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The fund-management industry has done very well�but mainly foritself, says Philip Coggan

fees, so they have little interest in recom-mending low-cost alternatives.

Hence the clients get engaged in a costlygame of chasing the best performers, eventhough by de�nition they are bound, onaverage, to lose it: after costs, the averagemanager inevitably underperforms themarket. Figures from John Bogle of Van-guard, an American fund-managementgroup, neatly illustrate the point. Over the25 years from 1980 to 2005, the S&P 500 in-dex returned an average of 12.3% a year.Over the same period, the average equitymutual fund returned 10% and the averagemutual-fund investor (thanks to his regret-table tendency to buy the hottest funds atthe top of the market) earned just 7.3%, �vepercentage points below the index.

But whereas the clients have not al-ways done particularly well out of the in-dustry, the providers have prospered. Inrecent years the growth of private equityand hedge funds has led to more wide-spread use of performance fees, creating anew class of billionaires. The balance be-tween the industry and its clients will notbe redressed until investors learn thathigher fees do not guarantee higher re-turns. �There’s a huge amount left to do inorder to provide a reasonable propositionto the client,� admits Alan Brown, chief in-vestment o�cer of Schroders, a Britishfund-management �rm.

Even so, fund management is undergo-ing a revolution of sorts. �The industry is inthe process of more change than I’ve seenin the 30-plus years that I’ve been in the

Better than beta?Managers’ superior skills are becomingharder to prove. Page 3

Plenty of alternativesBut hedge funds and private equity have theirlimits. Page 6

In the spotlightFund managers are having to polish their im-age. Page 7

All things to all menThe industry is becoming more diversi�ed.Page 9

We make, you sellSometimes it’s better to concentrate on onething. Page 11

Jam today, jam tomorrowWhy the industry will still be thriving in tenyears’ time. Page 12

The Economist March 1st 2008 A special report on asset management 1

1

Money for old hope

IMAGINE a business in which other peo-ple hand you their money to look after

and pay you handsomely for doing so.Even better, your fees go up every year,even if you are hopeless at the job. Itsounds perfect.

That business exists. It is called fundmanagement. Charley Ellis, a veteran ob-server, explains that fees in the industrytend to grow at around 15% a year becausemarkets rise by an average of 8% and sav-ings grow by 5-6%. This growth is beingmaintained despite the industry’s vastsize. According to a report by Watson Wy-att, a consultancy, the value of all profes-sionally managed assets at the end of 2006was $64 trillion (see chart 1, next page).

Under the normal rules of capitalism,any industry that can produce double-digit annual growth should soon beswamped by eager competitors until re-turns are driven down. But in fund man-agement that does not seem to be happen-ing. The average pro�t margin of the fundmanagers that took part in a survey by Bos-ton Consulting Group was a staggering42%. In part, this is because most fundmanagers do not compete on price. In-stead, they persuade their clients to selecttheir funds on the basis of past perfor-mance, even though there is little evidenceto show that this is a good predictor of fu-ture success. Nor can investors be sure thatthe intermediaries who sell the funds�brokers, advisers and bankers�will steerthem in the right direction. These middle-men often get a cut of the fund managers’

Also in this section

www.economist.com/audio

An audio interview with the author is at

www.economist.com/specialreports

A list of sources is at

AcknowledgmentsApart from those mentioned in the text, particular thanksgo to Cathy Alsop, Edward Bonham Carter, Peter Cham-bers, Gay Collins, Hendrik du Toit, Kyle Johnson, VincentLoporthio, Arlene Rockefeller, Keith Skeoch, FarleyThomas and Roger Yates.

2 A special report on asset management The Economist March 1st 2008

2 business,� says Mr Brown. In part, this re-�ects the lessons of the 2000-02 equitybear market. Pension funds had beenheavily exposed to equities in the 1990s,which allowed the sponsoring companiesto take contribution holidays. But whenshare prices fell, pension funds went intothe red, raising doubts over whether equi-ties were the right match for the long-termliability of paying out retirement bene�ts.Some pension funds switched to bonds;others demanded products that deliveredpositive returns, regardless of the perfor-mance of the equity index. That openedthe door to hedge funds, private equityand a whole school of investing known asalternative assets.

The market for retail investors is alsochanging. These days most fund managersdo not deal directly with such clients, butsell their funds to third parties such as bro-kers, advisers, private banks and pooledportfolios called funds-of-funds. Thissaves fund managers a lot of marketing ex-penditure, but it also leaves them at themercy of the middlemen. They can no lon-ger rely on the inertia of clients who staywith a �rm for most of their lives; instead,holdings are churned as the intermedia-ries seek to generate the highest possiblereturns and justify their fees.

Call me unpredictableOne of the industry’s biggest problems isthe markets themselves. Not only dowhole asset classes go through dismal pe-riods, but investing styles too go in and outof fashion. A technology manager with ashining reputation in 1999 may havefound that by 2002, 90% of his fund valuehad vanished. Even Bill Miller, the starmanager at Legg Mason who beat the S&P

500 index 15 years in a row, has just suf-fered two years of poor returns. The latestevent to ruin fund managers’ performance

numbers has been the credit crunch. A second problem is that, in fund man-

agement, size is not necessarily an advan-tage. True, it can bring an improvement inmargins; managing $2 billion does not costtwice as much as managing $1 billion. Italso gives managers the marketing clout tobuild a brand name. Yet size can also be theenemy of investment performance. If afund becomes too large, trading movesprices against the manager, or the fundstarts to resemble the overall market. Andstar managers may be driven away by bu-reaucracy or lack of freedom.

So far, fund managers have been re-markably successful in maintaining theirhigh fees, even in the face of lower invest-ment returns in recent years. For more thanthree decades they have been �ghting thechallenge from �passive� rivals, whichsimply track the market through an indexsuch as the S&P 500 or the FTSE 100. Butnow there are passive versions of otherfund-management styles too, even high-charging hedge funds. Asset managers, forso long the Bloomingdales and Harrods of�nance, are facing competition from thesector’s Wal-Mart in the form of exchange-traded funds (ETFs), a �exible vehicle thatgives investors exposure to almost any as-set class at low cost.

Yet the industry is also being presented

with two great long-term opportunities. Inthe developed world, populations are age-ing and the burden of retirement provisionis increasingly falling on the individual. Insome countries the state pension o�ers lit-tle more than a subsistence income, andcompanies are increasingly retreating fromthe expensive �nal-salary pension prom-ises that they made in the 1970s and 1980s.This gives the asset-management industryan opportunity to step into the breach.

In the developing world, meanwhile,rapid economic growth is creating an im-mense amount of new wealth. Energy bil-lionaires in Russia and sovereign-wealthfunds in China and the Middle East mayturn to the asset-management industry toguide their investment decisions.

Although those two huge opportuni-ties are likely to ensure that the industrywill survive and prosper, the future ofindividual companies is far more di�cultto predict. Only ten years ago the Britishpension-fund industry was dominated byfour big names; Mercury, Phillips & Drew,Gartmore and Schroders. But competitionhas blown that cosy oligopoly apart: the�rst two names on that list no longer existas separate companies.

Individual managers are having tomake a series of choices. Do they empha-sise their skill (�alpha� in the jargon) orhead down the passive (�beta�) route? Dothey stick to traditional asset classes, suchas equities and bonds, or branch out intoalternative areas such as hedge funds andcommodities? Do they stay small, aimingfor boutique status and putting the em-phasis on performance? Or do they aimbig, covering as many areas as possible,and protect themselves against the vicissi-tudes of the markets? Even more drasti-cally, do they give up the business of in-vesting altogether and concentrate on therelationship with individual clients, sell-ing them other people’s investment pro-ducts? That, in e�ect, is what Merrill Lynchdid, selling its fund-management businessto BlackRock. Citigroup made a similardeal with Legg Mason.

