Investment Firms: Trends and Challenges

Investment Firms: Trends and Challenges—An Overview Kathryn Dixon Jost, CFA Vice President, Educational Products The investment management industry is undergoing a dynamic transformation. Technology and economic globalization are combining to blur the lines between traditionally distinct domestic markets. Not only have cross-border investment strategies become commonplace; a number of firms in Europe and the United States have also embarked on missions to become global super firms that will provide almost every conceivable investment service. And with tens of trillions of dollars in assets at stake in the global marketplace, these firms have ample incentive. In such an environment, the debate over size has only intensified. Obviously, only extremely large firms can establish a global presence. But studies showing a negative trade-off between increased assets under management and performance suggest that smaller firms have their own advantages. Smaller firms, however, also face obstacles, such as limited distribution networks. As some firms have launched ambitious strategies—acquiring smaller firms to complete their repertoire of investment capabilities—finding the right ownership structure and management model has become a central task for firms of all sizes. Expanding firms must figure out how to capture and preserve the advantages of the smaller firms they acquire, and smaller firms must decide how they will survive in a landscape that may be dominated by giants. Globalization, size, and ownership structure are only some of the grand trends at work in the industry. Firms must also grapple with the myriad implications of other ongoing and emerging developments. The recent volatility of some of the major stock markets, particularly in the United States, may signal the end of the extraordinary performance investors experienced during the past decade, which would certainly affect firms’ ability to attract new clients and assets. Moreover, the trends stimulated by modern information technology will only accelerate. The result may be the empowerment of investors and investment intermediaries at the expense of investment management firms, but opportunities for innovative investment managers are also likely to arise.

The Future of Investment Management Charles Burkhart observes that the future of the investment management industry will be defined by

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survival of the fittest—not necessarily the fittest firms in terms of performance but the best-managed firms. Performance, though still critical, will not suffice to guarantee success. In order to thrive, firms will have to contend with changing industry economics and competitive dynamics. Burkhart expects the industry’s profit margins to decline because firms’ ability to generate new assets is likely to diminish while technology costs and compensation will continue to rise. In the new competitive framework, firm survival will depend on meeting five key challenges: closing the talent gap, making the most of e-business, leveraging investment knowledge, promoting brand loyalty, and establishing alliances with new intermediaries. Given that Guy Moszkowski depicts investment management as a growth industry, improved market valuations of publicly traded U.S. firms would seem to support a rosy forecast—if not for the fact that valuations were significantly higher in the past. Valuations have only recently begun to recover from extremely low levels relative to the S&P 500 Index, and room for improvement remains. Moszkowski sees the market sending the message that the investment management industry’s quality of earnings and predictability of growth rates have declined. Most importantly, although the majority of the growth in the industry will occur outside the United States, few U.S. firms are prepared to exploit this opportunity. Taking advantage of international growth, however, is merely one of several critical trends in the industry. Moszkowski concludes that three factors will drive firm success: brand strength, financial strength, and an innovative management culture.

Technology and the Investment Management Firm Technology has played a central role in the globalization of the industry. Robert Reynolds argues that the combination of technology and globalization is leading to the creation of a single global capital market and that technologically driven changes will further this trend. Legal and regulatory barriers, however, still pose formidable obstacles. How firms use technology will be critical for client service—and not only in the mechanics of the process. Clients typically seek more from investment managers than a particular service; they want a relationship. For many clients, a

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Investment Firms: Trends and Challenges firm’s mastery of and commitment to technology provides a symbol of its ability to grow with the evolving needs of clients and adapt to the changing dynamics of the industry. Accordingly, in Reynolds’ view, exploiting technology is no longer an option for firms; it is a basic necessity. Despite the impact of information technology on financial services, institutional asset management has remained relatively untouched, according to Patricia Dunn. The reason is that investment performance and relationship management, which are the fundamental value propositions of institutional management, cannot be readily replaced by technology. Dunn, however, expects technology to exert a greater influence on institutional management in the future. For example, although portfolio management is currently a labor-intensive activity, the eventual development of systematic, rigorous, and repeatable quantitative investment strategies not only will transform the nature of the portfolio management process but also will lead to fully integrated asset management services, from research to trading.

Ownership of the Investment Firm Ownership is at the heart of many of the challenges confronting the investment management industry. Whether the subject is the relative merits of small versus large firms or globalization or compensation, the basic principle involved is finding the ideal ownership structure. To illuminate some of the central issues, four authors address ownership from distinct perspectives. First, John Watts examines the motivations for and challenges of organizing effective combinations of investment firms. He argues that firms should address the questions of strategic control and operating independence as separate issues and should establish basic principles to govern each area, rather than trying to impose one set of overall rules. Joachim Faber describes the management model of a global investment organization, Allianz AG, whose goal is to create a hybrid structure that captures the benefits of worldwide distribution and economies of scale while preserving the strengths of smaller firms. Hilda Ochoa-Brillembourg approaches the question of size by considering the life cycle of firms. The answer, in her view, lies in achieving the right balance between “richness,” the stage at which a firm’s central goal is providing a truly exceptional product, and “reach,” the point at which a firm must either grow or fail. William Nutt concludes the panel with a description of his firm’s approach to helping its “Affiliate” firms solve succession and ownership issues. The organization helps Affiliates separate financial ownership from governance, thus allowing the founder/ owners of the Affiliates to maintain operational inde-

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pendence while resolving questions of ownership continuity.

Leadership Many firms struggle to find executives who combine the necessary investment management expertise with strong leadership ability. Susan Fowler and Richard Lannamann explain that to address the leadership challenge, their firm conducted a study to identify common traits among outstanding chief information officers and other senior executives. In the process, they discovered key traits (which they call “Investment DNA”) that are essential to effective leadership. With this competency model, firms may be able to more accurately identify superior candidates for leadership positions.

Performance Fees and Their Alternatives Performance fees are intended to align the interests of investment managers and clients. The key is to reward managers for adding value for clients and to minimize their incentive to do anything that might interfere with this goal. How best to achieve the desired result, however, is far from obvious. To this end, three authors address the salient aspects of performance fees. Langdon Wheeler observes that fixed fees simply encourage investment managers to increase their asset bases in order to grow fee income—and adding assets impairs a manager’s ability to add value for clients. The way out of this dilemma is through performance fees, which minimize a manager’s incentive to grow the asset base at the expense of performance. Wheeler also outlines the criteria for an effective fee structure. Anne Casscells is convinced of the benefits of performance fees but sees a significant challenge in trying to define the “value creation” on which the fees are to be based. Only after this question is resolved can a proper fee structure be determined. The story of performance fees, however, is not simply a matter of finding the right fee structure. Joseph McNay points out that whatever the merits of performance fee products, they often impose huge costs on investors. With this problem in mind, McNay considers whether the fee justifies the return and examines alternatives to performance fee products.

Conclusion The authors in this proceedings present diverse perspectives within the industry, but the common thread among the presentations is identifying and understanding the forces that will shape investment management firms. From the broad trends affecting the industry to the nuances of particular issues, the authors survey the current context and future prospects of investment management.

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Survival of the Fittest Charles B. Burkhart, Jr. President and Founder Rosemont Partners, LLC West Conshohocken, Pennsylvania

To succeed in the future, investment management firms will need to focus on more than performance. In particular, firms will have to grapple with evolving industry economics, changing competitive dynamics, and cost control. A new competitive framework is needed to help firms address key challenges and measure their success in meeting these challenges.

en years ago, I would have discussed which firms have not enjoyed unprecedented prosperity and why. Today’s environment, however, calls for the reciprocal discussion of which firms will survive and thrive and why. This presentation addresses two perspectives that coexist in the industry today concerning the management of asset management firms. One is a macroperspective of the trends in investment management. The second is a microperspective on the individual firm and the strategies required for competitiveness in the future. Finally, I discuss a new framework for assessing investment management companies. Throughout the presentation, I refer to a survey conducted by Investment Counseling, LLC, that collects and analyzes the best business, financial, and compensation practices in the investment management industry. The survey is titled Competitive Challenges and has been conducted annually for the past 10 years.

