers. At a European level, stricter requirements relating to product governance were also introduced as part of MiFID II, pushing firms to regularly review fees and expense incurred by their funds. This increased scrutiny, and firms’ accompanying efforts to justify fee levels, mark a change from previous European practice, albeit that fee sensitivities still vary widely around Europe. Over the first decade of this century, it was far more likely that funds would raise their management fees than lower them. In the UK, of those funds that changed their management fees over this period, 80 per cent increased them. This figure rises to more than 90 per cent when looking solely at actively managed equity funds. For EU-based funds sold internationally (examining those based in Luxembourg or Ireland), the equivalent figures are 70 per cent of funds increasing their fees, rising to 80 per cent for actively managed equity funds (Moisson 2011). Having said this, particular energy is spent on setting fee levels for new product launches to ensure that a fund’s charges do not act as a deterrent to inflows. Firms use competitor comparisons to determine a range of fee levels where their new fund might be positioned, as well as referring to the fees on their own products. Many firms use these two factors as the primary means to establish their fund’s charges. From my own experience, one chief investment 3. EFAMA, data at December 2020.

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officer could seemingly not comprehend the idea of lowering a management fee as a means to improve a fund’s mediocre performance because doing so would take the fee level below what competiors charged, or what the market would bear. However, not all asset managers rely solely on this approach. For example, Laurent Ramsey, managing partner of Swiss private bank Pictet Group and co-head of Pictet Asset Management, says that for his firm actively managed funds’ annual fee levels reflect passive fund costs plus 20 per cent of the expected alpha an active manager will generate, together with a premium reflecting an asset manager’s brand strength or the quality of its service (Moisson 2021a). Just as asset managers monitor their peers’ fund charges as a guide to determine their own, so what was charged in the past becomes relevant. In the UK, fund charges were capped at a total of 13.25 per cent over 20 years until 1980, when Margaret Thatcher’s reforming government brought this to an end and opened up charging to the free market. The reason why the government chose the figure of 13.25 per cent is lost in the mists of time. Funds would break the charge down by typically charging an initial, one-off charge of 5 per cent and then 0.75 per cent annually, or an initial charge of 3.25 per cent and then 0.5 per cent annually. A maximum annual commission of 1.25 per cent could be paid to stockbrokers, the main distribution channel beyond selling direct to consumers (St Giles 2021b).

Ongoing charges Beyond the management fee, or annual management charge, other costs can be charged to the fund, and borne by investors that together are referred to as a fund’s “ongoing charges”, or the OCF (ongoing charges figure) and is required to be disclosed in Europe. This figure, with relatively small methodological differences, was previously known as the total expense ratio (TER), a term that is still widely used, particularly in the US. The term ongoing charges was introduced in an effort by European regulators to make it more understandable to retail investors, although this has sadly been undermined a little by the industry’s propensity to use acronyms. 201

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The different types of expenses that can be charged outside the management fee vary between European jurisdictions. Different firms also adopt different practices in the way in which different costs are borne by their funds. For example, some asset managers have a single charge from which all costs are paid. This will be referred to when discussing economies of scale below. Whether paid from the management fee or charged separately, funds’ expenses cover the costs incurred for investment management, administration, custody or depositary, trustee, audit, legal, printing and publishing, marketing, fund directors, and distribution (retrocessions). Some of these are charged to the fund as a percentage, while others are charged as an absolute cost that then have a different percentage impact on a fund’s assets. For example, for the former, a management fee of 1 per cent on a £100 million fund generates a fee of £1 million a year, while for the latter if audit fees total £20,000 for a £100 million fund then this represents a cost of 0.02 per cent. How these costs are managed are particularly relevant in relation to funds’ economies of scale. Transaction costs, also referred to as trading, brokerage or dealing costs, are not included in funds’ ongoing charges. These costs are incurred when a portfolio manager buys or sells securities, as well as the taxes related to these transactions, such as UK stamp duty. Under MiFID II, European firms were required to separate and disclose trading-related costs for the first time. As these costs are not disclosed as an operating expense borne by the fund they were previously far less easy to identify and compare. Transaction costs are incurred, as the name suggests, when a portfolio manager undertakes transactions in underlying securities and so vary depending on the manager’s investment style or with changing market conditions. Similarly, index-tracking funds must incur these costs when there are changes to the constituents of the index they track. It is widely, and reasonably, argued that improved disclosure of these costs under MiFID II and the Packaged Retail and Insurance-based Investment Products (PRIIPs) regulation (EU rules that aim to help investors better understand and compare the key features, risks, rewards and costs of an array of investment products, not just funds) was undermined by a botched calculation methodology. This methodology includes not just explicit transaction costs (see above) but also so-called implicit costs, which reflect the difference in the price at which a transaction is executed with the price at which an asset is valued immediately before an order is made. At the least, confusion over 202

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the approach has meant that these disclosures have not been used as widely as expected. Having said this, there is a reasonable rationale for primarily focusing analysis and comparisons of fund charges on operating costs (i.e. ongoing charges) as these relate to the management and day-to-day running of the fund and are incurred regardless of whether a fund is traded.

BOX 9.1  ADDING UP A FUND’S CHARGES

Scrutinizing a fund’s annual report and accounts provides the details of the fees and expenses charged over the previous year. The level of detail provided in these disclosures varies widely between firms and jurisdictions. Table 9.1 gives two examples from the cross-border fund centre of Luxembourg to show how expenses beyond the headline management fee can add up. Luxembourg and UK funds typically offer several share classes with differing fee levels, whereas fund accounts show aggregate costs for the fund as a whole. But this remains relevant for an asset manager’s perspective on the revenues the firm generates from any given fund, as well as the costs the fund has to pay from its assets to external service providers. Fundsmith is best-known for its UK-based Fundsmith Equity Fund, the largest actively managed equity fund in Europe. The firm also offers a Luxembourg-based version of the same fund for EU-based investors, which provides a breakdown of the fund’s costs borne by investors. The extract shows that while Fundsmith retained management fees of more than €44 million over the year, it also paid out more than €4 million for other operating costs, adding 10 basis points to the charges paid by the fund’s clients. French asset manager Carmignac manages both France-domiciled and Luxembourg funds. The extract comes from one of the firm’s largest Luxembourg-based products. Carmignac is an example of a firm that often has performance-related fees in place. The example here shows that the fund bore annual fees and expenses totalling 3.1 per cent of the fund’s assets over the year. Over 60 per cent of these charges related to the fund’s performance fee. The size of this latter charge is a reflection of both the fund’s performance and the way the fee is structured (i.e. the way in which the fee “kicks in” given the return generated by the portfolio manager).

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Table 9.1  Examples of funds’ annual charges a.  Fundsmith SICAV Expenses

Euros

Management fees Despositary & Administration fees Taxe d’abonnement Bank charges Professional fees Directors fees Other expenses

44,572,754 2,429,650 871,537 637,937 98,930 51,346 32,153

Total expenses

48,694,307

Net assets at beginning of year Net assets at end of year Average net assets over year (est.) Annual fees and expenses (%)

4,112,138,884 5,525,102,355 4,818,620,620 1.01

b.  Carmignac Portfolio – Investissement Expenses

Euros

Management fees Performance fees Operating and establishment fees Taxe d’abonnement Custodian fees

2,184,692 4,914,172 519,329 112,191 37,963

Total expenses

7,768,347

Net assets at beginning of year Net assets at end of year Average net assets over year (est.)

229,966,764 271,454,839 250,710,802

Annual fees and expenses (%)

3.10

Excluding performance fees (%)

1.14

Source: Fund report and accounts, 31 December 2020.

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Performance fee structures The impact of performance-related fees is included in each fund’s ongoing charges, but because they are charged in a fundamentally different way it is worth dwelling on this fee structure a little more. Performance fees are charged in relation to a fund’s returns, rather than its assets, and so they may not be incurred in any given period, or indeed may never be incurred if a fund performs poorly. While commonly seen as the preserve of hedge funds, most European jurisdictions allow regulated mutual funds sold to retail investors to charge these fees. As a guide to their use, across approximately 60,200 share classes of actively managed equity funds in Europe, about 8,700 have performance fees in place, or 14.5 per cent of the total, according to Morningstar data. The best known performance fee level, borrowed from hedge funds, is 20 per cent of a fund’s returns, although the level of this fee can vary between funds. It is useful to offer a simplified example of how this fee translates into a percentage of a fund’s assets – comparable to other annual charges. For a fund with £100 million in assets generating a 7 per cent return over one year would result in increasing its assets by £7 million. The 20 per cent performance fee would therefore generate revenues of £1.4 million. In this scenario, the performance fee has increased the fund’s ongoing charges by 1.4 per cent (i.e. £1.4 million divided by £100 million). The difficulty of constructing a performance fee that is fair to both clients and managers means that there are various additional elements of the structure that are often, although not always, put in place. These include the high-water mark, hurdle rate and crystallization period. The high-water mark requires that a performance fee can only be paid if a fund has reached its previous high level of performance, in other words a fund cannot generate a performance fee twice for generating a certain return, dropping back and then charging again for recovering its previous performance. A hurdle rate is typically an absolute percentage return, say 4 per cent, before which performance fees are not calculated, which avoids charging fees for negative returns (this can happen if a fund outperforms a falling benchmark return). Lastly, the crystallization period is the time after which performance fees are paid, preventing fund managers for generating fees for short periods of good performance. While eminently sensible if set up correctly, these mechanisms 205