In response, a host of di�erent modelsis emerging, from tiny specialists with afew hundred million dollars of assets to re-tail giants such as Fidelity or hybrids suchas the Bank of New York Mellon, whichhas more than $1 trillion of assets spreadamong a collection of boutique managers.This special report will explain how fundmanagers make these choices and what isbest for the most important people: the in-dividuals who entrust their savings to thefund-management industry. 7

1Serious money

Source: Watson Wyatt

Global assets under management, $trn

1997 98 99 2000 01 02 03 04 05 060

10

20

30

40

50

60

70

OtherEuropeNorth AmericaJapan

2The top 20

Source: Pensions & Investments/Watson Wyatt *Now Bank of NY Mellon

Asset managers, December 2006

Total assetsManager $trn

UBS (Switzerland) 2.45

Barclays Global Investors (Britain) 1.81

State Street Global (United States) 1.75

AXA (France) 1.74

Allianz (Germany) 1.71

Fidelity Investments (United States) 1.64

Capital Group (United States) 1.40

Deutsche Group AG (Germany) 1.27

Vanguard Group (United States) 1.17

BlackRock Group (United States) 1.12

Credit Suisse (Switzerland) 1.09

JPMorgan Chase (United States) 1.01

Mellon Financial* (United States) 1.00

Legg Mason (United States) 0.96

BNP Paribas (France) 0.82

ING (Netherlands) 0.79

Natixis (France) 0.77

AIG Global Investment (United States) 0.73

Crédit Agricole (France) 0.70

Aviva (Britain) 0.70

1


WHAT exactly are fund managers sell-ing? At heart, they are o�ering exclu-

sivity. In the complex world of �nancialmarkets, the client wants the best brains tolook after his money. Picking the rightfund manager is like shopping at Saks FifthAvenue or having your shoes made by Ma-nolo Blahnik. But unlike a posh retailer, afund manager cannot guarantee to pro-vide a superior service year after year. In-deed, he cannot even be sure of o�ering apositive real return. All too often, clientshand over their money to managers thathave performed well in the past, hopingthat this superior record was down to skillrather than luck and that it can be repli-cated in the future.

Historically, fund managers’ appealhas been due to two things: risk reductionthrough diversi�cation, and an ability topick the right assets. Think back to the 19thcentury. Victorian investors faced speci�crisk because they usually held only ahandful of securities in their portfolios. Toavoid this risk, they often sought the helpof their accountants or solicitors. Thoseprofessionals soon found themselves witha lucrative sideline in investment advice.Investment trusts (which still exist today)were set up because it was more e�cient tobundle together clients’ assets into pooledportfolios. Mutual funds were built onsimilar principles; by agglomerating theassets of a whole range of clients, it waspossible vastly to reduce speci�c risk.

But since the development of index-tracking funds in the 1970s, the business ofdiversi�cation has become commoditised.Clients can get access to a broad portfolio,such as the shares in the S&P 500 index, forfees of a fraction of a percentage point ofthe assets a year. Indeed, the widespreaduse of indices has dramatically changedthe fund-management business.

Originally, indices were devised (oftenby newspapers) as a means of assessingthe stockmarket’s mood. Then it occurredto investors that they could use the indicesas a means of judging whether their fundmanager was doing a good job. As they be-came more sophisticated, they realisedthat fund managers would be able to beatthe index, in the long run, by taking morerisks, and started to move to risk-adjusted

performance measures that combined re-turns with volatility. These led to the de-velopment of alpha, a measure of a fundmanager’s skill, de�ned as the ability toproduce superior risk-adjusted returns.

It’s all GreekIn recent years there has been a move toseparate the e�ect of alpha from that ofbeta, which is the portion of an investor’sreturn that comes straight from the market.Thus, if the S&P 500 index rises 8% and anAmerican equity-fund manager delivers a10% return, the investor gets eight percent-age points of beta and two of alpha. Argu-ably, the client should pay top dollar onlyfor the two additional points, not the eighthe could have received even from a low-cost index-tracking fund.

But alpha is quite hard to de�ne. As An-drew Lo of the Massachusetts Institute ofTechnology points out, to primitive peo-ple, everyday technology like cars and tele-visions can seem like magic. Alpha is a bitlike that: it is the part of investment returnsthat we do not understand.

Investors’ attempts to isolate alphafrom beta have taken several forms. One isthe �core-satellite� approach: the bulk ofthe money is placed in index-trackingfunds and the rest allocated to managers

with a proven record of outperforming themarket. Often the index-tracking money isinvested mainly in developed markets andthe satellite money goes to areas such asemerging markets, where an active man-ager is more likely to be able to outperformthe index.

Consultants argue that in the past cli-ents devoted too much of their �risk bud-get� to equities, in the belief that theywould beat bonds over time (the so-calledequity-risk premium). Instead, theyshould have concentrated more on alphabecause the returns earned from it aremore likely to be uncorrelated than marketreturns, o�ering a better combination ofrisk and reward.

Another approach to �nding alpha is togive managers more latitude to stray fromthe index; in the jargon, to be �benchmark-agnostic�. The idea is that managersshould pick the best shares regardless oftheir weighting in the index. This shouldproduce better returns in the long run,even if it sometimes causes them to lag theindex in the short run.

As John Brennan of Vanguard (which,as it happens, is one of the largest index-tracking managers) says, �if you’re going tohave an active fund, make it take activebets.� As well as its well-known mutual

Better than beta?

Managers’ superior skills are becoming harder to prove

1


2 funds (including one $122 billion behe-moth that tracks the S&P 500 index), Van-guard o�ers a range of actively managedfunds which it contracts out to other man-agers. �When we hire someone with an ac-tive mandate, we want them to take risk,�Mr Brennan continues. �Me-too stu� willget you nowhere.�

In a way, this change has been good forthe fund-management industry, in that ithas given individual fund managers morecreative freedom. No longer are theyforced to buy shares in a company they dis-like simply because it has a 5% weight inthe index. There has been a fashion in themutual-fund industry for �focus funds�that own only 20-30 stocks rather than thehundreds needed to track the market. AsJim Connor of Morse, a consultancy, putsit, �the industry has gone from a manufac-tured model to more like the music indus-try where it looks for talent that can pro-duce hits.�

But betting on alpha really puts theonus on the fund manager to do betterthan the market. That explains the increas-ingly widespread use of performance fees.The idea is that the manager should re-ceive only a modest base fee to help coverhis �xed costs, but should take a biggershare of the gains when he succeeds in de-livering alpha.

Unfortunately for clients, the alpha de-livered by the average fund manager isnegative. That is because the performanceof the average investor mirrors that of abroadly based index, before allowing forcosts. Since costs are often sizeable, the av-erage fund manager is doomed to under-performance.

Even when a fund manager can beatthe index, his problems are not over. Just asbeta has been commoditised, so, in a way,has alpha as academics have started tobreak down its components. Most stock-market indices are dominated by largercompanies, which means that active man-agers’ best chance of outperforming lies inbuying the shares of smaller businesses.Another tried-and-trusted route to outper-formance is to take a �value� approach:buying the shares of companies that lookcheap on some valuation measure, such asthe ratio of the share price to pro�ts. The ra-tionale is that investors can become over-pessimistic about the prospects of strug-gling companies.

The increased sophistication of indicesmeans that investors can get access to fac-tors like value and smallcap stocks at lowcost; they have become betas. So fundmanagers who outperform with the bene-

�t of these factors are not really demon-strating alpha at all.

Indeed, there are now very few marketsthat investors cannot access cheaply,thanks to the explosive growth of a vehicleknown as exchange-traded funds (ETFs).These are quoted stockmarket vehiclesthat hold baskets of shares designed totrack a benchmark. The �rst one waslaunched in 1993. By 2000, ETFs had just$74 billion in assets. But by June last yearthere were more than 1,000 products withjust over $700 billion in assets, estimatesMorgan Stanley, an investment bank. By2011, the bank forecasts, the sector willhave $2 trillion under its belt.

Exchange-traded LegoWhat makes ETFs so attractive is their �ex-ibility. Funds have been established tocover almost any asset class, from Asianproperty to oil. That has given retail inves-tors an easy way of getting exposure to as-sets they might previously have been ableto access only in a more costly, or round-about, fashion. Those who foresaw gold’ssurge to a record high, for example, havebeen able to buy an ETF that tracks themetal’s price instead of paying a mark-upfor gold coins or buying shares in a miningcompany and taking a bet on the manage-ment’s competence.

Paradoxically, the biggest advantage ofETFs�their cheapness�also turns out to bethe biggest barrier to their acceptance byretail investors. The low fees leave no mar-gin to pay commission to intermediaries,who therefore have little incentive to sellthem. ETFs have been a success in theAmerican market, which is more attunedto fee-based rather than commission-based �nancial advice; in other markets itis up to small investors to discover thebene�ts of ETFs for themselves.

But ETFs have also been bought by in-

stitutional investors such as pension fundsand even by those modern-day masters ofthe universe, hedge-fund managers. Onereason is that an ETF represents a quickand easy way for investors to take a viewon an asset class. Say a hedge-fund man-ager believes that the Japanese market isset to surge. If he were to assemble a port-folio of stocks, he would have to do a lot ofresearch and might choose the wrongones. Instead, he can simply buy an ETF

linked to a broadly based benchmark suchas the MSCI Japan index.