T

Trends in Investment Management A number of people have written about the trends in investment management. Some of these supposed trends are debatable; others are widely accepted. After assessing these so-called trends, I will describe what I believe are the real trends in investment management. Perceived Trends. As an example of typical notions about industry trends, consider the vision of so-called “trends” in investment management collected and presented by Mark Constant.1 He summarizes these main trends as follows:

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■ When this bull market ends, the investment management business will no longer be a growth business. This idea is based on the premise that the investment management industry—effectively a $30 trillion industry—has only a single engine of growth. I believe that this industry has multiple engines of growth and that growth is contextual (that is, relative to historical growth, both industrywide and firm specific). Profitable growth is the greater concern, and achieving it will be a tougher task. To suggest that investment management will no longer be a growth industry is to greatly overstate the case. ■ Distributors will dominate manufacturers (product developers) in the long run. No one doubts that the distribution arms of financial services companies are currently increasing their share of overall fees relative to manufacturers. This trend, however, cannot continue because of the open architecture movement: The relationship between distributors and manufacturers is symbiotic. The large (greater than a quarter trillion dollars under management) financial services companies that are being created cannot simply sell their own products. The good independent providers of products are guaranteed an opportunity for the foreseeable future. ■ Because only the biggest, most highly capitalized firms will prosper, consolidation is inevitable. This view is common, but no real consolidation in the money management business has occurred. There has only been aggregation and disaggregation—purchases and divestitures of free-standing businesses. Anyone 1

Mark L. Constant’s presentation was given at Investment Counseling’s Competitive Challenges 2000, State of the Industry conference in New York City (September 26, 2000).

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Investment Firms: Trends and Challenges who thinks that the record number of mergers and acquisitions that occur each year represents consolidation is mistaken. M&A (merger and acquisition) activity has typically done three things for the investment management industry. First, it has helped companies increase their contributions to total earnings from investment management. Second, it has fattened owners’ bankrolls. Third, it has helped owners handle succession issues. Consolidation—the winnowing out of some competitors and increased dominance of others—is only in the embryonic stages in our industry. ■ Only a few firms are actually growing, and only a few leading brands have emerged and have begun to dominate the marketplace. Institutionally, this opinion is the farthest thing from the truth—for two reasons. First, many firms are growing at double-digit rates, and these firms represent a cross-section of sizes. In fact, according to Investment Counseling’s Competitive Challenges 2000 study, the smaller firms— whether the cutoff is set at less than $3 billion, $5 billion, or $10 billion in assets under management— have traditionally grown faster on a sustained rolling basis than the larger firms. Second, the issue of brands seems to be misunderstood. There are absolute brand associations in the minds of most managers, consultants, and plan sponsors. Competitors are closely identified (among clients and consultants) by style, asset class, ownership, and infrastructure. ■ A company must have a complete, global product line to remain relevant. For most managers, pursuing this type of strategy would be a poor decision. A number of firms already have a complete, global product line. Clients will still look to alpha specialists for niche management, and plenty of managers can succeed in this role. Real Trends. The popular macrotrends just enumerated do not reflect what I consider to be the real trends in investment management, which are the following: ■ Discretionary active investment management will remain one of the few differentiated, high-margin, highly sustainable financial services products. Even with margin pressure and fee pressure, active investment management will continue to have larger sustained profit margins than other areas of the investment industry, such as securities trading, custodial services, and credit analysis. ■ Many investment management firms will see real profits (not only a few large firms). The rising market made it difficult to differentiate between the firms with underlying real net growth and those that had merely ridden the rising market wave. When the smoke clears from the train wreck that the market of 2000 produced—with so many firms’ growth demol-

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ished by market depreciation—real profits will accrue to a diverse group of investment management firms with real net growth, not only a select few. ■ Private market values for investment management firms are reaching the highest levels ever seen, which reflects the extreme demand for these firms. The high valuations may suggest that a lot of these buyers are in for hard landings, and they might be. A sustained market downturn will make it difficult to earn back the premiums being paid, but investment management is still the most valuable asset many companies can hold on their balance sheet. ■ Intermediaries will continue to dominate the dissemination of investor education and advice, making direct relationships between investment managers and clients harder to build and sustain. Transparency—through a variety of decision-making tools and advice strategy products—is here to stay, but in all investor segments, clients will increasingly turn to intermediaries for advice. Performance data, style analysis, and other facets of manager information are increasingly Web enabled, and intermediaries are finding better technologies with which to do their jobs. ■ Pressure to perform (i.e., the burden of creating and maintaining the confidence of clients) will intensify. Every year, individual firms lose or gain billions of dollars in assets under management. Such asset volatility puts more pressure on the regulatory side of the investment industry. Are investors aware of the effects of such volatility on their managers and portfolios? Undoubtedly, this volatility puts much more scrutiny on performance. ■ Effective management of the business, more so than investment performance, will determine survivors and winners. One final point that I would like to add to Mark Constant’s list of perceived trends is that the future of the industry remains relatively bright, although success will not come as easily as it did throughout the halcyon days of the 1990s.

Managing to Be Competitive To be competitive in the future, investment management firms will have to pay more attention to the whole business, not simply performance. They will need to focus on the economics of the business, the competitive environment, and cost containment.2 2 Much of the data in this section are drawn from Investment Counseling research, specifically its annual best practices study, Competitive Challenges. The data are also reported in Paul Schaeffer’s “Don’t Get Trampled by a Walking Bull” presentation given at Investment Counseling’s Competitive Challenges 2000, State of the Industry conference in New York City (September 26, 2000). Mr. Burkhart was the founder of Investment Counseling and president until 2000, when partner Paul Schaeffer assumed control of the business.

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Survival of the Fittest Economics of the Business. The economics of the investment management business are changing. In 1998 and 1999, average annual asset growth was about 20 percent. Revenue growth fluctuated from about 25 percent in 1997 to about 30 percent in 1998 and dropped to 21.1 percent in 1999. Average profit margins hovered around 30 percent from 1997 to 1999, and this level is considerably lower than the 40 percent average margins generated in 1989, when I founded Investment Counseling. Furthermore, in 1999, the industry’s ability to generate new assets as a percent of average assets declined to a rate of about 12.6, down from about 15 percent in 1998 and 1997. Most of the growth in assets can be attributed to the markets—and much less to net underlying growth of the client base. I believe profit margins will continue to erode, as I discuss later in this presentation. Competitive Environment. Firms must be aware of new developments in the competitive environment. The pace of acquisitions and joint venture deals reflects a new competitive dynamic (as well as the reality that some independent investment management firms may never again see prices as high as they were in 2000). Table 1 shows the history of transactions from 1995 through June 30, 2000. The

first half of 2000 saw more transactions than any single prior year, and for some of these transactions, multiples soared to 30 times pretax earnings or more. Each one of these start-ups, management buyouts, acquisitions, and joint ventures creates or changes a competitor in some way, so imagine the impact these 244 transactions are having on the industry. Investment managers are facing not only traditional competitors but also new sources of competition. For example, some plan sponsors have enjoyed great results with alternative investments, such as hedge funds and private equity, and this success is sparking other plan sponsors’ interest in alternatives. Other forms of increased competition include direct investment, internally run pension funds, and clients managing their own affairs. The rise of online brokerages and managers also contributes to increased competition. In fact, by some calculations, online investing is beginning to dominate online trading. So, the notion that online investment activity will appeal to only a limited audience focused on the short term is quickly evaporating. Active exchange-traded funds (ETFs) are also coming. The U.S. SEC is scrutinizing the risks and benefits of such funds for investors, but the ETF movement that State Street Global Advisors and the

Table 1. Worldwide Investment Management Transactions, 1995–2000 Type of Activity

1995

1996

1997

1998

1999

2000a

U.S. acquisitions

60

47

69

49

48

60

5

2

2

5

5

8

11

6

10

7

7

10

U.S. management buyouts (MBOs) U.S. joint ventures U.S. start-ups/lift-outs

30

64

51

26

42

64

Total U.S. activity

106

119

132

87

102

142

U.S./cross-border acquisitions

9

16

12

23

29

26

U.S./cross-border MBOs

0

1

0

1

0

0

U.S./cross-border joint ventures

8

16

24

27

18

16

U.S./cross-border start-ups/expansions Total U.S./cross-border activity International acquisitions

3

1

4

0

6

4

20

34

40

51

53

46 38

12

28

17

23

39

International MBOs

0

2

1

1

0

2

International joint ventures

4

16

9

14

7

2

International start-ups/lift-outs

7

14

9

11

3

14

Total international activity

23

60

36

49

49

56

81

91

98

95

116

124

5

5

3

7

5

10

Total joint ventures

23

38

43

48

32

28

Total start-ups/lift-outs

40

79

64

37

51

82

Total transactions

149

213

208

187

204

244

Total acquisitions Total MBOs

aData

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annualized as of June 30, 2000.