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show how complicated performance fees can be and therefore how reliant retail investors are on the asset manager (and those overseeing the manager, such as a fund’s directors or trustees) to structure the fee fairly. The European Securities and Markets Authority has recently introduced guidelines for national regulators to use to avoid bad practice among regulated funds’ use of performance fees (ESMA 2020b). The guidelines include a requirement for a high-water mark, if used, to cover a minimum period of five years, i.e. not resetting a high-water mark for shorter time periods. The guidelines also require that “a performance fee should only be payable in circumstances where positive performance has been accrued during the performance reference period”, and the crystallization frequency should not be more than once a year. Put simply, the guidelines reflect some asset managers’ willingness to game the system. Asset managers’ arguments against ESMA’s proposals, revealed in their responses to the consultation, suggested that the guidelines would tempt firms to act against investors’ interests. This seemed to be a profoundly worrying admission of the extent to which their fiduciary responsibilities are seen as optional, rather than a fundamental part of a fund management business. For example, in relation to setting a minimum five-year period for a high-water mark, the French asset management trade body (L’Association Française de la Gestion financière) wrote in its consultation response that a predefined period “bears the risk of putting pressure on the management company to prefer setting a higher fixed fee model”, i.e. dropping performance fees altogether because firms can no longer make as much money as before.4 The BVI, Germany’s fund association, also opposed the change, saying: “The recovery of a major loss might take a very long time until a performance fee could again be generated. From an economic point of view, the liquidation of such a fund and a new launch of a similar product might be the sensible measure, which, however, is not necessarily in the interest of the investors”.5 The Alternative Investment Management Association added: “This could actually

4. See https://www.esma.europa.eu/press-news/consultations/consultationperformance-fees-guidelines-in-ucits. 5. Ibid.

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lead to misalignment with the fund’s investment objectives, incentivizing the management company to take excess risk to recoup prior losses”.6 There are several rationales for using a performance fee in addition to assetbased management fees (it is very rare for a fund not to charge the latter, although sometimes they are lower than average). The first is simply “I’m worth it” (see earlier discussion on the “L’Oréal delusion”), which, if successful, is hard to argue with, although it is surely a sad reflection of an asset manager’s view of investors’ interests. The second rationale is that performance fees incentivize a portfolio manager to perform better. With so many firms explicitly saying they only ever act in investors’ best interests in relation to generating higher returns, as well as having obligations to do so, this rationale for additional fees is often criticized. The accompanying argument that performance fees lead to excessive risk-taking – which prompted the US Congress in 1971 to prohibit the use of performance fees in mutual funds unless they are symmetric7 – suggests that at least some portfolio managers behave differently with different incentive structures. The third rationale, and surely the strongest, is that for certain investment strategies a fund’s assets should be limited in order to be most effective and not compromise returns. The logic is that asset-based fees work against this aim, incentivizing a firm to increase a fund’s assets, and so performance fees are used. That performance fees tend to be charged in addition to management fees could undermine this rationale but, at its heart, it is sound. The logic for charging both management fees and performance fees has been defended as the former is said to only cover operating costs, rather than being a significant source of revenue. As the former deputy chief executive of the Alternative Investment Management Association once said: “It all comes from a transparent formula, published in the [fund] prospectus. No one is being fooled. There’s a base fee which pays for electricity, the carpets and cleaners, and then there’s the performance fee. Spectacular returns only kick in when there’s spectacular performance” (Bowers 2008). This seems slightly disingenuous. Hedge funds’ average annual management fees (not including other operating costs) appear to be clearly higher 6. Ibid. 7. In other words, the extra revenue earned for outperformance has to be the same as the reduction in revenue for the same level of underperformance; see Servaes (2019).

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than those for European mutual funds, averaging 1.36 per cent (as at Q2 2021; see HFR 2021). This figure has been slowly falling over the past decade, having peaked at the end of 2009 at 1.6 per cent. Performance fees have also fallen over this period. They still averaged above 19 per cent in 2010, but have fallen since then and now average 16.17 per cent. So while many funds are still charging the traditional “2 and 20”, the latest averages reflect that some pressure on fee levels has also been felt among hedge funds. Even so, there is clearly a fee premium that hedge funds feel able to charge relative to mutual funds. And new product launches seemingly remain defiant when it comes to fees, with hedge fund launches in 2021 having management and performance fees that are both above average, with the latter at 17 per cent (the same as for new funds in 2020). The resistance of many hedge funds to potential pressure on fees might suggest that there is an innate or structural reason as to why hedge funds first started charging performance-related fees (beyond the justifications noted above). There isn’t. Alfred Winslow Jones, father of the hedge fund industry,8 worked with a lawyer who realized that by taking a share of a fund’s returns, rather than a flat management fee, the firm would be taxed at the rate for capital gains. At the time, the top personal tax rate in the US was 91 per cent, whereas capital gains were charged at 25 per cent. However, Jones did not tell his clients this, instead saying the model was based on ancient history, specifically that Phoenician merchants kept a fifth of the profits from successful voyages. Jones then simply termed the new fee as a “performance reallocation”, to distinguish it from a normal bonus, and hedge fund managers have happily followed the practice ever since (Mallaby 2011). Just as mutual funds can invest in other funds through a fund of funds, so some firms have adapted this approach to invest clients’ assets in hedge funds through a fund of hedge funds. In both cases the rationale is to offer clients, at a minimum, access to a diverse and professionally selected range of underlying funds. As hedge funds tend to be harder for retail investors to invest in, a fund of funds structure also enables a larger pool of investors to get exposure to these alternative investment strategies. However, as the above explanations show, hedge funds’ performance fees can increase charges borne by clients.

8. See https://awjones.com/about-us/firm/.

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The following hypothetical examples demonstrate the extent to which funds of hedge funds’ charges can stack up (see Table 9.2). In the first scenario, the fund of funds itself does not charge a performance fee, but does charge annual fees and expenses of 1.25 per cent. The underlying hedge funds’ annual fees also average 1.25 per cent while charging performance fees of 20 per cent of net gains achieved. With these underlying funds averaging returns of 5 per cent for the year, the resulting charge borne by clients is 0.75 per cent of the fund of funds’ assets. Adding these various layers of charges results in total costs borne by clients of 3.25 per cent. In the second scenario, the fund of funds itself charges a performance fee of 10 per cent of net gains. The underlying fund managers have achieved an aggregate gain of 15 per cent, resulting in a performance fee of 2.5 per cent of the funds’ assets. The underlying funds’ returns, less expenses, translate into a gain of 10 per cent for the fund of funds, which in turn results in an additional performance-related charge of 1 per cent. So in this scenario the overall costs borne by clients total 7.5 per cent for one year. Table 9.2  Fund of Hedge Funds’ charges Scenario 1

Scenario 2

Fund of Funds: Management fee Operating expenses Performance fee (10%)

1.00% 0.25% –

1.00% 0.50% 1.00%

Underlying hedge funds: Management fee Operating expenses Performance fee (20%)

1.00% 0.25% 0.75%

2.00% 0.50% 2.50%

Total fees and expenses

3.25%

7.50%

Performance fees in the UK Before 2004, UK open-ended funds were not allowed to charge traditional performance-related fees.9 A brief look at how their use has developed in 9. Investments trusts can use performance fees and many do, although their use has declined over the past ten years.

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the UK provides some insights into the way the industry works more widely. To overcome regulatory restrictions, in 1996 Portfolio Fund Management10 launched its Performance Fund, which introduced a “rough and ready” performance fee by reducing management fees from 1.75 to 1 per cent over different periods of time depending on performance. Gartmore’s Focus Fund range was later to take a similar approach. The success of these funds in terms of assets was generally modest and did not entice other firms to follow suit. Tellingly, when the two firms were acquired by rivals (ultimately both PFM and Gartmore became part of Henderson), these funds’ innovative fee structures did not survive the acquisitions. But in April 2004 the regulator lifted the ban on performance fees for retail investors, partly because of the quasi-performance fees noted above and partly because investments trusts suffered no restrictions in using performance fees – at the time the majority of these trusts did so. The rule change coincided with the rise of so-called absolute return funds, mutual funds aiming to deliver positive returns on different market conditions, à la hedge funds. Not ones to miss a trick, managers of these funds were quick to use performance fees. Some performed well and clients bought into the idea that the additional fees were worth paying for. But, in the main, IFAs were reluctant to invest in funds with performance fees. Scepticism about the fee structure was most strikingly argued by Hargreaves Lansdown, an influential IFA and the UK’s largest direct-to-consumer investment platform, which banished funds with performance fees to a separate section of its public list of favoured funds. This reluctance did not just relate to the theoretical justification of the fee structure, but also the more practical issue of intermediaries’ fee budgets, i.e. managing the total fund charges of clients’ portfolios. As the RDR’s changes came over the horizon, intermediaries became far more sensitive to the costs their clients incurred, but fees that could change dramatically each year – and perhaps not be charged at all – made this process far harder, prompting some to avoid these funds altogether. The widespread hesitancy among intermediaries to use funds with performance fees made it unsurprising that asset managers soon became very wary of using this fee structure.

10. Set up in 1993 by two innovators in the UK investment industry, Tim Miller and Richard Timberlake.

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Alongside these developments, a small number of firms have tried to use performance-related fees to make innovative, and arguably fairer, charging practices a central part of their business. Bedlam Asset Management launched in 2002 in a blaze of publicity and named after the infamous mental hospital to “demonstrate the stupidity taking place in the market”. It promised to charge investors only when its funds performed well. Struggling to deliver good performance and to attract and retain client assets, the firm announced its closure in 2013. Vinculum Fund Management, founded by the former founder of Liontrust Asset Management, was not quite so high profile, but adopted a similar charging structure and lasted less long, opening in 2011 and closing in 2014. It is not just fund boutiques that have tried this approach. Major global firms including Fidelity International (with funds launched in 2017) and Allianz Global Investors (in 2018) have adopted variable fees, also known as fulcrum fees, for some of their funds. But despite avoiding the excesses of hedge fund fees, share classes with these fees have generally struggled to gain traction with clients. These attempts have clearly shown that actively managed funds are bought based on their performance not their charges. This serves to underline that active funds are a fundamentally different investment proposition than index-tracking funds, where low charges are almost invariably a core part of the product. Despite this, a small number of firms are trying to innovate in this area. Orbis, founded in 1989, built an international institutional business and using performance fees. In 2015 the firm launched a direct-to-consumer offering in the UK and trumpeted its “performance fee only” charging model, which also partly refunds clients for underperformance. Its two UK-based funds had assets of £150 million by late 2021. Another firm, Equitile Investments, launched in 2016 with a new take on how to charge clients most fairly. The Equitile Resilience Fund charges an annual management fee of 0.7 per cent on the first £350 million of assets in the fund. Assets above this level incur no management fee, and instead clients are then charged a performance fee of 10 per cent of returns above the high-water mark. Its single investment strategy was nearing £300 million by the end of 2021. Importantly, both firms’ fee structures try to address the industry’s “conflicted” approach of charging an ad valorem annual fee that incentivizes asset managers to gather assets, which can arguably undermine performance as a result. Orbis and Equitile 211

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aim to use their fee structures to better align their interests with those of their clients. The relationship between scale, or asset gathering, and fees will be addressed next.