So ETFs could be viewed as a set of Legobricks from which an investor can assem-ble a do-it-yourself portfolio. They canalso be used to replicate the style biasesthat, some would argue, have often beenmistaken for fund-manager alpha.

One example is WisdomTree, an Amer-ican company set up with the help of Mi-chael Steinhardt, a hedge-fund legend, andwith the intellectual backing of JeremySiegel, a noted academic. It runs ETFs thatare weighted on the basis of the cash divi-dend paid, rather than the market value ofthe company concerned. The total ex-penses of its domestic funds amount to aquarter to a third of a percentage point, asmall fraction of the costs of a traditionalmutual fund. And yet over the ten years toMarch 30th 2007 its approach would havereturned 11.2% a year in the American mar-ket, around two-and-a-half percentagepoints more than the broadly based Wil-shire 5000 index. Other companies havecome up with similar ideas. Research A�l-iates has an index that uses four �funda-mental measures� relating to sales, pro�ts,dividends and asset, or book, value.

These ideas have their critics. Some ar-gue that such �active ETFs� are contami-nating the purity of the sector’s appeal andincreasing the costs paid by the investor(because the components of the indexhave to be changed more frequently). Oth-ers would say there is nothing new aboutthe techniques; they are merely value in-vesting in a new guise. Even if that is so,they still pose a considerable threat to tra-ditional fund-management houses. Thevalue school is one of the most respectedapproaches to investing. If its returns canbe matched by funds that mechanicallyuse a few ratios, why pay the fees de-manded by active fund managers?

Even hedge funds are seeing their terri-tory invaded. Its managers are the highpriests of alpha. Clients have so much faithin their skills that they are willing to pay 2%annually (as well as a 20% performancefee) for the privilege of having their money

3Passive aggressive


Growth in assets under management% change on previous year

1997 98 99 2000 01 02 03 04 05 0610

0

10

20

30

40

50

+

–

Top 500 managers Passive managers


2 managed by them. One particular hedgefund was recently able to charge 5% a yearand 44% of performance.

But how much of what hedge funds aredelivering is really alpha rather than beta?Research suggests that the correlation be-tween hedge-fund returns and the S&P 500index is already high and getting higher.Worse still, hedge funds are becomingmore strongly correlated with each other.Although the hedge-fund industry is verydiverse, there have been times in recentyears when nearly all the sectors havefallen in unison. This suggests that all ofthem may be exposed to some commonunderlying factor.

Grow your own hedgeBill Fung and Narayan Naik at the LondonBusiness School have analysed the perfor-mance of the hedge-fund industry over adecade and identi�ed seven or eight fac-tors that seem to be responsible for thebulk of its returns. All these factors, thetwo academics claim, can be replicated atlow cost in the market, capturing most ofthe bene�ts. So it is possible to set up afund that o�ers returns akin to those in thehedge-fund industry but is able to chargemuch lower fees.

Investment banks have (slightly sur-prisingly, given their close links with thehedge-fund industry) piled in, producingfunds that clone individual hedge-fundstrategies. Naturally, many hedge-fundmanagers are scathing about the banks’ ef-forts. A cloned portfolio is necessarilybackward-looking, they say, so investorswill be buying what hedge funds used toown, not what they are about to buy. Fur-thermore, clones will capture the entirebeta but none of the alpha of the indus-try�and it is the alpha that makes hedgefunds worth buying. Messrs Fung andNaik accept that hedge-fund managers dis-play skill, but would argue that most of thetime this alpha is absorbed by their fees.

Returning to Professor Lo’s de�nition ofalpha as the portion of investment returnsthat we do not understand, it seems possi-ble that as more and more analysis is un-dertaken, this portion will become smallerand smaller. The �magic� may turn out tobe sleight of hand, or it may be random.Some fund managers will always outper-form the market, but there is little hope ofidentifying them in advance.

Cloning represents a particular threatto the quantitative school of fund manage-ment. The quants, as they are known, usecomputer models to identify patterns andrelationships in the markets that have

been pro�table in the past. They are oftensta�ed by the brightest academic minds inmathematics and physics. Quants gener-ally have no interest in visiting a company,sampling its products or meeting its man-agement. Whereas traditional fund man-agers look at the fundamentals, such as thequality of a company’s business model orthe nature of its competitors, the quantstry to take the subjectivity out of fundmanagement by concentrating on thenumbers alone.

Some quants have a long-term perspec-tive, but many take advantage of the li-quidity of modern �nancial markets totrade very frequently indeed; companiessuch as AQR, D.E. Shaw, Highbridge andRenaissance often form a substantial por-tion of daily trading on the New York StockExchange. They may aim to conduct theirtrades in a matter of milliseconds as theytry to exploit �eeting anomalies. Some

funds put their computer servers veryclose to stock exchanges for a minusculereduction in the time it takes for data to betransmitted down the wires.

Quants have been remarkably success-ful over the past decade, but in August lastyear something went badly wrong: withinthe space of a week many of their modelsceased to work. The quants thought theyhad built diversi�ed portfolios by selectingstocks on the basis of a host of di�erent cri-teria that had previously had low correla-tions with each other, but suddenly a lot ofthe factors started to move in the same di-rection. Some funds put in a dreadful per-formance; for example, Goldman Sachs’sGlobal Alpha fund lost 38% on the year.

The problem seemed to be that if youset computers to analyse the same set ofdata, they are likely to come up with simi-lar investment strategies. As positions be-came crowded, returns started to fall,prompting the quants to use more bor-rowed money to improve them. When thecredit crunch hit, one fund was forced intocutting its positions, bringing down theprices of stocks held by all its rivals and set-ting o� a downward spiral.

Reinventing quantsThis does not mean the end of quant in-vesting. �To believe the quant game is overyou’d have to think reasonably priced, rea-sonable growth stocks will underper-form,� says Gus Sauter of Vanguard, whichruns quant-based funds. But it does meanthat in future quant managers may have toreconsider how much leverage to buildinto their funds, and will have to try evenharder to �nd factors that their rivals arenot exploiting. Mike O’Brien of BarclaysGlobal Investors (BGI) says the sectorneeds to move away from �data mining�and adopt a scienti�c approach, usingquant techniques to provide a sound basisfor original investment thinking. Insteadof letting the data generate the ideas, BGI

now tries to turn the process on its head,coming up with ideas �rst and then testingthem on the data.

But the quant funds may face a chal-lenge from the clones, which use comput-ers to identify a series of factors that pro-duce attractive investment returns. On theface of it, that does not look very di�erentfrom what the quant funds do. Quantmanagers may come up with a lot morefactors than the clones, but in practice justa few of them account for most of the re-turns. And the more mechanical and re-plicable the process of investment gets, theharder it becomes to justify high fees. 7

4Not alpha but omega

Source: John C. Bogle: “The Little Book of Common Sense Investing”

% of large-cap funds that outperformed the S&P 500

1969 75 80 85 90 95 2000 06

0

25

50

75

100

1


THE stockmarket is a hard taskmaster.Beating the indices on a regular basis is

di�cult, and low-fee rivals are competingever more vigorously. But the fund-man-agement industry has found a new won-der weapon: alternative assets. Whatmakes these special, the industry claims, isthat they are not correlated with the stock-market. They are also di�cult to under-stand, so they require greater skills to man-age�which have to be properly rewarded.

That explains why, even as ETFs aredriving fees on big stockmarket fundsdown to a few basis points a year, the man-agers of the main alternative-asset catego-ries�hedge funds and private equity�areable to charge two percentage points ayear, with a performance fee on top. Andclients are queuing up to pay them.

Why are they so enthusiastic? The rea-son goes back to mistakes made in the1990s. The long bull market encouragedthe belief that share prices could moveonly upwards, and investors who did nothave a big allocation to equities lookedfoolish. Corporate-pension sponsors wereable to put 80-90% of their portfolios intoshares and then stop making contribu-tions to the fund, on the assumption thatjuicy returns would continue.

The 2000-02 bear market revealedwhat an unwise bet that had been. To com-pound the problems of pension funds astheir assets fell with the stockmarket, theirliabilities rose because of the drop in bondyields, which made it much more expen-sive to purchase the income needed to paypensioners. So the pension funds (andtheir advisers) decided to broaden theirbets and reduce their risks.