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Investment Firms: Trends and Challenges American Stock Exchange started six or seven years ago will most likely develop into a serious business. Drivers of Competitiveness. Understanding the direction of the industry requires gaining insight into what managers believe is important. What do they spend money on? What do they believe is important for achieving their objectives? According to Competitive Challenges 2000, the most important criteria, in order of importance, are: • investment performance, • client-service capability, • sales capability, • marketing and distribution capability, • information technology capability, • employee satisfaction, • investment product diversity, • operations capability, • employee ownership structure, • investment product pricing, and • firm size.3 The criteria are not much different from those cited in the Competitive Challenges studies of the past four years. That investment managers rate investment performance as the most important criteria is no surprise, but every issue—from sales and marketing capability to efforts in technology, product diversity, and employee satisfaction—is important and costs more money. Curiously, investment product pricing was ranked second to last, which in our consulting experience suggests that the closet indexers do not really have much price elasticity and that real alpha generators have great price elasticity and little competitive pricing pressure. The survey’s low ranking of size is ironic. Many people have touted firm size as one of the most important drivers of a firm’s success and sustainability, but data suggest that, all other things being equal, smaller companies will outperform larger companies. A recent article in the Wall Street Journal reported that of the top-10 best-performing equity mutual funds (individual funds, not fund complexes) in each of eight major categories, only 6 (out of a total of 80) were greater than $1 billion.4 Nelson’s rankings of firms in three major product areas—growth equity products, value equity products, and international equity products—show similar results.5 The great majority of the firms in the top 20 of each category 3 Based on data from Paul Schaeffer’s “Don’t Get Trampled by a Walking Bull” presentation (September 26, 2000). 4 “Mutual Fund Scoreboard: Category Ratings in Eight Realms,” Wall Street Journal (November 13, 2000):Section C. 5 Nelson’s “World’s Best Money Managers” rankings are drawn from more than 1,500 managers and 4,500 portfolios (for three years ended September 30, 2000). Statistics are available online at www.nelnet.com/wbmm/intro.htm.

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manage less than $10 billion in assets, and others manage less than $1 billion in assets. And these are well-known, established firms, not tiny firms. Given these data, I have a hard time understanding the pursuit of size as a goal in itself. Managers need to recognize when size starts to hurt performance. Size does not appear to be an important factor in achieving growth. Figure 1 plots firm size versus growth. As Figure 1 shows, no compelling evidence suggests that larger firms, at any scale, grow faster than smaller firms. A persistent myth holds that expanding infrastructure will generate proportional growth of profit margins. In fact, this dynamic is not true, nor has it ever been. Consider how publicly traded fund companies have grown in size, not in margins, and how private companies have increased spending with the intention of fueling future growth. The bottom line tends to peak in the $5 billion to $20 billion assets under management range. Accelerating Costs. Costs are accelerating for all firms. In fact, as Table 2 shows, expense growth is outstripping revenue growth, which will impose a continued drag on profit margins. The industry will favor firms that have franchises that turn this expense growth into revenue growth, not those who refuse to spend or reinvest. The two major contributors to accelerating costs are information technology expenses and compensation. Table 3 shows that, from 1998 to 1999, the average total information technology expenditures for an investment management firm increased from about $4 million to $10 million. By far the greatest technology expenditure was for infrastructure, but spending on customer relationship management and Internet/e-commerce projects also increased. The most difficult expense to deal with is compensation expense. Cutting costs is difficult in a knowledge-based, human-capital-based business. Table 4 shows that compensation has accounted for about 60 percent of total costs in the industry between 1995 and 1999. The critical point is the proportion of fixed costs to variable costs (that is, costs linked to business conditions and competition). Most firms agree that despite market conditions in 2000, they will need to spend more and increase the bonus pool this year. Some firms, however, are beginning to realize that they have to defend themselves against the growing burden of compensation. As Table 5 shows, almost half the universe in the Competitive Challenges 2000 study said they are adding or enhancing long-term incentives for employees. This statistic is significant. Furthermore, few management positions have not experienced a significant increase in compensation. Table 6 shows the change 2001, AIMR®

Survival of the Fittest Figure 1. Size versus Growth for Investment Management Firms, 1999 3-Year Compound Annual Growth Rate (%) Log Scale 1,000.0

100.0

10.0

1.0

0.1 10.0

1.0

100.0

1,000.0

10,000.0

100,000.0

1,000,000.0

Assets under Management ($ millions) Log Scale Source: Based on data from Paul Schaeffer’s “Don’t Get Trampled by a Walking Bull” presentation (September 26, 2000).

Table 2. Growth in Average Operating Expenses and Revenue Growth, 1997–99 Growth

1997

1998

Revenue growth

25.5%

29.8%

1999 21.1%

Operating expense growth

20.6

23.9

22.9

Source: Based on data from Paul Schaeffer’s “Don’t Get Trampled by a Walking Bull” presentation (September 26, 2000).

Table 3. Average Information Technology Expenditures for Investment Management Firms, 1998–99 ($ thousands) Expenditure Technology infrastructure

1998

1999

3,524.0

8,497.7

Customer relationship management

442.0

1,334.8

Internet/e-commerce

155.0

366.4

Source: Based on data from Paul Schaeffer’s “Don’t Get Trampled by a Walking Bull” presentation (September 26, 2000).

in executive total compensation by position from 1996 to 1999. Curiously, although most of these growth rates look strong, the top-quartile key business professionals (i.e., the chief financial officer and chief operating officer) have had the smallest proportional increase in compensation over the period. The combination of higher compensation costs and lower revenue growth has led to lower productivity. Revenue per dollar of compensation dropped from $2.90 in 1997 to $2.50 in 1999.6 The data raise two questions: First, how many firms are trying to manage productivity? Second, for those who want to manage productivity, what are the right measurement criteria? For example, airlines and law firms have an easy time measuring productivity in terms of the number of empty seats at take-off and the number of billable hours worked, respectively. Investment management is not so straightforward. Other ways to look at productivity would be to measure net client tenure (in this time of increasing client mobility) or the firm’s capacity utility (that is, the maximum level of aggregate product capacity that 6 Data are from Paul Schaeffer’s “Don’t Get Trampled by a Walking Bull” presentation (September 26, 2000).

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Investment Firms: Trends and Challenges Table 4. Compensation Costs versus Total Operating Expense, 1995–99 Expense

1995

1996

1997

1998

1999

Compensation cost

62.1%

62.0%

62.9%

58.2%

64.0%

All other costs

37.9

38.0

37.1

41.8

36.0

100.0%

100.0%

100.0%

100.0%

100.0%

Total

Source: Based on data from Paul Schaeffer’s “Don’t Get Trampled by a Walking Bull” presentation (September 26, 2000).

Table 5. Changes in Compensation Components (percent of firms surveyed) Compensation Component

Incentives Increase Spending

Add Feature

Expand Eligibility 18

Short-term incentives

36

9

Long-term incentives

21

48

34

Sales/commissions

14

2

11

Note: Multiple responses are possible. Percentages may sum to greater than 100 percent. Source: Based on data from Paul Schaeffer’s “Don’t Get Trampled by a Walking Bull” presentation (September 26, 2000).