Economies of scale Funds’ charging structures are a key element in the financial appeal of running a fund management business. Firstly, the fund management company receives recurring revenue from the assets it manages, generating fees every day. Secondly, this revenue will rise in line with the larger pool of assets that the firm manages because the percentage fee charged is fixed (a 1 per cent fee charged on a fund with £100 million will earn 10 times as much as the same charge on a £10 million fund). As a result, an asset management company is, in principle, incentivized to grow its assets both through generating returns (performance) and through attracting and retaining clients (sales). Manager and client interests are aligned in wanting to generate higher returns, but this is not the case for client inflows. For some, if not many, investment strategies an ever-larger asset pool can be detrimental for the delivery of the intended level of performance. As Equitile writes: “If we charged only a fixed percentage of assets in the fund, as is normal industry practice, then we would be incentivized to maximize the assets in the fund rather than deliver good investment returns”.11 The most obvious way to reduce the incentive to increase a fund’s assets through sales is to reduce the annual management fee percentage when assets pass the point at which marginal costs become immaterial. Marginal costs in relation to fund management are the change in total costs when managing a growing pool of assets. The costs of managing a fund do not increase indefinitely the larger a fund gets. Or as Equitile puts it: “The costs of running a fund are finite and so, once these costs are covered, there are growing economies of scale”.12

11. See https://www.equitile.com/fair-fees. 12. Ibid.

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The UK and European funds industry’s reluctance to cut into a significance source of profit is shown in industry data. Until funds reach around £250 million in assets, average ongoing charges fall somewhat as assets rise, primarily focused on back-office costs charged by external companies. But additional reductions in charges are, in general, far more limited above this level. This reflects the fact that to reduce ongoing charges further, an asset manager would have to reduce its own percentage fees. Equitile places this threshold slightly higher, at £350 million, and switches from a management fee to a performance fee at that point, creating the fee structure noted above. One hedge fund manager places the threshold at $250 million (£190 million) and has, perhaps surprisingly, become a critic of fund managers’ charging practices. Guy Spier, chief executive officer of hedge fund Aquamarine Capital, has said: “The economies of scale that we have in this industry are insane. As soon as a fund manager like me manages more than a quarter of a billion dollars I ought not to take any more fees. The marginal cost for me of running another $25 million is zero. Fund managers have a moral obligation to align their interests with investors.”13 This is not just an abstract potential conflict of interest, it also has practical implications. Reduced annual charges are reflected in proportionately higher returns to clients, and these have a cumulative effect over time (see Figure 9.3). This can be seen in practice by looking at two of the UK’s largest actively managed equity funds.14 Fundsmith’s Equity Fund’s largest share class has assets of around £16 billion, charges 0.95 per cent and the fund generates estimated revenues of £150 million a year. The Baillie Gifford Managed Fund’s equivalent share class has assets of almost £6 billion, charges 0.42 per cent and the fund has revenues of £25 million. Fundsmith’s fund is more than two and a half times the size of Baillie Gifford’s, but generates revenues 6 times as large. Baillie Gifford cuts its management fees as assets rise, Fundsmith does not (see Figure 9.4). Some firms in the UK have even “doubled down” on their policy of making disproportionately higher revenues from managing larger funds. They have done this by fixing their ongoing charges, in other words, setting a fixed percentage charge that covers all costs, not just the management fee. This has 13. Guy Spier was speaking at the Transparency Task Force symposium, 25 April 2018. 14. Based on analysis carried out by the author in October 2021.

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Figure 9.4  Charges for the UK’s largest active funds

Source: Morningstar. Ongoing charges for each fund’s largest share class, as at September 2021.

been sold as a boost for transparency – investors know what the annual operating costs borne by their funds will be in advance. But I would doubt that many, if any, retail investors appreciate that this is also a way for the asset manager to generate higher fees. With fixed annual charges, if the costs incurred by the fund are less than the money raised from the percentage charge then the asset manager pockets the difference. This practice has been allowed to proliferate in the industry apparently unchecked by the regulator. However, the FCA’s assessment of value requirements mean that fund directors should now be reviewing this practice, although there is little or no evidence that it is changing. European firms’ shortcomings in relation to passing on economies of scale to retail investors are all the more striking when the opposite is the case in the US. Here management fees are adjusted as assets grow over time and the ways in which costs are passed on to investors are closely monitored. In general fees are low when funds are smaller because the management company waives most of the fee. Then, as the fund grows, the company waives less so the average management fee is higher. Finally, the fund reaches levels where real economies of scale kick in so management fees drop again. In this 214

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last phase, the asset manager applies so-called “fee breakpoints”, whereby the percentage management fees charged are lower above predetermined asset levels. Such practices are largely taken from the so-called “Gartenberg principles”, which derive from case law and indicate the points a mutual fund board should have regard to, when it is reviewing a fund management contract (FCA 2018a: footnote 11). However, Guy Spier contends that “you can’t regulate this behaviour. We have to bring in a culture in which you do not respect people for creaming [fees] off the top. The country hates [fund managers] for good reason.”15 Even allowing for the fiery language, it is clear that managing fee levels and the way fees are applied go to the heart of the potential conflicts of interest when running an asset management company. The company’s scale is clearly beneficial for its investors and its senior executives, but, with the practices adopted by most firms today, the benefits of scale are far less clear for fund investors.

Securities lending It is arguable as to whether securities lending belongs in a discussion on fund charges, but it is a potential source of revenue for an asset manager. In principle, a fund can lend out its securities in order to generate revenues that are then passed on to the fund’s investors, thus reducing overall fund costs and so improving investor returns. The asset manager will also retain a portion of the fee earned, in principle to cover its costs. Lending has primarily grown on the back of the growth in short-selling (discussed elsewhere in this book) undertaken by both hedge funds and UCITS funds, which necessitates a short-seller borrowing a security it wishes to sell short – in return for a fee. While the securities are on loan the borrower transfers collateral in the form of other securities such as shares, bonds or cash to the lender. The value of the collateral is equal to or greater than the value of the securities being borrowed. Not all funds are willing to lend stock in this way, with actively managed funds typically reluctant to do so. ETF providers in Europe have been increasingly open to engaging in securities lending, with all of the largest firms now 15. See note 13.

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permitting their funds to do so. Vanguard allowed its European ETFs to engage in the practice for the first time in 2016 and HSBC followed suit in 2021. The value of global ETFs’ on-loan balances (the value of securities on loan at any point in time) totalled $66 billion over the first five months of 2021, according to EquiLend, a securities lending platform (Boyde 2021). ETFs are still a small proportion of the total, representing 2.57 per cent of the lending market. Separate data has found that the global securities lending industry generated $7.7 billion in revenue for lenders in 2020, according to Datalend. From this one might estimate that ETFs generate around $190 million in revenues from securities lending. But such an estimate would appear to be lower than reality. BlackRock alone has reported in its Annual Report for 2020 that it generated securities lending revenue of $652 million in 2020, or 5 per cent of its total management fee revenues (that totalled $12.6 billion), although securities lending may also be undertaken by managed accounts and other funds. (For completeness, BlackRock also generated revenues of $1.1 billion from each of its performance fees, technology services, and distribution fees. The firm’s total revenues for 2020 were $16.2 billion, its annual report shows.) The European Securities and Markets Authority permits UCITS funds to undertake securities lending for the efficient management of portfolios. To support this specific aim, ESMA requires “all the revenues arising from efficient portfolio management techniques, net of direct and indirect operational costs, should be returned to the UCITS” (ESMA 2014). Consumer group Better Finance (2019) has tried to evaluate whether large ETF providers in Europe are following ESMA’s guidelines. Public disclosures by these firms showed that while Vanguard states that 95 per cent of securities lending revenues are paid to its fund (and 5 per cent retained by the asset manager), the equivalent figure was 60 per cent at UBS, 62.5 per cent at BlackRock, 65 per cent at Amundi, and 70 per cent at DWS and State Street Global Advisors. Better Finance says its findings “raise a serious concern with regards to the compliance with the rule that 100% of the net income must be returned to the funds” (Better Finance 2019). Critics of hedge funds, or of short-selling more generally, are often suspicious of stock lending for facilitating the former’s investment practices. They contend that borrowing a company’s shares puts downward pressure on them, effectively manipulating their price. By contrast, defenders of short-selling say it helps “price discovery”, the process by which the appropriate and robust 216

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price for a security is found. Putting these arguments to one side, ETF providers are clear that there are risks with securities lending. As BlackRock states, there is a risk of loss should the borrower default before the securities are returned, and due to market movements, the value of collateral held has fallen and/or the value of the securities on loan has risen. Another concern is that voting rights for the stock are transferred to the borrower, largely cutting off the ultimate stock owner’s influence on the underlying company. Such engagement has become increasingly important for asset managers grappling with ESG concerns. Japan’s Government Pension Investment Fund (GPIF), the world’s biggest pension fund, responded to these concerns by ending its stock lending programme in December 2019 (but not its lending debt securities). The pension fund explained that “as part of its stewardship responsibilities, GPIF requires its asset managers to enhance the long-term value of investee companies by conscientiously exercising voting rights for all the shares they hold”. It concluded that stock lending “can be considered to be inconsistent with the fulfilment of the stewardship responsibilities of a long-term investor” (GPIF 2019).