One big change, as described in the pre-vious section, was to put more emphasison alpha, the skill of the manager. Butfunds also started to widen their range ofassets, in the hope of earning a more stablereturn. The models for this were the uni-versity endowments of Yale and Harvard,which started moving into alternative as-sets in the 1970s and 1980s and have en-joyed considerable success with them.Morse’s Mr Connor sees this as an exten-sion of his music analogy: �The industryhas expanded from having a limited num-ber of genres into a wide range, from hip

hop to garage, thrash metal and the rest.� However, the move has not been with-

out controversy. It seems plausible thatemerging-market debt, property and com-modities are genuine alternatives to thetraditional staples of developed-marketequities and government bonds. But areprivate equity and hedge funds really inthe same category?

Private equity and its close cousin, ven-ture capital (which concentrates on start-ups), invest in businesses that are notquoted on the stockmarket. The idea is thatcompanies will be able to produce betterreturns if they are protected from the glareof constant public scrutiny and if the man-agers are given suitable incentives. Thisusually means o�ering them share optionsand loading the company up with debt,forcing managers to pay meticulous atten-tion to their cash�ow. These takeovers,also known as leveraged buy-outs, havebecome a big in�uence on stockmarkets.But is private equity really an alternativesource of return? After all, most of the fac-tors that a�ect quoted companies�thehealth of the economy, interest rates�af-fect private companies as well.

This is also true of hedge funds. Theseprivate pools of capital may be run in a dif-ferent way from traditional funds�for ex-ample, they can go short (bet on fallingprices) and use borrowed money to en-hance returns. But hedge funds still mostlyinvest in the same types of assets�equitiesand bonds�as traditional fund managers.

Most hedge funds are alternative only

in the way they are managed, rather thanwhere they invest. Because of their meth-ods, they claim to produce �absolute re-turn��in other words, a nominal gain re-gardless of market conditions. By contrast,traditional fund managers might thinkthey have done well if they lose 17% whenthe index has dropped by 20%.

The short answerHedge funds can pull o� this trick thanksto their greater �exibility, in particulartheir ability to go short. The worst year forthe industry was 2002, when the HedgeFund Research Index lost just 1.5% (al-though these indices may �atter, thanks tosurvivorship bias). Enthusiasts would alsoargue that if you believe in managers’ skill,you should give them as much freedom aspossible. Most companies have a tinyweighting in the index. A traditional man-ager who takes a dislike to a stock can onlygive it a zero weighting, which will makevirtually no di�erence to performance. Buta hedge-fund manager can make a muchbigger bet by selling the stock short.

It sounds good in theory, but in practiceshorting is very di�cult. A long positionthat goes wrong becomes a smaller part ofthe portfolio; a short position becomeslarger. And where hedge-fund managersuse borrowed money, bad bets can bedisastrous, as shown by the closure of Am-aranth, an energy-trading fund, in 2006and two Bear Stearns credit funds in 2007.

Even if some hedge-fund managershave special skills, can the industry con-tinue to deliver exceptional returns as itgets bigger? Its assets increased from $39billion in 1990 to $1.9 trillion by the end oflast year (see chart 5). Allowing for the useof borrowed money, McKinsey estimatesthat total assets under management maybe $6 trillion. If the skill of hedge-fundmanagers consists of exploiting marketanomalies, there must surely be feweranomalies to go around now. The resultmay be high fees for hedge-fund managersbut modest returns for clients, or worse.�Hedge funds are rapidly deteriorating inquality. There is a nasty accident waitingto happen,� says Jeremy Grantham ofGMO, a fund-management group.

The same arguments can be applied to

Plenty of alternatives

But hedge funds and private equity have their limits

5Can it go on?

Source: Hedge Fund Research Inc

Hedge-fund industry, funds under management$trn

1990 92 94 96 98 2000 02 04 070

0.5

1.0

1.5

2.0

1


2 private equity. If lots of people are compet-ing to do private deals, that is likely to forceup the price of deals and cut the level of fu-ture returns. According to McKinsey, theamount of private-equity capital in-creased by 120% between 2000 and theend of 2006 (see chart 6); including ven-ture capital, the sector’s total assets add upto over $1 trillion. �So much money has�owed into private equity, venture capitaland hedge funds that it has swamped theavailable talent,� says Mr Grantham.

McKinsey reckons that 62% of Ameri-can private-equity assets in 2006 were inthe hands of the top 20 �rms. This is notsurprising: the top 25% of funds seem con-sistently to beat the rest. If anything, it issurprising there has not been moreconsolidation, given the lacklustre perfor-mance of the rest of the industry. The aver-age investor in private equity has not seenparticularly attractive returns comparedwith those available in the public market.

And those returns may be about to de-teriorate. The most recent leveraged-buy-out boom ended with many �rms collaps-ing in the early 1990s recession. Mr Gran-tham fears history may repeat itself.�Private equity has a long tradition of add-ing value, but there is one issue they haveall missed,� he says. �Not a single �rm has

in its spreadsheet the expectation that pro-�t margins have to come down.�

The move into both hedge funds andprivate equity involves a paradox. For anasset class to be a true diversi�er, it needsto be small; but if it is small, then few inves-tors can be exposed to it. When lots of capi-tal �ows into an asset class, it starts to be-have like other markets. The recentproblems in the British commercial-prop-erty market are a good example. Retail in-vestors �ocked into the sector as a diversi-�er from equities, and in the ten years to2006 it performed brilliantly. But property

is an illiquid asset. When prices started tofall last year, investors rushed to redeemtheir holdings. But it was impossible forthe funds to realise on their properties insuch short order, so many of them havebeen forced to suspend dealings in theirshares and units. The asset class was sim-ply not liquid enough to be a real diversi-�er for so many investors.

That has not stopped investors fromlooking for diversi�ed returns elsewhere.In the second half of 2007 the truly hot ar-eas were �frontier markets�, or what mightbe called the �emerging emerging mar-kets�. The hope is that countries such asKazakhstan and Vietnam will eventuallyachieve the same sort of growth rates as In-dia and China.

Fund managers are also o�ering evenmore esoteric bets, known as �exotic beta�.Assets in this class include weather deriva-tives, distressed power stations and evenfootballers’ contracts. The attraction istwofold. First, these asset classes are so re-mote from the forces that drive the S&P 500index that any correlation is unlikely. Sec-ond, prices in this market may be set inef-�ciently, o�ering scope for astute fundmanagers to make money. At least that iswhat exotic-beta fund managers tell theirclients to justify their fees. 7

6Buying buy-outs

Source: McKinsey

nil

Global leveraged buy-out fundsAssets under management, $bn

1980 85 90 95 2000 05 060

200

400

600

800

WHEN industries become rich andpowerful, they inevitably attract at-

tention�and criticism. Fund managers areoften reluctant to embrace the spotlight,but are now being forced to do so.Whether it is private-equity groups ac-cused of �ring lowly workers, hedge fundsunder attack for destabilising the �nancialsystem or institutions being berated forholding shares in �unethical� companies,the public scrutiny is unrelenting.

Henry Kravis, one of the doyens of theprivate-equity industry, has found him-self the subject of a �lm, �The War onGreed�, as well as of a protest outside hisritzy Manhattan apartment. In Britain atrade union paraded a camel outside achurch attended by Damon Bu�ni, an-other private-equity titan, to remind himof the biblical story about the entry restric-tions to heaven imposed on rich men.

Such attention has forced the industry

to consider whether earning the highestpossible returns should be its sole concern.Fund managers have taken to trumpetingthe bene�ts they bring to the economy (bydirecting capital to where it will be mostuseful and helping to create employment)and to society at large (by making it easierfor individuals to plan for their old age).

Perhaps the unwelcome publicity wasinevitable once fund managers started tobecome rich and appear in the gossip col-umns. Only 30 years ago fund manage-ment was a bit of a backwater, just thething for those who were not quite brightenough to get into investment banking. �Atthe very �rst meeting I went to, a rival toldme I had joined the most boring industryin the world,� recalls Patrick Disney of SEI,a �rm that advises on selecting the bestfund managers.

But thanks to the rise of private equityand hedge funds, these days fund manage-

ment is a fast route to billionaire status. Bu-oyant markets and generous performancefees mean that managers who get it rightbecome very rich very quickly. A surveyby Alpha magazine found that the top 25hedge-fund managers between them tookhome $14 billion in 2006. And many ofthem like to splash their money around,with Steve Cohen of SAC Capital Advisersbecoming a prominent art collector andDaniel Loeb of Third Point reportedly pay-ing $45m for a Manhattan apartment.

Fund managers have become the latestgroup of rich people to incur public dis-pleasure, reinforced by a feeling that theydo not perform a socially useful functionbut merely speculate with other people’smoney. Some of the criticism is deserved.