Table 6. Compensation Trends by Position, 1996–99 (percent change in universe) Position

Top Quartile

Median

Chairman, CEO, and president

75.5

46.2

Average 57.8

Chief financial officer and chief operating officer

36.8

53.4

86.7 119.6

Chief technology officer

86.0

66.0

Chief investment officer

127.0

37.5

3.5

49.0

24.2

70.1

Senior equity portfolio manager Senior fixed-income portfolio manager

90.5

67.0

80.4

117.6

43.1

118.4

Director of marketing

334.8

32.2

46.0

Director of client service

127.5

65.9

96.1

Director of sales

Note: The number of firms included in the computations differs slightly from year to year. Source: Based on data from Paul Schaeffer’s “Don’t Get Trampled by a Walking Bull” presentation (September 26, 2000).

can be managed before diminishing investment returns take effect). Productivity will be one of the key determinants of future industry winners and should be emphasized by any firm serious about competing in the future.

A New Competitive Framework In his Competitive Challenges 2000 presentation, Paul Schaeffer warned of getting trampled by a walking bull. Figure 2 shows what he meant. What would happen if market performance after 2000 is more consistent with the historical average annual growth rate of 6.5 percent while spending continued its

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recent accelerating trend? The answer is that profit margins would decline dramatically. This scenario begs for a new competitive framework to carry the investment management industry into the future. Exhibit 1 illustrates a financial framework that has five main challenges. The first three are capability driven; that is, they depend on what firms can produce internally—closing the talent gap, making the most of e-business and technology capabilities, and leveraging knowledge. The other two challenges are on the customer side—promoting brand loyalty among clients and becoming a partner with new intermediaries. How distinctive is your firm? Investment Counseling was 2001, AIMR®

Survival of the Fittest Figure 2. Effect of Slower Growth and Rising Costs on Profit Marginsa Dollars (thousands)

Profit Margin (%)

800,000

30

700,000

25

600,000 20

500,000 400,000

15

300,000

10

200,000 5

100,000 0

0 2000

2001

2002

Average Revenue (left axis)

2003

2004

Average Operating Expense (left axis)

Profit Margin (right axis) a

Estimates from 1999 data. Source: Based on data from Paul Schaeffer’s “Don’t Get Trampled by a Walking Bull” presentation (September 26, 2000).

Exhibit 1. Financial Framework with Five Main Challenges Category Capability

Customers

Challenge

Scorecard

Closing the talent gap

Employee satisfaction

Making the most of e-business

Technology

Leveraging knowledge

Profitability and productivity

Differentiating the client experience (promoting brand loyalty)

Customer segment

Partnering with new intermediaries

Business growth

Source: Based on data from Paul Schaeffer’s “Don’t Get Trampled by a Walking Bull” presentation (September 26, 2000).

surprised that in the Competitive Challenges 2000 study, fewer than 35 percent of asset management firms had ever done client survey work to better understand their client base. Collecting abundant client information and data warehousing are relatively nascent developments in the institutional money management community, and the implications are interesting. How are firms going to focus more on the needs of the customer, and how will such an increased focus affect the market segments in which firms compete? Will this focus lead firms to create more partnerships with intermediaries? Firms should not ignore the increasing sophistication in investment decision-making tools, because these tools will deliver efficiencies for the client. ©2001, AIMR®

Ultimately, survivability will depend on how a firm compares with its peers on all of these issues. A serious ranking system should be developed to accurately assess which asset management firms have adopted a viable competitive strategy. Investment management firms should be willing to apply to themselves some of the same criteria they use to evaluate companies in which they invest.

Conclusion Important information can be gleaned from the current trends in the investment industry, and this information can help investment management firms compete and succeed in the future. Unfortunately, in the years ahead, success will not be as widespread as

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Investment Firms: Trends and Challenges in the past. I foresee an absolute decline in the valuations of privately held investment management firms. And as the general level of valuations declines, the dispersion in the valuations of these firms will widen and greater volatility in the stock prices of

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publicly traded investment management firms will be likely. Although competitive pressures are increasing, investment management is still an attractive industry in which the better managed firms will stand out from their peers.

2001, AIMR®

Survival of the Fittest

Question and Answer Session Charles B. Burkhart, Jr. Question: Do you believe that firms should move toward performance fees that are paid only if the manager delivers outperformance? Burkhart: This approach could be a logical solution for active management, but such a move was attempted 10 or 12 years ago and never caught on. It doesn’t make sense to motivate a manager to do a better job when he or she is already doing the best job possible. The main issue is aligning, without any uncertainty, the welfare of the client with the welfare of the manager. So far, the welfare of the manager has been dominant. Question: Because it is difficult to identify managers that can provide alpha, why shouldn’t clients migrate to indexers, whose fees are lower and whose performance matches the market? Burkhart: Many sponsors think indexing is the way to go, and a huge move to indexing has already occurred. But there are two questions that the plan sponsor needs to answer before hiring an index manager: First, does the active manager employed now have the tools to continue to generate alpha and be a distinguished active manager in the face of the industry’s market downturn? Second (and the more important question), will more or less assets be indexed in a bear market? In my view, the trend in the U.S. equity markets in the past few quarters will continue and will create a lower demand for indexing relative to active management. Asset inflows for many firms are going to be reduced. Enhanced indexing, or a guaranteed return plus potential alpha, is a different ©2001, AIMR®

story and may not suffer the reduction in popularity that straight indexing will. The big indexing boom of the past five or seven years is not going to be replicated soon, and the share of the pie that goes to indexing will be relatively static for the foreseeable future. Question: Please explain why there will be less indexing in weaker markets. Burkhart: For years, I’ve thought that investors (mainly individual investors) have an intuitive, inherent belief that they will outperform indexes. If they didn’t have this belief, there wouldn’t be thousands of active managers. Many investors are not going to be comfortable with the flat to singledigit returns that have been forecast for market growth rates (and hence index returns), and they’re going to continue to look for ways to try to achieve better performance. So, an increase in indexing seems unlikely in tougher markets. Question: Was spending on information technology and other operating needs in 1999 skewed by gearing up for the so-called Y2K crisis? Burkhart: I thought that the 1998 and 1999 information technology expenses were predominantly driven by Y2K, but in 2000, no drop off in spending was apparent for Competitive Challenges participants. A lot of the spending in preparation for Y2K was spread over a two- or three-year period, so I’d say it was a modest blip at best. Question: Is there a trend among traditional asset managers

toward equity participation by investment professionals, and if so, how important is the trend? Burkhart: This question involves a pivotal topic. The movement toward equity ownership in firms is powerful, broad, and ongoing—because such compensation is important to how firms can compete with other lucrative economic sectors (such as information technology or investment banking) to attract young talent. Question: Besides equity participation, what future trends do you see in compensation for top investment marketing professionals? Burkhart: I see fewer individual sales incentives, and I see more team sales incentives. The proposition that one person can bring in new business is getting hard to defend. In my view, marketing people are different from salespeople. Firms now have more intermediaries and more “clients” to sell to, so in addition to the efforts of the salesforce, management will have to undertake a thoughtful, allencompassing marketing effort to bring in clients. More equity ownership, or synthetic equity ownership, will also be a future trend among salespeople. The investment industry has too long been segregated into two classes of professionals—the actual investment people and the hired guns—and this division is not healthy for the long-term strength of a business. I predict that in the future, the more competitive firms will depend less on individual incentives and instead will concentrate on team incentives and equity-like arrangements.

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Investment Firms: Trends and Challenges Question: Where will small private management firms (i.e., less than $1 billion in assets) fit into the future competitive environment? Burkhart: The majority of the small private-client investment management firms should continue to run their business as they always have, but they may need to undertake some changes to sustain the type of operation originally intended by the founders. At a certain point, the competing interests of the founder(s) and the interests of

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a large employee base can become a problem. It is not true that the investing public is focused only on the large firms. Large firms are only one area of investor interest. Question: In your reasons for consolidation, do you mean that U.S. managers are ill-advised to be chasing offshore distribution? Burkhart: Firms that are not already in the midst of a global pursuit should not chase offshore distribution, because they will

have a hard time competing against firms that have huge head starts and they might compromise the integrity of the investment products they already offer. Also, such a strategy of globalization may create bigger, more complex firms with more infrastructure than the owners really want to manage or even could manage. Global business prospects are a necessity for some firms, but certainly not the majority of U.S. firms.