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10

CO N C LU S I O N S A N D T H E F U T U R E : H AV E W E R E AC H E D P E A K M U T UA L F U N D ?

High levels of profitability, rising markets that boost growth, and the prospect of increased demand as governments push individuals to take greater responsibility for their retirement savings, all point to the attractiveness of running an asset management business. And each of these is accentuated by the recurring revenues that mutual funds provide. So despite fund holding periods averaging just over three years, which might seem relatively short compared to changing home every 14 years, or changing car every 8 years, revenues are generated on fund assets every single day (IA 2021; Gibson 2021; SMMT 2021; Gillies 2017). And this holding period does not reflect that aggregate net inflows to mutual funds typically rise year-on-year, and certainly do so over any given three-year period. No wonder Bernie Cornfeld proclaimed, “If you want to make money, don’t horse around with steel or light globes. Work directly with money.” But the management of other people’s money brings with it potential conflicts of interest that need to be managed when growing a business while staying aligned to the purpose of fund management. The main purpose of fund management is to grow clients’ wealth over the long term by prudently investing in companies and other assets. The main vehicle for doing this is the mutual fund, where clients’ assets are shared and the manager is obliged to act in their best interests. Inherent in this is a fiduciary duty that goes beyond managing the fund in the way set down in legal documents. While the exact nature of this duty remains contested in Europe, pressure is increasing from regulators for firms to justify their charges and demonstrate that consumers’

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interests are at the centre of their businesses. Firms have so far largely resisted this pressure as it has the potential to threaten their profitability. The shock of some in the funds industry to regulators’ efforts both to make firms put client interests first, and to define how far-reaching these interests might be, suggests that many asset managers struggle with groupthink in some areas of their business. In other words, they struggle to think beyond what is accepted industry practice (asking one of the highly paid mega consultancies to repackage existing thinking about how to succeed does not really count). Groupthink can even become a subconscious part of a company’s culture – “this is the way we do things”. This book will hopefully have served as a means for some to step back and see the industry more objectively. As the largest asset managers in the UK and Europe have a disproportionately large influence over clients’ fund assets, then greater responsibility in addressing these challenges falls to them. With great power, or great assets under management, comes great responsibility. This responsibility goes beyond that of growing a business to make shareholders (or a parent company) happy. It involves addressing what is best for clients and, arguably, what is best for society and the environment. As more firms make larger claims about their environmental, social and governance investing credentials, including these last two areas is not so far-fetched as would have been the case even five years ago. It is clear that one challenge for asset managers is the temptation to chase assets, to prioritize sales and build fund sizes to as great a scale as the investment team deems viable (and maybe slightly beyond that), with new product launches used for similar reasons. The success of asset managers as sales machines is a significant part of the industry’s overall growth. There are clear examples of where the drive for asset gathering becomes a concern, for example, technology funds in the late 1990s, 130/30 funds1 and absolute return funds a decade later, and the rise of sustainable investment funds more recently. And now a wave of traditional asset managers is looking to increase

1. “130/30” and “120/20” funds were among the first hedge fund-style strategies used to take advantage of UCITS III’s investment powers, with 130 per cent (120 per cent) of a fund’s capital invested in long positions and 30 per cent (20 per cent) invested in short positions.

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their capabilities in private markets, with accompanying premium price tags. This phenomenon must set alarm bells ringing to any external observer. The focus on sustainable investing has increased the scrutiny of fund managers’ credentials in this area and the degree to which their claims are authentic. Such scrutiny has the potential to shake-up the way in which firms compete with one another, although previous, if dissimilar, threats have tended to end with the largest firms prevailing. At least it is hoped that the differences between each of ESG integration, impact investing, and investing sustainably, ethically or around particular themes, can all be made clear and firms’ claims judged accordingly. The current tangled web of these distinct approaches opens the industry to client misunderstanding, and therefore potential mis-selling, which is exacerbated by firms’ marketing and sales approach that often overlays clients’ values across each of these different investment approaches. A recognition by at least some firms that there are limits to what they can achieve would be no bad thing – asset managers should be wary of over-reaching. This is all the more tempting as having an environmental or social purpose appears as a potential holy grail for asset managers to find their purpose in wider society, beyond their immediate client base. Having said this, it would be churlish to dismiss the strides many firms have made in bolstering their consideration of ESG factors. As asset managers make bolder claims for their impact on the environment and society, they should be ready to consider how far this may lead. One senior figure in the industry has suggested that asset managers face an “existential challenge” because of their inability to evolve and deliver for the less wealthy in society. Dawid Konotey-Ahulu, co-founder of pensions advisory firm Redington, suggests that asset managers are good at making small improvements, such as lowering fees a little or making their businesses slightly more efficient, but they have not shown that they are capable of “major disruptive innovation” that can build wealth for the less well-off over the long-term. This is the result of firms’ focus on competing rather than collaborating with one another. The closest co-operation comes is via asset managers’ trade bodies, but this is primarily used as a means to interact with regulators or policymakers. If asset managers don’t deliver on this role for helping wider society, “then someone else is going to do it”, Konotey-Ahulu warns (Moisson 2018b). This leads to the opportunities that technology offers to asset managers. When considering the future of the industry, technology has the potential 221

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to improve asset managers’ operational efficiency, to enhance investment management (in areas such as data science and artificial intelligence), and to improve the customer experience. On the last of these, raising the profile of an asset manager’s online brand and trying to use it to attract customers has been largely undeveloped in an industry more at ease dealing with financial intermediaries (be they wealth managers or investment consultants). The cost of trying to do so has put off many firms, although not all. Competing for retail clients online also challenges asset managers to compete with other financial brands online that do not offer mutual funds, be they trading platforms (such as Trading212 or eToro), robo-advisers (such as Nutmeg or Moneybox) and even cryptocurrency exchanges (such as Coinbase or Binance). The power of social media platform Reddit to help push up the share price of GameStop, a US video games retailer, and force at least one hedge fund out of business will not have been missed by the rest of the industry (BBC 2021). And the prospect of a big technology firm (such as Google or Amazon) deciding to move into fund management would make many asset managers nervous too. Some of these rival online platforms already offer mutual funds, ETFs or managed portfolios of funds, so the threat to asset managers is clear if, at this stage, relatively small, at least in Europe. Past experience would suggest it will take a seismic shift for Europe’s distribution structures to change, which is something only government policy or regulatory interventions have previously succeeded in doing to any noticeable degree. Advances in technology have also raised the prospect of mutual funds being replaced altogether. A growing number of large asset managers have made clear that the future of the fund management industry may not lie with the mutual funds at all. Peter Harrison, Schroders’ chief executive, has suggested the asset management industry has probably reached “peak mutual fund” as demand for access to private market investments, users’ “self-service” digital experience in other aspects of their lives, and the “explosion” in cryptocurrencies have exposed mutual funds for their “80-year-old technology” (Cowie 2021; Keeley 2021; Moisson 2022). The firm is seeking to adapt its product development approach to prepare for “mass personalization”, which mutual funds were not able to offer, in order to avoid being “blindsided” by a shift away from mutual funds. He also pointed his finger at financial regulators for failing to keep pace with changing retail demands and so acting as a potential impediment to the industry’s progress. This is not merely a threat to mutual 222

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funds as investment vehicles, but also to investments managers. Harrison has said, “There is much less of a battle for [hiring] traditional portfolio managers these days. They will never thank me for saying it, but their value has declined relatively because actually there are so many other parts that need addressing.” One example of potential “mass personalization” is so-called “direct indexing”. Here a segregated account enables a customized portfolio to be built for each client, starting with one base index (the S&P 500, for example) and then adding other indexes, or adding or removing individual stocks, based on client preference. In this way the portfolio can reflect not just different asset class preferences, but also different ESG metrics or smart beta factors (such as lower price volatility or better dividends) (Noblett 2022). As the use of segregated accounts suggests, this approach has traditionally been restricted to ultra high-net-worth investors in order to make the approach cost effective. But asset managers are exploring direct indexes with an eye on advances in technology helping to make the approach available to smaller clients too. Several large US asset managers have bought firms working in this area, including Morgan Stanley taking over Parametric (October 2020), BlackRock buying Aperio Group (November 2020), JPMorgan acquiring OpenInvest (June 2021), Vanguard buying Just Invest (July 2021) and Franklin Templeton picking up O’Shaughnessy Asset Management (October 2021). Turning such ambitions into reality, Fidelity’s US business made direct indexing available to retail investors in February 2022.2 Before predicting that this is a sign of what the future will look like in Europe, it is important to bear in mind that the emergence of this approach has taken place in the US. On the other side of the Atlantic, passive funds control a larger proportion of assets (and so are a larger immediate threat to active fund management) and, in addition, tax can play a much more significant role in determining the best investment vehicle to use than in the UK or Europe.3 Also, the contention by direct indexing proponents that retail investors are demanding more customization seems more than a little surprising given that 2. Minimum investment of $5,000, starting with one of three main investment strategies, and clients are charged an annual advisory fee of 0.40 per cent. 3. Fidelity states that nearly 95 per cent of investors in similar direct-indexing strategies have seen tax savings that fully covered their advisory fee; see https://digital.fidelity. com/prgw/digital/msw/overview.

