The curious case of asset management

Betting on the business of asset management can be more remunerative than betting on their funds. Asset managers (also referred to as asset management companies — AMCs — or investment management companies) manage money by sponsoring mutual funds, alternate investment funds (real estate investment trusts, hedge funds, private equity funds, and so on). Their customers include retail investors, corporations and endowments.

They charge a fixed management fee, which is usually a percentage of assets under management (AUM) and depends on the nature of funds. For instance, index funds and debt funds have lower fees compared to equity funds and hedge funds.

In addition to the fixed fee, asset managers in the alternate investments business also charge a variable fee (commission) on the returns that the funds generate based on pre-agreed thresholds. Typically, the fixed-variable split for alternate investment management is 2 per cent of AUM and 20 per cent of profits.

Attracting capital

Globally, investment management is an extremely competitive business with individual fund managers having to justify their existence and fees — on a monthly basis, in terms of returns generated.

Despite all this pressure, academic finance research shows that over the long term, on an average, actively-managed funds generate after-fee returns that are less than returns from a passive index (for example, S&P 500).

However, active asset managers continue to attract ever-increasing amount of capital from investors, thanks to their inclination to bet on recently successful funds.

Also, asset managers have the ability to hedge their bets by sponsoring multiple funds under their umbrella — backing different genres, styles and managers.

This way even if individual funds underperform/fail, the asset manager can still survive and thrive through its other schemes that have done better.

Blessed they are

An analysis of stock performance of asset managers vs key indices — globally as well as in India — throws up an interesting finding.

Asset managers have outperformed the broad index by generating around 50 per cent more returns per annum over the last 10 years.

In my opinion, the asset management industry is one of the few blessed with attractive economics. The fixed fee provides steady stream of revenues and the variable fee provides upside, when applicable.

Asset managers can grow their AUM and consequently their revenues through market and fund performance and additional in-flow of capital.

Redemption pressures can shrink AUM from time to time, depending on market conditions, but over the long-haul, markets trend upwards and asset managers that have a decent basket of funds (in terms of performance) can continue to grow their revenues.

The key costs are fund management and distribution costs, the latter being applicable mainly for mutual funds.

The core fund management or investment operations cost does not have to expand linearly with fund size — as the same team could potentially manage more money.

Consequently, there is limited re-investment required to maintain and grow operations, leading to high free-cash flow and dividend yield.

This means growth in revenues often leads to disproportionate growth in margins, profits and return on equity (ROE) for asset managers.

Healthy margins

Historically, the margins for global asset management industry have been healthy — around 30 per cent.

This translates to a healthy return on equity (ROE) for the players, which can be over 30 per cent during prolonged bull phases. As a result, there is minimal need to borrow money (use debt) to finance operations.

In fact, it is these economic characteristics that make even small asset management companies profitable.

Unfortunately, the story may be somewhat different for the Indian mutual fund industry, which displays dichotomy.

While the large asset managers such as HDFC AMC are extremely profitable with ROE of over 40 per cent, many of the smaller ones continue to make losses.

This is primarily due to high distribution costs and the regulatory regime.

(The author is a business consultant. He can be reached at >perspective@thehindu.co.in) . The views are personal.)

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