©2001, AIMR®

Investment Management: Trends and Challenges Guy Moszkowski, CFA Managing Director Salomon Smith Barney New York City

Investment management is a growth industry. The fundamentals of publicly traded investment management firms are strong (particularly as measured by net asset inflows), and market valuations for these firms have improved. Recent acquisitions of investment firms by financial services companies indicate that the investment business is expected to be a future source of growth and profitability. For investment management firms, future prosperity will depend on three factors: brand strength, financial strength, and innovative management culture.

ublicly traded investment management companies had a good year in 2000, despite the fact that the market was not particularly favorable. Today’s stock prices for public investment management companies reflect the market’s positive perceptions of the future state of the industry. But significant challenges are ahead.

P

A Good Year Overall, 2000 was not a good year in the stock market, but the stock prices of investment management companies proved to be an exception. Two factors drove the performance of investment management stocks. First, the fundamentals of the industry improved in several ways. Second, deal activity in the industry increased substantially, with a number of high-priced acquisitions of investment management firms. Industry Fundamentals. One reason for the success of investment management companies in 2000 was that many managers again outperformed the market, and this development had a positive impact on asset flows into mutual funds. Performance is now much less concentrated—not just in the hands of a small group of investment management companies. Active managers have regained a larger share of the investable asset universe from passive (index fund) managers and unmanaged portfolios. (By unmanaged portfolios, I mean buy-and-hold types of strategies used by individual investors.)

©2001, AIMR®

The percentage of actively managed U.S. equity funds that outperformed the S&P 500 Index for each year from 1990 through third quarter 2000 tells an interesting story, as shown in Figure 1. In the early 1990s, slightly more than 50 percent of actively managed domestic growth and growth income funds outperformed the S&P 500. This result is spectacular because, with fees and expenses, actively managed funds are usually at least 100 basis points behind from the get-go. The year 1993 represented a peak in outperformance, but unfortunately, performance subsequently collapsed, largely because active managers tended to be overweight small-cap and value stocks, which underperformed after 1993. For a few years, only 10–20 percent of active managers could generate excess returns (and they generally were not the same managers year after year). These disappointing returns began to weigh heavily on the mutual fund industry’s share of asset inflows. By 1998, however, the tide was starting to turn. About 75 percent of active equity managers outperformed the S&P 500 over the 12 months ending third quarter 2000; and for 2000 as a whole, 65 percent of active managers outperformed the S&P 500. Net asset flows into actively managed investment products have been increasing, and holdings of individual stocks have been declining among individual investors. For a few years, new individual investors have felt that they could beat an active manager by simply holding the right combination of

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Investment Firms: Trends and Challenges Figure 1. Percentage of Mutual Funds Outperforming the S&P 500, 1990–2000 Percent of Outperforming Funds 80 70 60 50 40 30 20 10 0 91

90

92

93

94

95

96

97

98

99

00

Source: Based on data from Strategic Insight Simfund and Salomon Smith Barney.

large-cap growth stocks and a few technology-stock winners—a strategy that obviously came to a halt in 2000. Figure 2 compares the total return of the average actively managed mutual fund with that of the S&P 500. The average active manager outperformed the

S&P 500 from 1991 to 1993 and then underperformed through 1998. Performance turned around in 1999 and continued to be positive in 2000. During the past two years, as average performance improved and as more investment firms were able to outperform the S&P 500, cash inflows became less concentrated among the

Figure 2. Total Return of Average Actively Managed Mutual Fund versus S&P 500, 1990–2000a Return (%) 40

30

20

10

0

90

91

92

93

94

Average Fund

95

96

97

98

99

00

S&P 500

a Data through third quarter 2000. Source: Based on data from Strategic Insight Simfund and Salomon Smith Barney.

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2001, AIMR®

Investment Management: Trends and Challenges investment management firms in the industry. In 1999, 81 percent of the net inflows were concentrated with the top 20 managers in terms of assets under management. In 2000, as of the third quarter, the top 20 managers had captured only 62 percent of the net inflows. Even more interesting is the share of the top five gainers in net asset inflows. In 1999, the top five received 40 percent of net flows, but as of third quarter 2000, their share was only 28 percent. The net inflows to equity mutual funds, after a big decline in 1998 and a flat 1999, are in line to surpass the 1997 level. As of third quarter 2000, equity mutual funds had net inflows of slightly more than $250 billion. For those who believe investment management is a growth industry (although it did not see organic growth over the past 2–3 years), the fact that outperformance has broadened and that active managers are again able to beat unmanaged portfolios is a promising sign. Consider the organic growth rate of the mutual fund industry. Table 1 shows new capital inflows to equity and hybrid funds as a percentage of the assets under management at the beginning of the period. Evidence points to the maturity of the mutual fund industry, at least in the United States. Even though 1990 was a dreadful year in the U.S. stock market, the organic growth rate was still 5 percent. And in every subsequent year through 1997, the organic growth rate was in the double digits. This persistent pattern of new inflows is good evidence that investment management is a growth industry, but less robustly so than a decade ago. In 1998 and 1999, organic growth slowed to the single digits. In 2000, the U.S. mutual fund industry’s organic growth rate appeared to have bounced off the bottom, reaching 6.3 percent, but it is difficult to say how much higher the U.S. industry can go. For a number of reasons, the industry is much more mature than it was in the early to mid-1990s, and double-digit growth rates for the mutual fund industry in the future are likely to be difficult to achieve. Of course, given historical market performance, the industry’s revenues and earnings will probably continue to experience a growth rate in the low to middle teens, but an organic growth rate of 10–20 percent will rarely occur in the future. The share of mutual fund industry inflows into passively managed funds has returned to a normal level. In the period after 1993 (when active managers were having so much trouble outperforming), the share of inflows going to passive funds increased steadily, skyrocketing in 1998 and peaking in 1999 at nearly 35 percent. In 2000, because of the better performance by a greater number of active managers, the inflows to passive funds tailed off. Through third quarter 2000, net inflows to passive funds had returned to about a 12 percent share of net mutual ©2001, AIMR®

Table 1. Mutual Fund Industry Annual Organic Growth Rate Year 1990

Net New Capital Flows 5.1%

1991

17.0

1992

22.1

1993

29.0

1994

15.5

1995

12.6

1996

15.7

1997

12.3

1998

6.2

1999

5.2

2000

6.3

Source: Based on data from the Investment Company Institute and Salomon Smith Barney.

fund inflows, which is only a little more than the passive funds’ share of total mutual fund assets—a more normal relationship. But the data indicate that the passive funds’ share of assets will continue to gain relative to the share of active funds, even in 2000. In the future, exchange-traded funds (ETFs) will be an interesting phenomenon. In my view, however, they are not going to be the explosive trend that some are predicting, because few investors think intraday trading of mutual funds is important. Increased Deal Activity. The significant increase in deal activity supported the stock prices of the investment management companies. European financial institutions, with good distribution power in their local markets but weakness in product and marketing skills for investment management, led the charge by making many of the acquisitions. The high prices being paid by them and other acquirers show that the managements of most financial services companies continue to view the investment management business as being extremely lucrative and investment management companies as having many of the growth and profitability characteristics that banks and other financial services firms want to incorporate. The average price paid for private market companies is revealing. In 2000, acquirers paid an average EBITDA (earnings before interest, taxes, depreciation, and amortization) and P/E of 13.3 and 26.6, respectively. Relative to the public companies that we track, these private company valuations are considerably higher—about 30 percent higher on both scores.