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there are approximately 3.2 million individual indexes available worldwide4 and more than 125,000 funds.5 But more than quibbles over the commercial prospects of direct indexing, there must be a concern that this approach ignores some key benefits underpinning the mutual fund concept. In particular, that pooling clients’ assets together lowers percentage costs and so improves returns. With direct indexing the advisory fee may, over time, be influenced by market forces but the direct relationship between growing scale and decreasing charges is lost. As the fees charged are more akin to those of a financial adviser or wealth manager, perhaps this indicates the motivation for asset managers’ moves into so-called direct indexing – acting as a financial intermediary. Of course, part of the rationale firms might give for moving away from mutual funds is gripes about regulation: the regulation of the fund as an investment vehicle, of its investment manager, of its governance structure, and of its sales process. There is a slight irony in Europe when these moans are heard despite so many asset managers having grown on the back of the success of UCITS regulations giving clients’ confidence in fund regulation across Europe and into Asia and Latin America. Yet these benefits tend to be retained by asset managers, rather than passed on to clients. For example, research from the ESMA shows that UCITS funds sold into several EU markets are, on average, larger than funds sold in only the market where they are based, but these cross-border funds have higher charges than domestic funds. “This holds on average across asset classes and when funds are clustered by size”, ESMA’s researchers find. ESMA adds that “one reason behind this may be linked to heterogeneity of distribution channels and costs, and related cost treatment that would impact the cross-border marketing of a fund” (ESMA 2022). In other words, investors are paying higher fees to help the asset manager sell through more distribution channels and so build assets, but without the cost benefits. Criticism of regulations inevitably reflects commercial imperatives, not least when regulations depart from a reliance on market forces to set pricing levels and push firms to lower their fees (most recently with the FCA’s 4. See Index Industry Association’s fourth and fifth annual benchmark surveys, October 2020 and October 2021. 5. EFAMA, International statistical release, as at December 2020.

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assessments of value for funds). The tricky balancing act comes when asset managers also portray themselves as acting in clients’ best interests. For this reason, if for no other, one should not throw out the mutual fund too quickly (and Schroders, referred to above, makes clear it has not given up on mutual funds). Combining a fund manager’s interests with those of his/her clients is a powerful concept, however old its technology might be (and one could reasonably argue that the ETF has revitalized this technology). Regardless, mutual funds already have competitors when it comes to investment products that customers can choose from, most obviously structured products – about which many asset managers are normally willing to offer dire warnings in relation to their cost structures and risks. The striking lack of price competition among actively managed funds in the UK and Europe has been discussed earlier in this book. Regulators are clearly pushing asset managers to engage more on this issue, and one of Britain’s leading economists John Kay has predicted that “the future of asset management in the 21st century [will be] less about the capital asset pricing model and more about models of product pricing” (Kay 2021). However, one cannot underestimate the scale of change for asset managers’ commercial models if this does come to pass in the UK, let alone across Europe. This is particularly the case because a focus on the capital asset pricing model (if Kay’s phrase is taken as a proxy for investment returns) is already only one of two legs on which an asset management stands – or falls. The other leg is sales. And while, in principle, good fund performance (investment returns) should drive sales (inflows), this is not always the case. Sophisticated asset managers understand this and they understand the multitude of different preferences, or needs, that each client has, and adapt their business to meet these needs. But in an intermediated business, the needs of a wholesale or institutional client might not be the same as the needs of the end-investor (for example, if the intermediary is part of a bank that wants its own, newly-launched funds to be bought). Nor might those needs align with achieving better investment returns (for example, growing a fund beyond its optimum size so as to maximize revenues). The commercial attractiveness of adapting an asset management business to deliver sales growth – often more dependable than the vicissitudes of stock markets – is hard to ignore. The urge to launch new products fits into the same mindset.

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The tension between sales (including product development) and investment performance is implicit in open-ended funds and so, to a certain extent, hidden. But asset managers have also been slow to identify flaws in their businesses that were apparently hidden in plain sight. One example is seen within the corridors of their offices, namely their lack of diversity, be it gender, race or educational background (among others). Firms’ claims to be “people businesses” have too often rung hollow and their ability to deliver best outcomes for clients have been diminished as a result. But here most larger firms are now making efforts to enhance their workforce and change their culture. This apparent blindness also applies to commercial aspects of fund businesses, namely the fees they charge and the salaries and bonuses they pay. The latter is relevant as it is increasingly hard to argue that this does not discredit fund managers (see also Hadas 2015). One can make a philosophical argument about the need for appropriate compensation, or remuneration matching skill and experience, or for pay related to the commercial success of fund companies, but with so many active managers’ performance falling short and with these same managers expected to hold company executives to account for their remuneration policies, this is a growing problem for the industry – not least as it is often happy to gloss over it. The different pressures on active fund managers in Europe and the US are worth dwelling on for a moment. While the rise of index-tracking funds and ETFs in Europe suggests that the continent is moving in the direction that the US has already taken, it would be premature to draw this conclusion. Both because of a home bias and more importantly because of markets in which active managers have been less able to deliver alpha (market outperformance), namely developed western markets. While US, UK and European equity funds make up 70 per cent of equity fund assets in the US, the same proportion is 53 per cent in the UK and just over 33 per cent in Luxembourg and Ireland (used as a proxy for EU investors).6 This, rightly or wrongly, makes the UK and Europe much more resilient for active managers. Despite all this, the value of the mutual fund concept – whether managed actively or passively – and the potential for mutual funds to fulfil their purpose to the benefit of both investors and the wider economy (and potentially 6. Author’s analysis of Morningstar data on mutual funds and ETFs, as at 31 December 20021.

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society too) still holds true. While senior fund executives will inevitably focus on their commercial priorities, and will argue that they are obliged to do so, the industry does seem to be slowly shifting, whether it likes it or not, to bring client interests within commercial considerations. It is surely correct to suggest that an “under-appreciated merit of markets” is that “when they work properly, they make bad people do good things” (Dillow 2021). Firms must have an incentive to change, but this has largely been lacking throughout the history of mutual funds in Europe. However, more firms are now being nudged to recognize that it is in their self-interest to put client interests ahead of their own, even when it comes to commercial matters. With these different elements in mind, it is not fanciful to imagine two futures, both of which may exist in some form. While these may rub along side-by-side, they represent conflicting views of fund management. One is based on the expected demise or redundancy of the mutual fund, the other embraces the principles embedded in the mutual fund (or ETF) structure. The former looks for the best way to maximize revenues and avoid the effects of a squeeze on fund fees, the latter is willing to interpret fiduciary duty as including a commercial dimension (i.e. lowering fees to help clients through improved returns). One takes the route of offering various iterations of alternative investment strategies that are presented as new sources of investment returns to clients, but presented as new sources of revenue and higher profits to shareholders. The other focuses on the real purpose of fund management for clients. In this context, the demise of the mutual fund would not be wrong from a commercial perspective, but would be a sad reflection of a short-sighted view of long-term client interests.

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G LO S S A R Y

Absolute return  Funds that aim to deliver a positive, or absolute, return regardless of the direction in which market indices move over a multi-year period. Active share  The degree to which a fund’s portfolio of investments overlaps with its benchmark. Administrator  A fund administrator has a range of roles, including valuation of a fund’s assets, calculation of a fund’s net asset value, keeping a register of shareholders, and administering the movement of clients’ money into and out of the fund. Algorithmic trading A computer programme follows a defined set of instructions (an algorithm) to place a trade, thus limiting human intervention in any given trade. Alpha  The extent to which a fund has outperformed the market. This can be used as the basis for establishing whether a fund manager has skill. Asset allocation  Strategy or tactics relating to which types of securities to invest in and when, as well as ensuring the portfolio of investments is appropriately diversified and in line with the fund manager’s approach to investing. Asset class  Different types of financial asset in which funds invest. Authorized corporate director The UK equivalent of a management company, although in the UK the ACD’s role combines the management 229

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responsibilities of a management company with oversight responsibilities by also providing a board of directors, albeit one step removed from the fund. Beta  The extent to which a fund’s returns fluctuate with the market. A beta of 1 reflects that the volatility of a fund’s returns exactly matches the market it follows. Bitcoin  See Cryptocurrencies. Blockchain  A technology that proponents say creates a safe way to share information across multiple parties in a model known as a distributed ledger. Bond  A financial instrument that is a type of debt or loan issued by companies (also known as corporate bonds or credit) or by governments. Bond issuers borrow money from lenders (mutual funds in this case) to raise money to finance long-term investments, or for a government to finance its current spending, in return paying interest, or income, to the lender. Closed-ended funds  Commonly known as investment trusts in the UK, closed-ended funds have a fixed number of shares in issue at any one time. Investors buy and sell shares in a closed-ended fund from one another on the stock market. Closed-ended funds therefore have a fixed capital structure. Commission  Sales commission paid from a fund’s assets is known as trail commission in the UK. This is also known as a rebate or retrocession as the fee is levied by the fund but then paid back to the financial intermediary or distributor. Commodities  Funds can invest in physical commodities or derivatives linked to commodity prices. These include agricultural commodities, metals and precious metals. Cryptocurrencies  Digital assets or tokens, such as Bitcoin or Ethereum, that were first devised as a type of electronic cash, but are not currencies as normally understood. There is no central bank or government to support the system, which instead relies on technology to “mine” and transfer the tokens. Individual tokens that make up a cryptocurrency are encrypted strings of data. 230