Private equity owes some of its successto anomalies in the tax system. For exam-ple, when it buys a company it often loadsit up with debt and claims tax relief on the

In the spotlight

Fund managers are having to polish their image

1


2 interest paid. In an ideal system the taxtreatment of debt and equity should be thesame. Private-equity executives have alsobene�ted by having a large part of theirearnings classed as capital gains, which inmost countries are subject to a less severetax regime than income.

Hedge-fund managers have bene�tedfrom light regulation that has given themadvantages over their traditional fund-management rivals�such as being al-lowed to keep the details of their holdingssecret, for example, or being able to bene�tfrom falling, as well as rising, prices.

As yet, governments have made littlecoherent attempt to crack down on thesetax and regulatory privileges, mainly be-cause capital is so mobile these days andcountries such as Britain and America donot want to drive away rich residents orantagonise the �nancial community. Thatmay change if an economic downturnprompts voters to demand action.

What about the workers?Perhaps the most potent attack waslaunched by Franz Müntefering, a promi-nent German Social Democrat politicianwho in 2005 described the hedge-fund in-dustry as �locusts�. He gave voice to thewidely held view that both hedge fundsand private-equity �rms were interestedonly in short-term pro�ts and catered ex-clusively to the needs of shareholdersrather than employees, customers or thewider community.

This view was taken up by trade unionsin Britain, particularly in the early monthsof 2007 when a new private-equity-funded takeover deal seemed to be an-nounced every week. Calls for the govern-ment to change the rules, particularly ontax privileges, resulted in a botched reformof the British capital-gains-tax regime thatpenalised small businesses far more thanprivate-equity bosses.

The private-equity industry, surprisedby the intensity of the criticism, duly sup-ported the creation of voluntary codescommitting �rms to greater transparency.In Britain at least, the hedge-fund sectortook similar steps. Both industries can af-ford a high-powered lobbying machine.Private-equity �rms cited academic stud-ies that appeared to show that, far from de-stroying jobs, the industry was a net crea-tor of them.

The industry also argued that its modelwas superior to that of the traditional pub-lic company because the interests of man-agers and investors were more closelyaligned, high debt required managers to fo-

cus on cash generation, keeping them hon-est, and managers found it easier to taketough long-term decisions away from theglare of media attention. The debate wasstill continuing when, in the middle of theyear, the credit crunch hit home and theprivate-equity funds suddenly found it farmore di�cult to raise money. That seemsto have shifted attention to a di�erent typeof investor, the sovereign-wealth funds.These funds, particularly those set up bygovernments in Asia and the Middle East,were prominent among those helping tobail out the American banking sector inthe aftermath of the credit crunch.

Hedge funds have also slipped out ofthe limelight somewhat since last sum-mer. But although unlike private-equitygroups they rarely launch takeovers ontheir own, they can still wield a lot of in�u-ence. They frequently lobby for executivesto realise value for shareholders by return-ing cash, selling o� unpro�table subsidiar-ies or agreeing to bids from larger groups.Such �activist� hedge funds usually try torecruit other institutions to their cause.They then organise a shareholder vote,campaign in the media or attempt to enlistoutside bidders to get the company’sboard to change tack.

One of the best-known activists is theChildren’s Investment Fund (TCI), a Euro-pean hedge fund. It successfully blockedDeutsche Börse’s attempt to take over theLondon Stock Exchange and then, with astake of just 1%, set the scene for ABN

AMRO, a Dutch bank, to become the targetof a bidding war between Barclays and theRoyal Bank of Scotland. More recently,hedge funds attempted (unsuccessfully) tocontrol the terms of the rescue of NorthernRock, a struggling British bank.

Such activism has not made them pop-

ular, either with the public or with com-pany boards. In the days of autocratic chiefexecutives, fund managers, like small chil-dren, were expected to be seen and notheard. Even today, rules at many Ameri-can companies make it di�cult for inves-tors to unseat the management. If inves-tors do not like the way a company is beingrun, they are expected to shut up and sellthe shares. European companies can alsobe sni�y when investors speak up. And inJapan they hardly ever do.

Gradually, however, activists are be-coming more widely accepted. �Even inFrance and Germany, governments aregradually coming to the conclusion that ac-tivism is an acceptable instrument of cor-porate governance,� says Michael Treichelof Audley Capital, an activist fund. Be-sides, now that markets are global, it isvery hard to keep the activists out withoutdriving away the international capitalmost companies want to attract.

However, hedge funds are not the onlyactivist shareholders. Other fund manag-ers, often re�ecting the views of their pen-sion-fund clients, have pushed for compa-nies to pass ethical and corporate-govern-ance tests, such as decent treatment ofworkers in the developing world or theseparation of the jobs of chairman andchief executive. This could leave compa-nies open to attack on both sides. Even asactivist funds might be asking them to cutcosts and lay o� employees, ethical inves-tors could be urging them to think abouttheir workers.

To make things more di�cult, the ethi-cal camp is itself split. Old-school ethicalinvestors, often guided by religious princi-ples, did not want their money to be usedin businesses they disapproved of, from al-cohol and arms manufacturing to gam-

1


2 bling and tobacco. In recent years, thanksto the Middle East’s increasing wealth,there has been rapid growth in �nancialproducts compliant with sharia law,aimed at Islamic investors.

Do the right thing, but which?Another ethical trend, supported by thoseof a leftish (in America, liberal) persua-sion, has been for socially responsible in-vesting (SRI), although the term has beeninterpreted in a variety of ways. �Socialresponsibility is in the eye of the be-holder,� says Ed Bernard of T. Rowe Price,an American fund-management group.But in general, socially responsible inves-tors try to avoid companies that exploitworkers (for example, by using child la-bour in poor countries), cause pollution,add to global warming or operate in coun-tries with dubious human-rights records.

A third school adds some hard-headed

calculations to elements of both the ethi-cal and the social-responsibility ap-proaches. Believers in sustainable invest-ing think that picking out the bestcompanies on non-�nancial criteria willultimately lead to higher returns. DavidBlood used to work in the money machinethat is Goldman Sachs. Together with AlGore, a former American vice-president,he set up Generation Investment Manage-ment, a �rm that specialises in sustainableinvestment. Firms that treat workers or theenvironment badly, he says, will eventu-ally face lawsuits or a backlash from con-sumers or regulators, so a narrow focus onthe balance sheet does not make sense inthe longer term.

Cynics claim this preoccupation withcorporate governance encourages a �box-ticking� mentality; companies will simplymeet the minimum standards and cheerup the annual report with some feelgood

pictures of racially diverse groups of work-ers, fetching children or leafy glades. Bo-zena Jankowska, head of sustainability re-search at RCM (part of Allianz GlobalInvestors), agrees that �questionnaires area waste of time� and adds that it is impor-tant to talk to companies face to face: �Ifthey are not telling the truth about socialresponsibility and sustainability, they areprobably not telling the truth about therest of the business either.�

Some see socially responsible or sus-tainable investing as a backward step thatwill tie down fund managers just as theyare escaping the shackles of the index.�The world is moving towards uncon-strained investing, but SRI is moving in theopposite direction,� says Mr Connor ofMorse. Still, as long as some clients care asmuch about where their money is in-vested as about how much they earn, SRI

is not going to go away. 7

ASK management consultants to reviewany sector, and the chances are they

will forecast that a few big groups willcome to dominate it, with a few niche busi-nesses at the tail end.

The remarkable thing about the fund-management industry is how little it hasconsolidated. Much of that is due to therandom in�uence of markets. A strugglingfund-management group can have its for-tunes transformed by hiring one star man-ager or perhaps having a lucky year. Hen-derson, a British fund-management group,is exactly the kind of mid-sized businessthat the management consultants wouldhave expected to disappear, but in recentyears it has been very successful in sellinginternational funds to American investors.

In most industries, companies canhope to thrive by following the Wal-Martmodel. Economies of scale will allowthem to become more e�cient, reduceprices and attract more customers. But inthe fund-management industry that strat-egy works only in index-tracking, or pas-sive management. This is a commoditybusiness. Some technical expertise isneeded to ensure that the benchmark istracked accurately, but the business ismainly about price. Large companies areable to spread their �xed costs, allowing

them to charge lower fees. Sure enough,two giants, Barclays Global Investors andState Street, dominate the industry.