Market Perceptions Based on the improving picture for net inflows and performance, the market might appear to think that

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Investment Firms: Trends and Challenges the future of this industry is incredibly bright. The valuations, however, were much better in the past than they have been recently. Consider the recent stock performance of investment management companies in November 2000, as shown in Figure 3. A few outliers—BlackRock, Federated Investors, and Neuberger Berman—were up more than 150 percent, but even the relative pikers— such as T. Rowe Price Group or Franklin Resources (the parent company of Franklin Templeton Investments)—were up 20, 30, or 40 percent from their 52week lows (which generally came at the very end of 1999). They all have trounced the broader market, as represented by the S&P 500. (Note that although Figure 3 represents an attempt to capture all passive management strategies in the data, ETFs are still a small enough phenomenon that they would not have much impact on the numbers.) In general, investment management firms have recovered from extremely low levels of valuation relative to the S&P 500. The average P/E relative to the S&P 500 for the past 10 years has been about 84 percent, as shown in Figure 4. During the recent trough in fourth quarter 1999, investment management companies had an average relative P/E of roughly 60 percent of the S&P 500. Since then, the average P/E has staged a huge recovery, rising to almost 80 percent. Obviously, there is still room for improvement. In fact, for the record, between late 1992 and early 1993 and the first and second quarters of 1998, the investment management stocks almost uniformly traded at a premium or close to the market multiple.

Clearly, the stock market is saying that something about the business now is different from the early and mid-1990s. In my view, the problem is as follows: The quality of earnings, the predictability of earnings, and the predictability of growth rates for the industry as a whole are not what they used to be. And while the U.S. market for investment management services has matured, few of the U.S. investment management firms have adopted ways to take advantage of the tremendous growth potential in global investment management services. This global growth will likely occur outside the United States in places where the comfort with equity investing is not yet high and the culture of investing in anticipation of retirement is not widely developed but should become more accepted with the passage of time. The quality and predictability of investment firm earnings have been greatly affected by investors who have become more short-term oriented, more performance oriented, and quicker to switch out of products that are not performing up to their requirements. For example, a steady increase has occurred in the share of equity fund net inflows into the funds that have four- and five-star ratings from Morningstar. This upward trend accelerated wildly in 1999 and has accelerated a little more in 2000. Of course, in 1999 and 2000, because more than 100 percent of fund flows were going into the four- and five-star funds, one-, two-, and three-star funds experienced net redemptions. The effect of these conditions has been a collapse in the average holding period of mutual funds. In 1990 and 1995, the average holding period was 5.7 years. By 2000, however, the average holding period

Figure 3. Stock Price Performance of Investment Management Companies since 52-Week Low, as of November 29, 2000 Return (%) 200 180 160 140 120 100 80 60 40 20 0 AC

AVZ

BLK

FII

BEN

GBL

NEU

SV

TROW S&P 500

Note: AC = Alliance Capital Management Holding; AVZ = AMVESCAP; BLK = BlackRock; FII = Federated Investors; BEN = Franklin Resources; GBL = Gabelli Asset Management; NEU = Neuberger Berman; SV = Stilwell Financial; and TROW = T. Rowe Price Group. Source: Based on data from Reuters and Salomon Smith Barney.

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2001, AIMR®

Investment Management: Trends and Challenges Figure 4. Historical Relative P/E of U.S. Investment Management Companies, as of November 30, 2000 (trailing 12-month operating earnings per share) P/E (%) 120

100 S&P 500 Average = 84% 80

60

40

20

0 90

91

92

93

94

95

96

97

98

99

00

Source: Based on data from company reports, Datastream, and Salomon Smith Barney.

had declined to 3.9 years. Clearly, such a huge decline has an impact on the economics of the industry: Investment management firms have to scramble that much harder and spend much more marketing money to offset natural redemptions. This trend speaks somewhat ill of the future organic growth rate for the investment management industry. As an analyst, I follow the bulk of the publicly held mutual fund management firms traded in the United States, and AMVESCAP is the only firm that has a significant portion (23 percent as of November 2000) of assets from non-U.S.-based investors. AMVESCAP was able to achieve this feat over the past three to five years through the acquisition of various investment management firms and the pursuit of an international growth strategy. Alliance Capital Management Holding at 13 percent and Franklin Resources at 14 percent have also done a relatively good job of acquiring non-U.S.-managed assets. BlackRock follows at 6 percent, with both Federated Investors and T. Rowe Price at 2 percent. The market’s pricing of these fund management companies’ stocks does not recognize that this industry is now positioned to take advantage of international growth, probably because few of the firms in this industry are really ready to do so. Some of the other financial services companies that I follow—such as Goldman, Sachs & Company, Morgan Stanley Dean Witter & Company, and Merrill Lynch & Company— have rapidly moved to attract non-U.S.-based inves©2001, AIMR®

tors, and they currently get about 40 percent of their revenues and earnings from outside the United States, especially from Europe. These companies now dominate the competition in some highly lucrative undertakings, such as equity underwriting and mergers and acquisitions advisory work in Europe.

Future Trends For investment management firms, the principal future trends will involve switching behavior, distributors of financial resources, the growing market for advice, the importance of brands, high-net-worth clients, and international growth. Switching Behavior. At Salomon Smith Barney, we believe that the performance sensitivity of investors that has caused frequent switching among mutual funds will continue. Because of the rise of Internet trading and the actions of intermediaries, such as Charles Schwab & Company and others, investors today have an enormous amount of data at their fingertips and can easily and quickly compare the performance of various mutual funds. Consequently, investors hold a tremendous amount of power to switch their assets between fund managers, and they have been exercising it. Distributors of Financial Resources. The greatest financial power and profit will continue to rest in the hands of the distributors of financial

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Investment Firms: Trends and Challenges resources and information. These companies have the strongest client relationships because of products and services, such as Charles Schwab’s One Source, that investors and consumers have found easy to use. The mutual fund industry has in many ways lost the initiative in terms of distribution and customer relationships. Historically, a similar loss of initiative has also occurred on the institutional side with the rise in the importance of the consultants, who intervene between the client and the institutional money manager. Distributors, especially in the retail area, are going to demand more and more from the fund companies whose products they deliver, whether in terms of payment for shelf space or brand-building efforts. Growing Market for Advice. At Salomon Smith Barney, we are convinced that the market for advice is growing, not shrinking. Based on the continued aging of the baby boomers, and with many more boomers still to enter the key retirement accumulation age of 45–65 years old, the amount of money that they must acquire and manage and the shortening time horizon in which they have to accomplish these tasks will intensify their need for advice. Our opinion is in stark contrast to those who believe that because of the empowerment of the Internet and the amount of information that the Internet provides, advisory services will become increasingly less important. Most people have neither the time to filter all the information that the Internet brings them nor the knowledge base necessary to analyze it. These investors need a helping hand. So, in our view, the existence of the Internet does not mean that financial and investment advice is going to be less important or less sought after. Brands. We also think that brands will be increasingly important. During the past few years, performance differentials in the industry were so enormous that brands became somewhat less important while sheer performance record became more significant. As good performance continues to spread among the universe of mutual funds, the power of brands will reassert itself. Some players—such as Janus, which essentially built its brand on spectacular performance over the past few years—actually have earned a lasting and positive legacy from their recent experiences because their brands continue to evoke a reputation for outstanding performance in the minds of investors. High-Net-Worth Clients. An increasing number of the investors served by the industry will be high-net-worth investors, as variously defined by the Spectrem Group and others. They will have about half a million dollars or more in investable assets and/or a few hundred thousand dollars or more in

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annual income. As the typical client’s net worth rises, on average, special client needs that were not prominent in the past will become more significant, as will the ability to satisfy these needs—such as the ability to provide separate-account products and other taxsensitive products, the ability to provide alternative products (e.g., hedge fund investments and private equity), and the ability to provide trust services. Traditional intermediaries can more easily provide such services, which is another reason why we think they will gain power in the future. International Grow th. Finally, at Salomon Smith Barney, we expect the international growth of the investment management business to accelerate for two principal reasons. First, growth will accelerate because equity investment culture in continental Europe and Japan is much less developed than in the United States and United Kingdom. Second, over the next 20–30 years, these countries will have a desperate need to begin funding the retirement of their own baby boomer generations. The population imbalance between working people and retired people in these countries will actually be much worse in Europe and Japan than in the United States, but they do not have nearly as much money put aside in funded accounts as people do in the United States. The U.S. investment management companies still face a challenge in trying to penetrate these markets, but the opportunity will be there.