GLOSSARY

Custodian and depositary  Organizations or entities that have responsibility for the safekeeping of a fund’s assets. Fund custody involves protecting the shareholders’ assets and preventing a fund manager from having access to the assets themselves. The depositary protects shareholders’ assets (although this is often delegated to a custodian), as well as being responsible for the supervision of the conduct of business of the fund’s operations, thus providing external oversight of these activities. Depositary  See Custodian and depositary. Derivatives  Financial instruments that derive their value from other assets. They include futures, swaps, warrants and options. Distribution  Roles and processes involved in distributing a fund from an asset manager (as manufacturer of the fund) to an individual investor (the consumer). Domicile  Legal jurisdiction where a fund is established. Economies of scale  Process by which percentage costs fall as a fund’s assets rise. Environmental, social and governance (ESG)  Non-financial considerations that can be integrated into an investment portfolio. Equities  Term used for shares in a company. Exchange-traded funds  A type of open-ended fund that is bought and sold on a stock exchange. Factors  Investment factors are different drivers of investment returns that have been found by academics to generate better returns than the stock market over some time periods. Investing in an index based on a particular factor is often referred to as Smart beta. Feeder fund  Similar to a fund of funds, but the feeder fund invests at least 85 per cent of its assets into a single master fund, normally managed by the same asset management company. A feeder fund is sometimes set up to make the underlying investment strategy available in a different country but without having to fully replicate the fund. The feeder fund can also be adapted for local requirements without having to change the underlying master fund. 231

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Fiduciary duty  The obligation to act in shareholders’ best interests. Flows  The movement of clients’ money into (known as inflows or sales) and out of (known as outflows or redemptions) a fund. Net flows are the sum of a fund’s inflows and outflows over a given period. Fund of funds  A fund that invests in a range of other funds, either within the same asset management company (known as internal or fettered), or in other firms’ funds (known as external; or unfettered). Futures  A futures contract is an agreement between a buyer and seller that an asset will be bought or sold at a predetermined price on an agreed date. Gearing  Term used for the ability of a fund to borrow. A fund can then use this debt to invest more than its capital, offering the potential for higher returns – and larger losses. Gearing is expressed as the amount a fund borrows as a percentage of its assets. Gilts  Bonds issued by the UK government. Greenwashing  Talking the talk but not walking the walk on sustainability. There are arguably two types of greenwashing: intentional, where an asset manager’s claims are not matched by its actions, and unintentional, where an investor’s expectations are not the same as an asset manager’s actions. Hedge funds  There is no clear-cut definition of a hedge fund. For some, it is a standalone asset class or range of investment strategies that aim for differentiated returns. Originally hedge funds were more lightly regulated and their investor base was more restricted than for mutual funds, which are sold to retail investors. But in Europe this is less clearly the case than originally. High-frequency trading Here a computer programme executes a large number, potentially thousands, of trades in fractions of a second to take advantage of a range of discrepancies in the pricing of securities. Holdings  The investments held by a fund. Index-tracking funds  Funds that seek to track closely the returns generated by an index of securities. Income  See Yield. 232

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Information ratio  This is used to assess the potential for an active manager to outperform a benchmark by calculating the fund’s returns above the benchmark relative to the volatility of the fund’s returns (using its tracking error). Initial charge  A potential one-off charge borne directly by a client when investing in a fund, often used to pay sales commission to a financial intermediary. The equivalent charge levied when withdrawing from a fund, known as an exit charge, is rarer. Each is referred to as a “load” in the US, i.e. front-end load and back-end load. Institutional mandate  Also known as 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. Investment trusts  See Closed-ended funds. Key Investor Information Document  Designed to provide retail investors with a simple summary of the key features of a UCITS fund, introduced by the EU in response to the shortcomings of the previous simplified prospectus. UCITS KIIDs are in the process of being replaced by Key Information Documents as part of the EU’s PRIIPs regulation. Liquidity  The ease with which a financial asset can be bought or sold. Money market instruments are very liquid, whereas real estate is not. Listed  Refers to companies that have sold all (or some) of themselves as shares, which are in turn available to be bought or sold on a stock exchange. This process means the company is publicly traded, or publicly listed, albeit privately managed. Load  See Initial charge. Long/short  See Short-selling. Management fees  Annual charges paid from the assets of a fund to the asset management company and indirectly borne by investors through reduced returns. In principle management fees are paid to the asset manager, but the charge is sometimes used to pay for costs incurred by other organizations servicing or distributing a fund.

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Manager of managers  Funds that outsource their investment management by dividing up their assets into several mandates that are each managed by an external fund manager, sometimes known as a sub-advisor. Individual funds can also be managed by a single sub-advisor. Management company  The company, also known as a “manco”, that provides oversight and compliance function to funds. Can be outsourced to a third party. Market capitalization  The size of a listed company based on its market value. This value is calculated by multiplying the total number of a company’s outstanding shares by the current market price of one share. Master-feeder structure  See Feeder fund. Mixed asset fund  See Multi-asset fund. Money markets  Financial instruments that offer investment features similar to cash deposits, with a low level of risk together with low expected returns. Multi-manager funds A term referring to both Funds of Funds and Managers of Managers. Multi-asset funds  Funds that can invest into multiple-asset classes. The distinction between a mixed-asset and multi-asset fund is a slightly grey area, although use of the latter term usually reflects that the fund can invest in asset classes beyond equities, bonds and cash. Mixed-asset funds were traditionally called balanced funds. Mutual fund  Also known as a collective or pooled fund, this is the main product around which an asset manager’s business is built. 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. Net asset value (NAV)  A fund’s net asset value is the total value of its assets, less its liabilities. The NAV is calculated by multiplying the number of shares (or units) in the fund by their price. Offshore  Traditionally used to describe jurisdictions that had looser regulations and a lower tax regime, giving funds greater investment freedoms,

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GLOSSARY

making them attractive to hedge funds. The development of Luxembourg and Ireland as bases for UCITS funds sold internationally have led to them being labelled as “offshore” centres too. Ongoing charges  Annual operating costs incurred by a fund and indirectly borne by investors are known as its ongoing charges. These costs include paying for the fund’s investment management (management fee), as well as for back-office service providers and potentially sales commissions to financial intermediaries. Ongoing charges is a term introduced by the EU to replace total expense ratio and, while similar, the two are calculated slightly differently. Open-ended funds  The most common form of mutual fund, which expands or contracts as investors move their money in or out of the fund, with the asset manager creating new shares when investors buy and cancelling shares when investors sell. Open-ended funds therefore have a variable capital structure.The open-ended fund’s structure means that the value of its shares directly reflects the value of its underlying investments. Different legal types of open-ended fund include ICVCs, OEICs, SICAVs and unit trusts. Options  See Warrants and options. Pension scheme  Broadly split between defined benefit (DB) schemes that are managed by an employer and pay former employees an income based on their salary and/or length of service, and defined contribution (DC) schemes that combine employee and employer contributions to give employees a lump sum at retirement. Performance  See Return. Performance fee  A fee that varies depending on performance of the fund, rather than being based on the fund’s assets. Platform  A form of online investment account where clients can hold funds, shares and other investments in one place with the aim of reducing administration and costs compared to investing directly with each company. Financial intermediaries also use platforms to outsource this administrative burden.

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Portfolio  The assets or investments held by a fund. Price  The value of one share (or unit) of a fund. See also Net asset value. Be aware that occasionally the pricing of a fund may refer to its annual charges, which is a different concept. Private markets  Financial assets, such as private equity, that are not available via public markets (such as companies listed on a stock exchange or government bonds). Regulated mutual funds are typically limited in the amount they can invest in private assets, for example, UCITS funds can only invest a maximum 10 per cent in illiquid assets. Real estate  Funds can invest in commercial property, including industrial (such as warehouses), retail (such as shopping centres), as well as offices and student accommodation. However, UCITS funds can only invest a maximum 10 per cent in illiquid assets. Retail clients  References to retail clients by asset managers will tend to include wholesale clients, i.e. financial intermediaries that advise end-clients on their investments. These intermediaries include independent financial advisers, wealth managers and private banks. It is these intermediaries that are asset managers’ main non-institutional clients. By contrast, sales directly to retail clients (D2C) typically make up a small fraction of fund companies’ overall business. Retail Distribution Review Rules introduced following the UK financial regulator’s review of the retail investment market. The RDR raised the minimum level of adviser qualifications, improved the transparency of charges and removed most sales commission payments from funds to financial advisers and platforms. Retrocession  See Commission. Return  The change in the value of a fund investment, normally shown over one year or multiple annual periods. This is often referred to as the performance of a fund. The total return of a fund includes both capital gains in the value of its investments as well as any income generated (and retained) from those investments. See also Absolute return.

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GLOSSARY

Securities lending  In principle, a fund can lend out its securities in order to generate revenues that are then passed on to the fund’s investors, improving investor returns. The asset manager will also retain a portion of the fee earned. Segregated account  See Institutional mandate. Sharpe ratio  This shows a fund’s risk-adjusted performance by dividing the fund’s annualized returns above a so-called risk-free (cash) rate by its annualized standard deviation (measuring the volatility of a fund’s returns). Short-selling  Funds that take both long and short investment positions, often associated with hedge fund investing. Conventional funds take long investment positions in companies, buying securities in the expectation that their value will rise. A fund manager will take additional short positions if they expect the value of a company to fall. To do this, the fund manager borrows shares of the company, then sells them in the expectation that the share price will fall. When the fund manager needs to return the borrowed shares, he or she buys them from the market and returns them to the lender. If the shares have fallen in price during this period, the fund manager will have made money, but there is also the risk of losing money if the shares have risen in price. Smart beta  See Factors. Spezialfonds  German funds dedicated to institutional clients; described as mandates in a fund wrapper. Stewardship  A term used to describe fund managers engaging more fully with investee companies’ management to improve the way the companies are managed. The distinction between investment and stewardship is underlined by the fact that asset managers’ stewardship teams are normally separate from their investment management team, although the exact structure may depend on the size and resources of a firm. Sub-advisor  See Manager of managers. Swap  A contract whereby two parties exchange, or swap, a financial instrument’s cash flows for a specific period of time. The most common are interest rate swaps.