When it comes to active management,there is a big debate over whether size is ahelp or a hindrance. The �small is beauti-ful� school points out that some of the besthedge funds were started by two men anda spreadsheet. �Total assets under manage-ment is a relatively poor explanatory vari-able of success,� says David Hunt ofMcKinsey. �Scale in many styles worksagainst performance.�

Sandy Nairn has worked at both Tem-pleton and Scottish Widows InvestmentPartnership (part of the Lloyds TSB bank-ing group). He now runs his own boutiquebusiness, Edinburgh Partners, with just£3 billion ($6 billion) under management.�Often in �rms, there are three key peoplewho make all the di�erence,� he says.�There is a limited number of very goodpeople so the bigger the �rm, the smallerthe proportion of top talent.� Mr Nairnadds that �the bigger you are, the moresales-oriented you become because youare tapping into the mass market. Fundmanagers become less important than themarketing and compliance people.�

Mr Nairn may be biased, but he raises afundamental dilemma for the industry.

Charles Ellis, an industry veteran, de-scribes it as the di�erence between profes-sional-led and business-led companies. Inthe �rst sort, the fund managers are incharge. The second kind are in danger ofbecoming too preoccupied with short-term pro�t, increasing the proportion ofassets under management and runningthe risk of damaging the culture and long-term reputation of the �rm. For example,marketing people may persuade �rms tolaunch funds in hot areas (such as technol-ogy in 1999-2000) even when investorsthink the top of the market may be in sight.

�When I started in the industry in 1972,�says Ed Haldeman of Putnam, a Boston-based fund-management group, �all asset-management companies were led by in-vestment people. Being good at invest-ment didn’t necessarily make them goodat leading the �rm. Eventually, the busi-ness and marketing people came to lead.The risk was that they ran the company onthe basis of what was best in the shortterm. Now we are trying to �nd a balancebetween the two.�

What are the problems of scale in thefund-management industry? The �rst isthe culture it can create. Most people agreethat you have to be clever to be a successfulfund manager, and also a bit of a contrar-

All things to all men

The industry is becoming more diversi�ed

1


2 ian: there is no point in buying what every-one else is buying. The danger in a largecompany is that individual managers willbe second-guessed by strategy committeesor risk managers or simply intimidatedinto going along with the rest of their col-leagues. �Fund management requires tal-ent, just like being a concert pianist. Indus-trialising the process really doesn’t work,�says Nigel Blanshard of Culross, a hedge-fund group.

Not everybody sees control systems asa disadvantage. Rogue fund managershave ruined the reputations of plenty ofbusinesses, and clearly there is a need forsome sort of oversight. But even if a man-ager is given his head and becomes a star,the company may not reap the success itexpects. It is all too easy for a star managerto be lured away by a rival and take his cli-ents with him.

A lot of fund managers, particularlythose that deal with institutional clients,emphasise the �process��the systematicapproach they take to beating the markets.In some �rms, such as Capital Interna-tional, this is driven by teams of analystsrather than by fund managers; the hope isthat even if the star is run over by a bus, the�rm will still perform well.

But scale a�ects other aspects of thebusiness too. For example, if a fund hashundreds of billions of dollars of assetsunder management, it may not �nd itworth its while buying stakes in smallercompanies. If it does, it risks becoming thedominant shareholder. Robert Harris ofMajedie, a specialist British equity man-ager, illustrates the maths. �How much of acompany with a £2 billion market valuedoes a fund manager need to hold to havea 2% position across his portfolios?� heasks rhetorically. �If the manager has £5billion of assets, it needs to own just 5% ofthat company. If it has £20 billion of assets,it needs to own 20%.� It may be possible toassemble that kind of stake, but it will notbe easy to sell it quickly.

Another problem for large fund manag-ers is that the act of buying and selling canmove prices against them. The big groupsdo their best to reduce this problem by set-ting up specialist trading desks, splittingtheir orders among brokers and keepingtheir plans to themselves, but it is hard toescape the issue entirely. �If you start tomove share prices when you have assetsover a certain size, that must a�ect perfor-mance,� says Mr Nairn. Some managersclose their funds or discourage new inves-tors if they think that further growth maya�ect their performance. For managers

motivated by performance fees, this willusually make �nancial sense, because theloss of performance fees would outweighthe extra fees from managing more assets.

But a deliberate strategy of stayingsmall also has its problems. If the businessspecialises in just one product area, a cou-ple of bad years in that speciality can be fa-tal. Similarly, the business may remainsound only for as long as the founders arewilling to stay on; if they get bored or com-placent, it may not survive. �It’s a one-gen-eration business,� admits Mr Nairn. �Buteveryone pretends it’s a two-generationbusiness so they can sell out.�

Convergence and divergenceSo an odd combination of trends is atwork. The clients are moving away frominvesting in a limited number of assetclasses to a much broader range. In re-sponse, the specialists in the fund-man-agement industry are venturing into newareas; for example, hedge funds are goinginto private equity and vice versa. Clientstrategies are diverging whereas fund-management �rms’ strategies are converg-ing on a broadly based model.

For the �rms, this means diversi�ca-

tion. For example, in the hedge-fund in-dustry, managers who used to concentrateon one particular product line, such as ar-bitrage, in recent years have added otherstrings to their bow and become multi-strategy �rms. Others have taken the diver-si�cation several steps further, addinglong-only funds or moving into other oper-ations, such as private equity, direct lend-ing or market-making. That should pro-vide them with better protection against afreak bad year. It should also allow them tokeep those of their clients who are nowharing o� in di�erent directions, lookingfor returns from asset classes such as com-modities and private equity.

Traditional �rms have set up their ownhedge-fund operations or established hy-brid funds that o�er a watered-down ver-sion of hedge-fund strategies. �Big �rmswere never going to miss out on hedgefunds. They weren’t going to let their sta�be lured away or miss out on the fees,� saysRob Fairbairn of the BlackRock Group. In-vestment banks, too, have taken control of,or stakes in, hedge-funds groups; it wasthrough this route that Vikram Pandit be-came chief executive of Citigroup.

In a few years’ time there may no longerbe such a thing as a hedge-fund group,only groups that o�er a range of ways ofmanaging money. Clients will be able tochoose from their menu of long-only orlong-short, rather like diners in a restau-rant can order their eggs scrambled orsunny side up.

By diversifying, fund managers alsohope to avoid some of the old traps ofscale. Firms pride themselves on being a�collection of boutiques�. Sometimes thegroups try to create these boutiques inter-nally; more often they go out and buythem. That allows the founders of smallerfund-management groups to cash in onsome of the value they have created and totake advantage of the larger group’s mar-keting clout.

Yet when boutiques become part of alarger business, they risk losing the sparkthat made them successful in the �rstplace. Horacio Valeiras now works forNicholas-Applegate, a small and midcapmanager that is part of Allianz Global In-vestors. He was reluctant to join a largergroup after an unhappy experience whena previous employer was taken over byMorgan Stanley. �We wanted to maintainour philosophy and control our own des-tiny,� he recalls. He talked to Allianz inGermany and they convinced him theywould allow him autonomy. �I confessthey have given me more freedom than I

7Reach for the stars


Asset managers, fastest-growing firms% increase of assets under management, 2001-2006

0 100 200 300 400

BlackRock Group

Bank of America

Natixis

Capital Group

Generali Group

Barclays Global Investors

AIG Global Investors

Aviva

Goldman Sachs Group

Old Mutual

State Street Global

AXA

Prudential

Northern Trust

HSBC

Franklin Templeton

Fortis

MassMutual Financial

Vanguard Group

Wellington Management

1


2 expected,� he says.So the integration of boutiques needs

careful handling. �It is possible for a fund-management company to have a largenumber of funds and run them well,� saysEd Haldeman of Putnam. �But we believeit needs distinct teams as opposed to beingall controlled from the top.� Having suchteams, or internal boutiques, means theindividual fund manager can feel respons-ible for his own operation. Incentives canbe set at the level of the individual unit.�The worry in big groups is that some guyin another part of the group has lost yourbonus,� says Jonathan Little of Bank ofNew York Mellon.

Boutique-style giantsMr Little’s group now has $1.1 trillion of as-sets under its wing, with 13 brand namesincluding Dreyfus (an American mutual-fund arm), Newton (a London-based equ-ity manager with a thematic approach)and EACM (an American fund-of-hedge-funds manager). Ronald O’Hanley, thegroup’s chief executive, says this diversityis an advantage. �We have three globalbond products, so depending on the cli-ents’ attitude towards, say, credit, we cansteer them in the direction of the appropri-ate fund manager,� he says.