Factors for Success In the future, the three critical factors for the success of investment management firms will be brand strength, financial strength, and an innovative management culture. If brands matter, as they apparently do, then having a strong brand will be a key to success. Only a few investment managers can be lucky enough to have winning fund products in every management style so that the investment management company can maintain strong growth through different market cycles. Because the majority of investment managers are usually not so lucky, however, the financial strength to withstand periods of weak growth or of net withdrawals and faltering revenues and earnings will be crucial to survival. Creating and preserving such financial strength will be the key to longevity. Finally, having a management culture that encourages innovation in both product development and distribution will still be a major determinant of success. An example of innovative distribution is the recently announced joint venture between Scudder Kemper Investments1 and Thomas Weisel Partners. Scudder and Weisel are both trying to generate a new 2001, AIMR®

Investment Management: Trends and Challenges kind of distribution for alternative products—and to some extent, more traditional products—among high-net-worth investors who are attracted to “new economy”-type investments. So, the joint venture is going to focus on private equity and other alternative products, such as hedge funds. On the product side, we also expect a growing number of separateaccount products. For example, more than one innovative company has started to market a separateaccount product for non-multimillionaire accounts. The investment management business does not particularly need to be consolidated, but some of the anticipated industry trends and strategies will drive more merger activity. Diversifying management styles organically is difficult. Few examples exist of a successful growth strategy firm that succeeded in organically incubating an equally successful value strategy. A lengthy period is required to build a performance record for the new investment management strategy of style diversification, and at the end of that period, the record for the strategy may not even be good enough to tout. So, the urgency to diversify styles is going to drive more mergers, such as the merger between Alliance and Sanford C. Bernstein & Company, which brought together a successful large-cap growth product and a successful longterm value product. Channel, or distribution, diversification can also be accelerated through mergers. This aim was another driver of the Alliance–Bernstein merger. During the past 10 years, Bernstein had built a successful high-net-worth distribution channel, which had achieved a national presence, with well over 100 productive salespeople. Alliance found this channel powerfully attractive because it had been looking for an entrance to the high-net-worth sector but had been stymied before this merger. Because U.S. investment management firms perceive international markets as hard to penetrate, large mergers between European financial institutions and U.S. asset managers will continue for at least the next year or two. As I previously mentioned, non-U.S. financial institutions are looking to build the expertise they will need over the next 10–15 years in order to address investors’ needs in their local markets. U.S. asset managers are confronting the maturity of their markets and are thus more receptive to seeking a partner. In many cases, the prices being paid are steep and reflect a level of hope that is perhaps excessive. This type of activity may be curtailed after a year or two when the results of some of 1 In January 2001, Scudder Kemper Investments was renamed Zurich Scudder Investments.

©2001, AIMR®

these mergers simply fail to justify the prices paid. For the time being, however, mergers will be the name of the game.

Conclusion Performance will make firms successful. Performance, however, cannot be planned, and unfortunately, luck will always be part of the equation. Methods exist for cushioning bad luck and exploiting good luck. The managers who pursued large-cap growth strategies in the past few years experienced the greatest concentration of outstanding performance and higher asset inflows, but we believe that asset managers will have a growing desire to diversify their asset classes and styles. Of course, for a manager, increasing the diversity of investment strategies is fine and probably the right tack to take, but doing so will not improve the overall drawing power of the manager if only one or two of the strategies is successful. Often, switching or adding different strategies does not truly help and can be quite costly. On the other hand, when performance records are established, they can be compelling. Consultants have a tendency to direct assets toward small- to midsize asset managers that have successful and consistent track records over time, so the asset distribution among firms of different sizes evens itself out. At Salomon Smith Barney, we expect more mergers among firms that are disparate in terms of client base and product offering and thus are complementary as a business mix. Such firms want to create certain component sets of management styles and distribution channels because they do not want to keep riding the cycle of investors switching from one popular style to the next—with firms’ asset flows turning wildly upward and then suddenly reaching a plateau or even declining. A variety of tactics, however, will be necessary in order to achieve steady performance. Although we continue to believe that investment management is a growth business, it is becoming clearer that U.S. investment management firms can no longer count on the industrywide, double-digit, organic growth of the early and mid-1990s. Thus, firms will have to respond innovatively to changes that include investors’ switching behavior, the growing power of distributors, the rise of the advice market, brand importance, the significance of the high-net-worth sector, and international opportunities. We expect the firms best able to cope with these challenges will likely be those with strong brands (whether built or bought), financial strength, and an innovative management culture.

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Investment Firms: Trends and Challenges

Question and Answer Session Guy Moszkowski, CFA Question: What strategies should U.S. firms follow to increase their non-U.S. presence? Moszkowski: In terms of strategies, the field is fairly open. This topic gets brought up all the time when discussing distribution in Europe because most European countries have no equivalent of the Glass–Steagall Act and no fragmentation of the banking system. Europe has strong financial institutions that control both institutional and retail financial relationships, so shaking off the power of these distributors will not be easy. Furthermore, joint ventures with these institutions have often been disappointing. Some of the big U.S. firms (primarily brokerage firms) are going to make and have been making small acquisitions, principally in Spain, Italy, and the United Kingdom. In countries such as France and Germany, few small, investment-oriented acquisition targets are available. The Internet still presents interesting opportunities in Europe because, although such a venture could be expensive and building awareness could take time, once European investors understand the need to invest (which is starting to happen) and the economic terms being offered by the products of the institutions they have traditionally dealt with, they may see that the big European banks and insurance companies are not particularly appealing. These companies don’t have the performance records or capabilities that European investors need. Thus, European investors could be willing to move away from their traditional distributors, and this change may mean that Internet distribution will become more impor-

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tant for investment management in Europe than it has been elsewhere. It also may mean—and this outcome is probably the most likely— that open architecture will become as big a deal among European institutions as it has become in the United States. Ultimately, in my view, penetrating the distribution infrastructure in Europe will be a little easier because many European firms will soon realize that even if they’ve made investments in building their own proprietary products, they’re going to have to offer some choices to investors. Question: Which U.S. mutual fund companies have the greatest penetration in Europe? Moszkowski: Alliance has a relatively large proportion of its assets placed abroad. As one of the pioneers, it has been relatively successful in Europe. Putnam Investments—not directly a public company, although it is public through Marsh & McLennan Companies—has given us a little information. Putnam has done well in certain joint ventures. Franklin Resources, through its Templeton Group, has a reasonably sizable offshore funds business. Merrill Lynch, especially after its acquisition of Mercury Asset Management, has a strong and growing presence in Europe. Question: Will small investment management firms survive, and will mid-size firms lose out to small local firms and large international firms? Moszkowski: For a number of years, a lot of controversy has erupted over whether this industry needs to consolidate or not.

According to the typical argument in favor of consolidation, at some minimum scale, room will always exist for the small, focused firms, but the mid-size firms will be squeezed out. I have never found the intellectual justification for all the consolidation arguments, and during the past 10 years, little consolidation has actually occurred. The share of defined-benefit pension money in the hands of the top 10 or so managers has increased a little. A small amount of concentration has taken place in the pension fund business, which is to be expected because this business is not experiencing rapid organic growth. Question: What will be the effect of alternative investments that are market neutral, specifically hedge funds, and will there be an increase in institutional investors using market-neutral strategies? Moszkowski: In the aggregate, alternative investments will most likely continue to grow, especially in the high-net-worth (defined as half a million to a million dollars and up) markets. Some firms, such as Weisel and Scudder, will try to bring the alternative investment products to the less than super rich, so it is important for the industry to understand the trend toward new products. As I noted earlier, separate-account products will matter more because of greater customization and tax management potential. If investment management firms do not participate in directing alternative investments to individuals, some of their market share will be lost in an investment management industry that is now a mature business. ©2001, AIMR®

Investment Management: Trends and Challenges On the institutional side, after a year such as 2000, in which some of the market-neutral strategies appear to have again proven their worth, more institutional money will most likely go toward marketneutral strategies. Question: What trends do you see developing in the ultra-highnet-worth markets, and what do you think of a strategy to have a firm with accountants, lawyers, and portfolio managers all under one roof? Moszkowski: The ultra-highnet-worth segment is interesting, although few participants understand it well enough and have strong enough skills in that area to make a national business. I’m not an expert on structure—such as bringing together accountants, lawyers, and portfolio managers—but I’m skeptical of the prospects for such a structure. For all the talk of one-stop shopping, wealthy people prefer to have advisors coming from different organizations because they perceive that unrelated advisors have some objectivity. Question: If power is going to the distributors, why are they paying such high prices for investment-product-only firms?