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Total expense ratio  See Ongoing charges. Total return  See Return and Absolute return. Tracking difference  The difference between the return of an index-tracking fund (or ETF) and that of the index it tracks. Tracking error  Sometimes called active risk, this shows the volatility of a fund’s excess returns relative to a benchmark, with a lower figure suggesting that the fund is not being actively managed. Trading costs  These costs are incurred when a portfolio manager buys or sells securities, as well as the taxes related to these transactions, such as UK stamp duty. Also referred to as transaction, brokerage or dealing costs, these are not included in European funds’ ongoing charges. Trustee  This function exists in countries where trust-related law governs funds (notably the UK). The trustee’s role is similar to the control function of the depositary in other jurisdictions, but the trustee does not have a custody role. Umbrella fund  An asset manager’s overarching fund vehicle that must be authorized by an EU regulator before sub-funds within the umbrella can be sold to investors. UCITS  The product-related regulation that sits at the heart of the EU’s Directive on Undertakings for Collective Investment in Transferable Securities. This set down the legal fund structures that UCITS could take, their permitted investments, liquidity requirements, prospectus disclosures, and the duties of related functions, such as custodians or depositaries. In this way UCITS is a fund label, rather than a legal structure. With these ground rules established, UCITS has since established itself as an international standard of robust, retail investor-friendly fund regulation. Unit trust  A trust-based open-ended fund structure that used to be the most common fund structure in the UK. Since overtaken by OEICs. See Openended funds. Unit-linked  Unit-linked funds, or unit-linked insurance plans, provide an insurance policy wrapper around a mutual fund, thus combining insurance and investments in one product for the insurer’s clients. 238

GLOSSARY

Volatility  The range of returns generated by a fund (or stock) over a given period of time. Warrants and options  Options give the holder the right – but not the obligation – to buy or sell an asset from/to another party at a predetermined price before an agreed date. The option to sell an asset is called a “put option”, while the option to buy an asset is called a “call option”. A warrant is a variation on this, giving the holder the right to purchase a company’s stock at a predetermined price on an agreed date. Wholesale clients  See Retail clients. Yield  A fund’s yield is the income generated from an investment, such as the interest received from bonds or the dividends paid from shares.

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248

TA B L E S A N D F I G U R E S

Tables 1.1 1.2 2.1 3.1 3.2 3.3 7.1 9.1 9.2

Size of the global funds industry World’s largest asset managers Direct employment by UK asset managers Largest managers of UK-domiciled funds Pay at listed asset managers (€’000) Profitability, costs and revenues of asset managers Open-ended funds vs closed-ended funds Examples of funds’ annual fees and expenses Fund of Hedge Funds’ charges

4 7 16 44 59 60 143 204 209

Figures 2.1a Fund flows in the UK (£bn): Sales versus redemptions 2.1b Fund flows in the UK (£bn): Retail versus institutional sales 2.2a Asset managers’ European marketing budgets, 2021: Proportion of firms’ total marketing spend 2.2b Asset managers’ European marketing budgets, 2021: Proportion of firms’ marketing spend by category (%) 2.3 New funds drive industry growth: European fund assets (€ trillion)

23 23 28 28 33 249

THE ECONOMICS OF FUND MANAGEMENT

3.1 Distribution of European fund assets by firm size 3.2 Where an investor’s money goes 3.3 Average annual fees paid by UK advised clients 3.4 Breakdown of retail fund managers’ costs (%) 3.5 Asset management valuations, median value of listed asset managers as percentage of AUM 4.1 Size of European fund asset classes (€bn) 4.2 Asset class returns (%) 4.3 Past and future returns (%) 4.4 Same returns, different volatility 4.5a Multi-manager products: Manager of Managers 4.5b Multi-manager products: Fund of Funds 6.1 UK retail investor average holding periods 8.1a BlackRock’s growth since its acquisition of BGI ($bn): Cumulative asset growth 8.1b BlackRock’s growth since its acquisition of BGI ($bn): Annual asset growth 8.2 Size of European markets 8.3a European asset managers’ largest institutional clients ($bn): Insurance assets 8.3b European asset managers’ largest institutional clients ($bn): Pension assets 8.4 Retail distribution channels 8.5 European fund launches and closures 8.6 Number of technology funds launched in Europe 9.1 Passive proportion of fund assets 9.2a Impact of RDR on charges and shares classes: Average fund charges (%) 9.2b Impact of RDR on charges and shares classes: Assets ($bn) 9.3 Drag effect of annual charges on fund returns 9.4 Charges for the UK’s largest active funds

250

41 51 53 57 63 71 76 77 90 94 94 125 166 166 170 172 172 178 182 184 191 193 193 199 214

INDEX Numbers in bold refer to tables and figures. Aberdeen Asset Management (abrdn) 29–30, 43, 44, 47, 59, 64–5, 92, 101, 107, 114, 130n, 160 absolute return 79, 108, 110, 185, 210, 220, 229 acquisitions see mergers and acquisitions active versus passive 17, 79–80, 87–92, 125–6, 136–7, 139–40, 144–5, 168, 183, 189–91, 195–6 administration (of funds) 8, 16, 21, 35–7, 47, 49, 51, 55, 81, 186, 202, 229 algorithmic trading 84–5 see also data science Allianz 7, 8, 211 alpha 86, 89, 201, 226, 229 Alderwood Capital 46, 62 Alternative Investment Management Association (AIMA) 206–207 alternative investments 73–6, 80–81, 153–6, 206–208, 227 Affiliated Managers Group (AMG) 46 Amundi 7, 8, 45, 59, 89, 176–7, 181, 193, 216 Anderson, J. 131 Aon 173, 197 Artemis Investment Management 46, 148 Asia Pacific (funds industry) 4, 6, 146, 167, 183, 224 assessment of value 196–7, 200, 214, 225 asset allocation 67–8, 73, 93–5, 173, 229

asset class 70–7, 153, 167–8, 229 Association Française de la Gestion financière (AFG) 206 audit 16, 34–5, 51, 202 authorized corporate director (ACD) 47–8, 114, 116–7, 121–2, 143, 157, 196, 198, 229 AXA Investment Management 8 back office 9, 35–6, 55–6, 186 Baillie Gifford 8, 44, 92, 131, 213 banks (as fund distributors) 3, 19–20, 42–3, 49, 52, 92–3, 163, 167, 174–9, 182–3, 188, 225 Barings 98–9, 101, 185 Bedlam Asset Management 211 beta 62, 86, 230 bitcoin see cryptocurrency BlackRock 7, 8, 25, 29, 44, 59, 82–3, 138, 159, 181, 216–7, 223 iShares 80, 89, 142, 193 sales machine 165–7 see also Lyttleton, M. blockchain 29, 38, 230 Blue Whale Capital 101 BNP Paribas 7, 35, 177 Bogle, J. 142, 144 bonds 70–72, 76–8, 83, 111–2, 137, 145, 154, 190, 199, 230, 232 borrowing see gearing Bond Vigilantes (M&G) 26 Boston Consulting Group (BCG) 1n, 56–60 251

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boutique asset managers 39–42, 46, 100, 154, 181, 211 branding 24–30, 40, 93, 168, 201, 222 Brexit 18, 22, 33–4, 46–7, 135, 146, 148–9 Broadridge 33, 41, 169, 171–2, 177–9, 192–3 Buxton, R. 100, 169 buy lists 167–9 BVI (trade association) 206 Candriam 136–7 capitalist economy (fund managers’ role in) 125–7 Carhart, M. 87 Carmignac 41, 181, 203–204 Cerulli Associates 6n, 27–8 CFA Institute 34, 157 charities 45, 49, 170, 172–3 Chatfeild-Roberts, J. 115 Christianity (and investing) 70, 173 climate change (and investing) 128, 131–8 client service 16, 19–23 closed-ended funds 65, 92, 102, 116, 141–3, 153, 230 Columbia Threadneedle see Threadneedle commission (for fund sales) 50–53, 103, 178, 188–9, 192–3, 201–202, 230, 233 commodities 70–77, 145, 230 compensation see remuneration compliance 15–16, 25–6, 34–5, 55–7, 156 conflicts of interest 12, 112–3, 122, 133, 157–61, 165, 199, 211, 213, 215, 219 consumer duty 160–61 Cornfeld, B. 102–104, 119, 122, 146, 150, 155, 165, 219 corporate culture 29, 91, 99, 109–10, 117–22, 215, 220, 226

252

cost-to-income ratio 57 cost management (of business) 54–7 Covid-19 pandemic 5–6, 24, 37–8, 39, 58, 69, 82, 112, 164 Credit Suisse 64, 77n, 177 Crux Asset Management 148 cryptocurrencies 38, 75–6, 81, 131, 180, 222, 230 culture see corporate culture custody 36, 51, 145, 231 Dasgupta Review 137–8 data science 81–4, 222 Deloitte 62–3, 66 demand see supply and demand depositary 36, 47, 145, 153, 231 derivatives see hedge funds direct indexing 223–4 direct-to-consumer (D2C) 50, 179–80, 236 discretionary manager 20, 49, 53, 56, 177–8 diversity 37, 119, 226 domicile (of fund) 155, 231 Donaldson, W. 12 dot com bubble 183–4 DWS 8, 45, 59, 89, 129, 177, 216 economies of scale 55, 196, 202, 212–5, 231 education and qualifications 25, 119–20, 226, 236 employment (by asset managers) 8, 15–16, 37, 58–9, 118–22 engagement see stewardship environmental, social and governance (ESG) 51, 68–9, 126–40, 220 Equitile Investments 211–3 equities 51, 70–73, 76–80, 190–91, 226, 231