Another group that is unashamedlyaiming for scale is BlackRock. At the end ofits latest �nancial year the company hadsome $1.4 trillion of assets, thanks to thepurchase of the old Merrill Lynch Invest-ment Management (MLIM) business andof Quellos, a hedge-fund group. Accordingto Mr Fairbairn of the group’s London of-�ce, the �merger between MLIM and

BlackRock was driven by a real opportu-nity to build strength across equities, �xed-income and alternative assets to get agreater share of the wallet.�

BlackRock also has ambitions to ex-pand outside the fund-management area.It is one of the pioneers of ��duciary man-dates� where the manager takes totalcharge of a pension fund, dealing with is-sues like asset allocation and administra-tion as well as stock selection. The com-pany also has a business called BlackRockSolutions that allows it to model portfoliosand assess risk; the system is sold to bothclients and competitors. In the thick of thecredit crunch, the company was called inby the state of Florida to advise on the han-dling of a money-market fund with expo-sure to subprime-related securities.

In these examples, fund managers aremoving into business areas previously oc-cupied by actuaries and consultants. Fundmanagers are trying to exploit their sizewithout running into the diseconomies ofscale peculiar to the industry. Such diversi-�cation brings potential con�icts of inter-est; for instance, �rms might favour theirhedge-fund clients, who pay higher fees,over their traditional clients. Nevertheless,

the business opportunities are too attrac-tive for fund managers to pass up.

Besides, nobody wants to be seen as abig monolithic group that might producemediocre results. Until recently, that was adanger facing Fidelity, arguably the bestbrand name in global fund management;at the start of this decade, its funds wereperceived as too large and unwieldy togenerate exciting returns and it developeda reputation for chasing asset growth.However, Fidelity has recently turned itsinvestment performance around.

In 2005 it installed Harry Lange as thenew manager at Magellan, which formany years had been Fidelity’s �agshipfund. Mr Lange made some daring but suc-cessful bets in 2007, as a result of which,for the �rst time since 1997, Magellan hasjust been opened to new money. Insiderspoint to the extra money that the com-pany’s chairman and key shareholder,Ned Johnson, has devoted to research overthe past couple of years. But the companyhas also seen some reorganisation underRodger Lawson, whom Mr Johnson re-cently installed as president, in an attemptto sharpen its focus and to ensure that thebusiness is run e�ciently. 7

IF FUND management is such an attrac-tive business, why would large banks

such as Citigroup and Merrill Lynch wantto give it up? After all, with both groupsfacing write-o�s related to the creditcrunch, the steady revenue from assetmanagement would have been a comfort-able cushion.

But there is one big problem with beinga fund manager: you have to beat the mar-ket. If you don’t, intermediaries such asbrokers and private banks will not selectyour funds. And regulators, at least in

America and Britain, will get upset if theythink you are stu�ng your poorly per-forming funds down your clients’ throats.

This has prompted a move in the An-glo-Saxon markets to separate the jobs of�manufacturing� (managing portfolios)and �distribution� (selling them to clients).In continental Europe and Asia fund man-agement is still dominated by the bigbanks and insurance companies. In Italy,for example, 92% of assets are gathered di-rectly by salesmen tied to, or employed by,the fund-management group; in Britain

the proportion is just 14%.Manufacturing may sound like the

more attractive part of the business. Pro-vided the company gets its performanceright, its pro�ts will go up exponentially: itcosts little more to manage $2 billion than$1 billion. But �rms that act as distributorsstill earn fees from fund management, bycharging investors for the oversight oftheir portfolios or by taking commissionon the funds they sell. At the same timethey cut out much of the cost.

There are three main kinds of distribu-

We make, you sell

Sometimes it’s better to concentrate on one thing

1


2 tion. The �rst is simply to sell productsmanaged by your own �rm. The second is�open architecture�. This allows the clientaccess to almost any fund manager on themarket, or at least to all the managers whoare willing to allow their funds to be of-fered on such a platform. For various rea-sons, some are not. For example, they maywant to control the type of clients that owntheir funds, or limit the size of funds undermanagement to avoid their performancebeing diluted. Or they may object to hand-ing over part of the annual managementfee to the distributor. �Some of the reallyinteresting boutiques don’t want to be onplatforms and give away half their fees,�says Alan Bartlett of WestLB Mellon AM, a�rm that specialises in identifying skilledfund managers.

Decisions, decisionsAnother problem of open architecture isthe so-called paradox of choice. Retail in-vestors can feel overwhelmed by the thou-sands of funds on o�er, so they are in-clined to choose names they recognise.This favours funds that spend a lot on mar-keting and advertising. As a result, clientsmay not choose the best (and almost cer-tainly not the cheapest) funds. But there isnobody to steer them in the right direction,because giving clients individual advice istoo di�cult and too expensive.

The third sort of distribution is �guidedarchitecture�. In this model, a distributoro�ers the funds of a restricted number of�rms that it has pre-selected as being suit-able for clients. This narrows down thechoice for investors and o�ers a degree ofstability to the fund managers involved.

The e�ect of the manufacturing-distri-bution split is that the retail market is be-coming almost as institutionalised as thepension-fund market. Just as a pension-fund manager’s ability to get business usu-ally depends on winning over a handful ofconsultants, attracting money from the�high net worth� market (ie, the rich) de-pends on a manager’s ability to convincean elite group of private banks. That givesthe managers plenty of scope to bandyabout terms like alpha and beta in theirpresentations. �At least this means we cantalk at the level we’re accustomed to,� saysone manager.

This opens up opportunities for bou-tique-style �rms. �Groups like Citigroupand Merrill Lynch have got out of assetmanagement and moved to open architec-ture; we, as an independent asset man-ager, are just what they are looking for,�says Jim Kennedy of T. Rowe Price. Out-sourcing distribution allows fund manag-ers to specialise in their area of expertise.

But there is a price to pay. Dependingon outside distributors means the fund

manager loses direct contact with the cli-ent. One industry veteran recalls how his�rm used to maintain a department to dealwith the letters from investors; now thecorrespondence has slowed to a trickle.The result may be less hassle but also a re-duction in customer loyalty. There is a lotmore �churn� (turnover of customer ac-counts) than there used to be. �These peo-ple [the distributors] have to do somethingto justify their fees,� laments one fundmanager, and that something usuallymeans switching to a new fund as soon asone appears to falter.

The recent decline in the fortunes ofNew Star, a British fund-managementgroup, illustrates the danger. New Star wasfounded by John Du�eld, formerly of Ju-piter Asset Management, with the explicitaim of recruiting well-known individualfund managers. Its funds were popularwith both retail investors and distributorssuch as �nancial advisers and privatebanks. But in 2007 performance faltered asthe company became overexposed to theBritish property market. In the second halfof the year �ckle investors left in droves,withdrawing almost £2 billion from thegroup’s funds. The company cut its divi-dend in the expectation of further with-drawals this year. In response, its sharesfell by nearly a third. If you live by short-term performance, you can die by it too. 7

THE fund-management industry mayhave its problems, but it also has two

enticing opportunities ahead of it. Youcould call them the two Es�the emergingand the elderly.

Twenty-�ve years ago, developedcountries in Europe and America started todrop the capital controls they had had inplace ever since the second world war. Ra-tional investors took the opportunity todiversify their portfolios. The fund-man-agement industry pro�ted richly as it tooka slice of the capital �owing freely be-tween nations.

Now the capital markets are trulyglobal. One of HSBC Global InvestmentFunds’ most successful products in recentyears was the sale of a BRICs (Brazil, Rus-sia, India and China) fund through the Ital-ian post o�ce. Here was a London-based

manager selling the shares of Russian oil�rms and Brazilian co�ee companies toItalian pensioners, neatly demonstratingthat �nance has become borderless.

Not that globalisation is a new phe-nomenon. Before the �rst world war, Brit-ish investors were funding the develop-ment of Argentina’s railways and Frenchones were buying Tsarist bonds issued bythe Russian government. But now the capi-tal is coming back the other way, most ob-viously in the form of the sovereign-wealth funds that have been every bank’sfavourite sugar daddy over the past 12months. The deals that hit the headlinesare the direct investments, but sovereign-wealth funds are also likely to spread theirportfolios more widely. That will not onlydiversify their risk but may also avoid a lotof political hassle. The fund-management

industry will bene�t from the opportunityto o�er a range of investments to the newcentres of �nancial power.

And it is not just the sovereign fundsthat will be accumulating assets. As indi-viduals in emerging markets becomewealthier, they will start to build up theirown savings. Foreign fund-managementgroups will compete for the chance to tapinto this fast-growing pool of capital.

Just as in the West, the market will prob-ably split into three. Institutions are al-ready looking abroad for internationalequity exposure. Rich individuals will alsobe potential targets as they look for moresophisticated products such as hedgefunds. The mass market will be harder tobreak into. In some countries, such asChina, the best route will be to link upwith a domestic partner.