INDEX

ethics see corporate culture see also Christianity (and investing) see also Shari’ah (and investing) European Fund and Asset Management Association (EFAMA) 4, 5, 16, 163, 170, 183, 200, 224 European Securities and Markets Authority (ESMA) 47, 197, 206, 216, 224 exchange-traded funds (ETFs) 75, 80, 134–7, 139–40, 142, 144–8, 165–7, 180, 215–7, 225, 231 factsheets 24–5, 152 Fama, E. 89 family offices 175–6 Fancy, T. 138 Fidelity 7, 8, 43–5, 76, 92, 100, 121, 160, 179–80, 211, 223 fiduciary duty 127, 158–61, 184, 197–8, 206, 219, 227, 232 Financial Conduct Authority (FCA) 19–20, 47, 48, 112–3, 117, 130, 146, 159–61, 214, 224–5 asset management market study 32, 60–61, 188, 195–9, 215 financial crisis (2008) 5–6, 15, 60–1, 113, 153, 160, 165, 181 Fink, L. D. 59 Fitz Partners 6n, 192, 193 fixed income see bonds Flossbach von Storch 100, 181 Fonds commun de placement (FCP) 144 Foreign & Colonial investment trust 141 Franklin Templeton 7, 8, 40, 45, 59, 147, 223 front office 16–19 fund of funds see multi-manager fund selection 19–20, 41–2, 49, 52, 85, 89–95, 99, 135, 167–9, 173, 178, 189, 197–8

Fundsmith 26, 40–1, 44, 100, 181, 203– 204, 213–4 GAM 1–2, 59, 63–4, 110–13, 121 Gamestop 222 gearing 143, 232 Gilbert, M. J. 46, 64–5 Goldman Sachs 7, 46 governance (of funds) 32, 47, 121–2, 156–61, 200–201, 224 see also assessment of value governance (of investee companies) 68–9, 84, 126, 131–3 see also stewardship Government Pension Investment Fund (Japan) 217 greenwashing 35, 129–30, 135–6, 232 Gross, W. H. (Bill) 190, 199 groupthink 220 H2O Asset Management 1–2 Hargreaves Lansdown 117, 177, 180, 210 Harrison, P. 59, 222–3 Haywood, T. 110–13, 119, 121 hedge funds 74–7, 80–81, 84–5, 150, 153–6, 216–7, 222, 232 and performance fees 205–209 see also short-selling high frequency trading 84–5, 232 holding period 124–5, 219 home bias 195, 226 Horlick, N. 101, 106 impact investing 127–8, 221 independent financial advisers (IFAs) 19–22, 43, 49, 52–3, 117, 168, 177–9, 188, 191, 210, 236 index-tracking see active versus passive see also exchange-traded funds individual savings account (ISA) 3 information ratio 86, 233 253

THE ECONOMICS OF FUND MANAGEMENT

information technology (IT) 16, 36–8, 56–7 instiHub Analytics 6n, 93 insurance companies 3, 8, 50, 51, 103, 170–72, 176, 178, 197, 238 Invesco 8, 44, 59, 66, 76, 92, 113–5, 160, 169, 185 investment analyst 16–19, 25, 68, 100 Investment Association (IA) 8, 15–16, 23, 34, 36, 55–6, 58, 60, 85, 115, 124–5, 160 Investment Company Institute (ICI) 191–5 investment objectives 5, 24, 70–71, 85, 130, 134–7, 139–40, 178, 206–207 investment strategy 78–81, 127–8, 139–40, 145 investment trusts see closed-ended funds investor protection 36, 146, 151–2, 155, 231 International Organization of Securities Commissions (IOSCO) 84 Investors Oversees Services (IOS) 102–4, 146, 165 J.P. Morgan 7, 8, 35, 43, 44, 76–7, 100–101, 223 Jensen, M. 87 Kay, J. 225 key investor information document (KIID) 32, 151–2, 233 Konotey-Ahulu, D. 221 Legal & General 7, 8, 44, 132, 176, 179–80 Lindsell Train 100 Link Fund Solutions 44, 47–8, 114, 116–7, 121–2

254

Lipper 181–2 liquidity 35, 114–6, 124–5, 145, 233 long/short investing see short-selling Lyttleton, M. 107–10, 119, 121 M&G 26, 44, 59, 66, 141–2, 148, 159, 160, 176 machine learning see data science Malkiel, B. G. 87 manager skill 87–92, 97–8, 229 mandates 5–7, 22–3, 92–4, 169–74, 192–3, 233 margin (profit) 54, 60–61, 197 marketing 24–30, 55–7 Markets in Financial Instruments Directors (MiFID) 18, 19–20, 32, 52, 158, 188–90, 192, 200, 202 Marshall Wace 44 Massachusetts Investors’ Trust 141–2 McKinsey 58–61 mental health 106, 109–10, 117–22 Mercer 6, 93, 173, 197 mergers and acquisitions 43, 46, 61–6, 75 middle office 34–5, 55 model portfolios 178 money market funds 54, 71–3, 150, 170 Morgan Grenfell 64, 104–107 Morningstar 6n, 71, 75, 78, 150n, 164, 175, 183–4, 186n, 191, 205, 214 multi-asset 73–4, 234 multi-manager 93–5 Municipal & General First British Fixed Trust 141 Musk, E. 131 Muzinich & Co 100 Natixis 2, 7, 40 net asset value (NAV) 11, 35, 72, 143, 144, 229, 234 new products see product development

INDEX

Norway Government Pension Fund Global 171 offshore 103, 155–6, 234–5 old boys’ network 119–20 open-ended investment company (OEIC) 142–4, 148–9, 157, 235 operations (of fund company) 16, 35–8 Orbis 211–12 outsourcing 21–2, 33–5, 45–9, 54–7, 92–5, 163–4, 171–2, 178 oversight see governance (of fund) ownership models 9, 39–45 packaged retail investment and insurance products (PRIIPs) 202, 233 passive investing see active versus passive past performance 30, 76–8, 85, 87–92, 152, 168, 183, 189 pay see remuneration pension schemes 49, 51, 56–7, 91–2, 132, 158–9, 169–74, 176, 196–8, 235 performance (of funds) see past performance performance fees 154, 203–204, 205–12 Pictet 8, 40, 45, 201 PIMCO 8, 41, 83, 147, 190 platforms (online) 9, 26, 43, 49–52, 124–5, 144, 179–80, 192, 222, 235 price competition 178, 187–91, 196, 225 pricing see valuation (of fund) pricing see product pricing principles for responsible investment (United Nations) 133–4 private banks 49, 175, 177–8, 236 private equity (as business owner) 45–6 private markets 74–5, 153, 220–22, 236 product development 30–34, 181–6

product pricing 200–201 profitability 12, 40, 54–66, 119, 124–7, 172–3, 196–7, 199–200, 213, 219–20, 227 proliferation (of funds) 32–3, 183–6 property see real estate prospectus (fund) 17, 32, 145, 151–2, 207, 233, 238 qualifications see education and qualifications quant investing 79, 128, 131 Ramsey, L. 201 real estate 71, 73–5, 143, 153, 176, 233 rebates see commission Rees-Mogg, J. 148 remuneration 58–61, 120–21, 190, 226 Retail Distribution Review (RDR) 50, 53, 144, 177–8, 188–93, 200, 210, 236 retrocessions see commission revenue 10–13, 50–66, 173, 186, 188–91, 194, 199–200, 205, 207, 212–7, 219, 227 risk see volatility (of fund performance) Rize ETF 136–7 robo-advisers 179–80, 222 sales (of funds) 19–23, 164–80 Schroders 8, 43–5, 59, 82, 114, 132, 160, 169, 199, 222, 225 Scottish Mortgage investment trust 131 securities lending 215–7 segregated accounts see mandates shares see equities Shari’ah (and investing) 70 sharpe ratio 86, 237 short-selling 80–1, 84, 150, 154–5, 215–17, 237 skill see manager skill

255

THE ECONOMICS OF FUND MANAGEMENT

smart beta 79, 145, 223 social media 25–8, 82–3, 222 Société d’investissement à Capital Variable (Sicav) 142, 147, 235 soft dollars 18–19 Somerset Capital Management 148–9 sovereign wealth funds 171–2 Spezialfonds 5, 170, 237 Spier, G. 213–15 split capital investment trusts 65 St James’s Place Wealth Management 93, 177 stamp duty 202, 238 Standard Life Investments Global Absolute Return Strategies 185 State Street 7, 35, 89, 142, 216 stewardship 68–9, 126, 130–33, 217, 237 sub-advisor 92–5, 234 subscale (funds) 88, 185–6 supply and demand 9–10, 187–91 survivorship bias 87–8 Sustainable Development Goals (SDGs) 130, 134–7, 139 sustainable finance disclosures regulation (SFDR) 135–40

Threadneedle 44, 148, 180 tracking difference 80, 190, 238 tracking error 86, 238 trading costs 202, 238 transaction costs see trading costs trash ratio 75

tax advantage for ETFs 144, 147 advantage for investors 3, 31, 156, 174 corporate rates 146, 155, 156 and performance fees 208 taxe d’abonnement 148, 156 taxonomy (sustainable) 135–6 Tesla 75, 131 Thatcher, M. 201 third-party distribution 22

wealth managers 19, 22, 49, 93, 135, 168, 170, 177–8, 236 Wheatley, M. 159–60 Willcocks, J. 159 Willis Towers Watson 7n, 173, 197 Woodford, N. 1, 26, 46, 48, 100–101, 113–17, 119–22, 169

256

UBS 7, 63, 89, 101, 177, 179, 216 UCITS 74–5, 142–56, 238 umbrella funds 147, 238 Union Investment 1, 120–21, 177 unit trusts 142–4, 148, 238 United Nations see Sustainable Development Goals (SDGs) see also principles for responsible investment valuation of companies 61–6 of funds 11, 35, 236 value see assessment of value value chain 9, 48–54 Vanguard 7, 8, 43, 44, 45, 89, 142, 144, 147, 193, 216, 223 volatility (of fund performance) 78, 86, 90, 145, 151–2, 239

Young, P. 104–107, 121 Yu’e Bao 54