Jam today, jam tomorrow

Why the industry will still be thriving in ten years’ time

1


2 McKinsey reckons that the best oppor-tunity for growth is not, in fact, in any ofthe emerging markets but in Japan, whichalready has personal �nancial assets total-ling $13 trillion, against China’s $2 trillion.In the past a lot of that money has beenlocked up in low-yielding deposits. Lessthan 3% of household assets are in mutualfunds, against nearly 20% in America.

Fund managers are even more excitedabout the Middle East, with plenty ofwealth being generated by high oil pricesand looking for a home. Some of this is go-ing into local stockmarkets which are nowenjoying another boom, not long after theprevious one �zzled out in 2006. But someof it is also being grabbed by Americanand British fund managers. As one of themsays, �the great thing about these accountsis that if you win one, it can easily beworth $500m.� Flights from Heathrow toDubai are packed with managers chasingthe Arab dollar.

The region is also developing its ownfund-management community. Invest-corp was founded in 1982 and sells a rangeof alternative investments to local inves-tors, from hedge funds through privateequity to real estate. Assets under manage-ment are growing fast, reaching $15 billionearlier this year, and the group now has asigni�cant presence in the fund-of-hedge-funds market.

Between them, the growth of Asianand Middle Eastern markets may repre-sent as great an opportunity for the fund-management industry as the rise of cor-porate-pension plans in the 1970s and1980s or the love a�air between baby-boomers and mutual funds in the 1980sand 1990s. But there is also much to do forthe industry nearer home.

An age-old problemIn the core European Union countries, theold-age dependency rate (the number ofpeople above retirement age as a propor-tion of the working-age population) is setto rise from 21% today to 50% in 2050, ac-cording to Elizabeth Corley of AllianzGlobal Investors. Responsibility for fund-ing retirement income is increasinglyswitching from the state and the corporatesector to the individual.

But a lot of people have no interest in,or understanding of, the pensions market.They underestimate the amount of capitalthey will need to live on in retirement. Andthey can be overwhelmed by the task ofdeciding what to do with their pensionsavings. �It is asking a lot of uninformedindividuals to handle the responsibility

for asset allocation for their retirement,�says Je� Knight of Putnam, a Boston-basedfund-management group.

The �cafeteria� model of pension provi-sion, in which employees are invited tochoose from a vast range of funds, leads in-vestors to worry about the wrong things.�People are focusing too much on whichfunds to choose and not enough on the to-tal amount of their contributions andwhether that will provide a decent return,�says Alan Brown of Schroders.

The privatisation of the Swedish social-security system provides a useful casestudy. Swedes were encouraged to picktheir own funds, with 456 to choose fromat the launch in 2000, according to a 2004paper by two academics at the Universityof Chicago, Henrik Cronqvist and RichardThaler. But despite the large choice, mostparticipants put their money into fundswith an alluring recent record. The favour-ite fund at launch, specialising in technol-ogy and health care, had risen 534% in the�ve preceding years. Over the next threeyears, however, it lost 70% of its value.Oddly, once having made their choice,participants slumped into inertia; fewerthan 4% changed their portfolio each year.

Chastened perhaps by their experi-ence, over 90% of Swedes now choose thedefault option (the one that scheme mem-bers are assigned to if they do not want tomake their own choice). Similar �gureshave been observed in America and Brit-ain. This suggests that particular careneeds to be taken in designing the defaultfund so that it o�ers a broadly based mixof assets.

There are three possible ways ofachieving this, each of which would havedi�erent implications for the fund-man-agement industry. The �rst is to use indexfunds to get exposure to the main assets ofequities and government bonds. Thatwould be the cheapest option and wouldprovide plenty of business for passive spe-cialists such as Barclays Global Investorsand Vanguard, but the rest of the industrywould not get a look-in.

The second route would be for onefund manager to run the entire fund; thatwould be a great business opportunity forone of the big groups, such as Fidelity orBlackRock. The third option would be for afund-of-funds group to select the portfolio,choosing funds that specialise in areas likeemerging markets, property and so on.This would be good for the boutiques,which might otherwise be shut out of thepension-fund industry.

But o�ering the right pension funds isonly one of the industry’s preoccupations.It will also need to cater for the fact that asWestern populations age, they are likely tostop building up assets and start runningthem down�or, as the management con-sultants like to put it, from the accumula-tion phase into the decumulation phase.Investors will no longer be looking for cap-ital gains but for income.

The trouble is that fund managers donot provide clients with the informationthey need to make sensible plans. Peoplethinking about their retirement are notreally interested in whether their portfoliohas beaten the S&P 500 index or outper-formed its peers in the global-equity-fundssector. What they want to know is howmuch income they can expect and howmuch spending power it will command.

People in traditional de�ned-bene�tpension schemes have a rough idea of theanswer. Provided they stick with their em-ployer, they know what proportion oftheir �nal salary they will draw in retire-ment, so they can prepare for it. But thosewho are relying on a de�ned-contribution,or money-purchase, scheme are com-pletely in the dark. They can be given illus-trations of the sort of income that di�erent


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rates of return will produce, but there is noguarantee that those returns will beachieved, and the e�ect of in�ation can behard to understand.

The sort of product that most peoplewant is probably something that requiresthem to pay in a given sum a month for therest of their working lives in return for agiven annual income, or some proportionof their �nal salary, for the whole of theirpost-retirement lives. Anyone who couldo�er them something along those lineswould crack the market.

Yet fund-management companies �ndit very di�cult to make that kind of pro-mise. The only investment that can o�er aguaranteed in�ation-linked return is in-dex-linked government bonds, which of-fer very low real yields. Add in a fund man-ager’s fees, and the client would have tosave a huge amount to get the income hewants. That explains the prevalence of thecurrent system: the client saves less andthe funds invest in equities in the hope ofearning good returns, but they do not o�era guarantee.

Why don’t fund managers take advan-tage of the fact that equities nearly alwaysoutperform bonds and cash in the longterm? They could o�er their own guaran-tee and rely on the stockmarket to do its bit.After all, this is what �nal-salary pensionschemes have traditionally done. The pro-blem is that regulators would not allowmanagers to make such an unfunded com-mitment because things might just gowrong. Instead, they would ask the fundsto put up an enormous amount of capitalto back such a guarantee.

This has put the onus on fund manag-ers to come up with products that dealwith some of people’s retirement worries,but without o�ering guarantees. Amongthe most popular are lifestyle funds, whichswitch investments from equities to bondsas retirement approaches. The idea is toprevent disaster in the form of a stock-market crash hitting the fund just before re-tirement. Similarly, so-called target retire-ment funds allow investors to choose the

year of their planned retirement so thatthe manager can adjust the asset alloca-tion accordingly.

Then there are variable annuities,which tend to be o�ered by insurancecompanies. In return for a fee, these allowinvestors to lock in the value of the fund(and the expected income) on a regular ba-sis; this gives investors the security theycrave but still allows them to bene�t from arise in the market. But ultimately the guar-antee is only as strong as the insurer’shedging strategy and balance sheet.

Other options include guaranteedfunds that o�er investors, say, 90% of therise in an equity market over the following�ve years, but with the promise that capi-tal will be returned if the market falls.These products appeal to �rst-time inves-tors who want to get some exposure tostockmarkets but are nervous about therisks. Lastly, there are products that seek touse most people’s biggest pool of savings,their homes, allowing them to convertcapital into income.

These outcome-oriented products, asthey have become known, are likely to in-crease in popularity. McKinsey reckonsthat between 1994 and 2005 such products

grew at 28% a year, compared with 13% forthe conventional mutual-fund industry;and that by 2010 perhaps 25-30% of theearnings of leading asset-management�rms will come from products not yet ono�er today.

Guaranteed uncertaintyIndeed, one of the few sure predictionsthat can be made about the fund-manage-ment industry is that in ten years’ time itwill have changed drastically. Leavingaside the havoc that turbulent markets canwreak, some managers will have taken ad-vantage of the rise of the developing worldand the ageing of Western populations,and some will have failed miserably.Some will have built a franchise in thecomplex world of alternative assets andsome will have su�ered embarrassinglosses. Fund management will still be agreat business in aggregate, but there willhave been plenty of scope for individual�rms to make a complete hash of it.

But whatever happens to the industry,it would do its reputation a power of goodif over the next ten years its activities wereadjusted to bene�t its clients a little moreand its managers rather less. 7

Future special reportsCountries and regionsAmerica’s foreign policy March 29th

Israel April 5th

Vietnam April 26th

Business, �nance, economics and ideasResources in China March 15th

Telecoms: mobility April 12th

International banking May 17th

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