©2001, AIMR®

Moszkowski: Even though the power is shifting marginally to distributors that are able to claim a bigger and bigger share of the combined economics of the manufacturing plus distribution chain, manufacturing is still an economically superior model to distribution. You no longer need to lose money or make a small profit margin on the distribution of an investment management product because the pricing power of the distribution channel has improved. The asset manager still enjoys a much better return on equity, a much better profit margin, and much better stability of revenues and earnings than the distributor. So, investment management is still a better business model, which is why the distributors want to acquire such firms. Question: Will investment management fees rise or fall? Moszkowski: The only logical expectation is that the fee trend will be down, but it depends on what sector you’re talking about and how much of a commodity a given product is. Although the trend has tended to be down ever so slightly, asset managers have been predicting fee pressure for the past 10–15 years, but serious pressure has never really materialized. Unless markets slow in the future, fee pressure will continue to be

present but modest. A collapse in fee levels is unlikely, especially for such noncommoditized products as active equities or some of the separate-account products that will be more difficult to compare, such as some alternative products. As long as people can hope for excess returns from a product, they won’t be price conscious. Question: What are your thoughts on the trend of mutual funds getting into the separateaccount business to a greater extent, and how far is the trend likely to go? Moszkowski: I understand that working out the technological challenges of profitably managing separate accounts at a size of half a million dollars has become easier than it was a few years ago. As a result, given the tax advantages, this approach can be cost effective. Sanford C. Bernstein has operated a separate-account business for accounts of $400,000 or more for many years, so we know that this approach can be managed economically with the right technology. With the tax effectiveness and the higher degree of cachet that a separate account has relative to a mutual fund, this trend will continue to gather momentum and investment management firms will pursue it.

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Technology and the Investment Management Firm: The Global Industry Robert L. Reynolds Vice Chairman and Chief Operating Officer Fidelity Investments Boston

Modern information and communications technology has played and will continue to play a key role in the globalization of the asset management industry. Technology also has profound implications for client service, product distribution, and the collection and use of marketing information. Firms that fail to exploit new technology will have trouble remaining competitive.

nvestment firms in the United States and around the world have a new imperative: to be on the leading edge of the development and application of new technologies. At Fidelity Investments, we firmly believe that when clients choose to do business with us, they are seeking a relationship. Clients want someone that can serve them not only today but also in the future. How a firm uses technology can determine whether investors perceive that it has the capability to remain on the cutting edge of the investment industry and grow with its clients. Technology affects three key areas: globalization, client service and product distribution, and the collection of marketing information. This presentation describes how technologically driven changes in these areas are affecting investment management firms.

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Globalization Technology has played a central role in the globalization of the industry and is enabling the development of a single global capital market. For example, in the 1990s, the evolution of computing power and telecommunications permitted the increase in cross-border investing. Without the technological advances that have been experienced worldwide, investors could not have acquired their current depth of understanding about risk and risk-adjusted rewards. New technology allows investors to pursue complex stratEditor’s note: The joint Question and Answer session of Robert L. Reynolds and Patricia C. Dunn follows Ms. Dunn’s presentation.

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egies in multiple markets and currencies—strategies that would have been impossible to carry out in the past. Currently, there are more than 160 stock markets throughout the world, which is roughly double the number existing in the mid-1980s. And in 1999, for the first time ever, the world’s total stock market capitalization surpassed 100 percent of total world economic output. Global stock market capitalization reached $31.7 trillion on the MSCI World Index compared with the expected $30 trillion in global GDP estimated by the International Monetary Fund. Global industries—such as energy, health care, information technology, consumer goods, materials, and automobiles—are also emerging. Depending only on local markets as the major source of relevant information about the leading companies in these industries is outdated and limiting. Technology enables investors everywhere to learn about these companies and act on that information in a timely fashion. Moreover, a global securities trading and investment custody infrastructure is forming. Countries have developed central securities depositaries, clearing systems, and other systems needed to facilitate trading and record keeping. And cross-border alliances and cooperative arrangements between stock exchanges are proliferating. As technology spreads around the globe and provides access to information, some serious legal and regulatory barriers arise that need to be overcome. For example, the European Union should do more to remove the national regulatory barriers that stymie the growth of a true pan-European market in 2001, AIMR®

Technology and the Investment Management Firm: The Global Industry financial services. Currently, these barriers raise costs and form a de facto tax on mutual fund and pension service providers—all at a high cost to European economies and individual investors.

Client Service and Product Distribution Modern computer and telecommunication technologies allow firms to improve customer service and product distribution. For example, because of the Internet, Fidelity is much more closely in touch with its clients. In the past three years, the use of the Internet to access information and tools has grown at an astounding rate. For example, in November 2000, 85 percent of our 15 million clients conducted transactions via the Internet. In the past, a typical Fidelity client would call three times a year. Clients still call us three times a year, but they now also access Fidelity over the Internet an average of 15 times a year. A prime benefit of this shift in client contact being more heavily toward the Internet is that these Internet visits cost less than phone contact and are equally, if not more, efficient. New tools are also helping clients become more sophisticated investors. An individual investor with a desktop computer today has better access to information than an investment professional did 10 years ago. The investor is empowered. For example, our Web site has a fund evaluator that analyzes more than 4,000 funds, and a visitor to our site can evaluate those funds according to various criteria—performance, fees, style, or particular holdings. The investor can even get specific information on individual stocks. In addition to their increasing sophistication, online investors are demanding unbiased analytical tools from providers of investment services. If an investment firm does not display total neutrality in the analytic products it promotes, clients will not believe anything the firm says and will go to another investment firm.

©2001, AIMR®

The Internet provides valuable tools and new means of interaction for both firms and clients, but it will not become the sole point of contact. Many clients still like the personal touch—whether visiting a physical location or calling with specific questions.

Marketing Information Technology has empowered not only the investor but also the financial service provider. Firms are acquiring a lot of marketing information on investors— their investing behaviors, preferences, and motivations. Fidelity is in the process of rolling out aggregation services in which individuals can have all their financial holdings at one place. Aggregation means greater convenience for investors, and it puts extensive client information in the hands of the service provider. This increasing ability to store marketing information places a major responsibility on firms and the industry itself. If e-commerce is to flourish, the industry must guarantee that client privacy is completely secure. Analyzing client information allows firms to present clients with products they need and tools they want. Thus, keeping investors’ trust is imperative if firms are to stay privy to client data.

Conclusion Technology has now become a critical and integral part of the investment management industry. The Internet in particular is transforming the way firms interact with clients. Major financial services firms no longer have the option of developing this technology because they have no choice; they simply must have it in order to compete. As advances in technology continue to improve investors’ access to information, firms can use technology to strengthen client relationships (for example, using marketing data to improve and innovate services). Above all, firms must establish—and maintain—their clients’ trust.

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Technology and the Investment Management Firm

Question and Answer Session Robert L. Reynolds Patricia C. Dunn Question: What are the longterm trends in technology investments in your companies? Reynolds: Fidelity Investments puts about 20 percent of its revenue back into the firm through technology. Each area, such as the manufacturing side and multiple distribution side, has its own budget. In the money management group, we are spending to make sure the information gets into the right people’s hands in the least amount of time—arbitraging information is important. Fidelity is investing in trading systems as well to better implement investment decisions. We are also spending to lower trading costs and ensure best execution. This year, our budget on the Internet is in excess of a quarter of a billion dollars. Although being privately held helps us, in a severe downturn, even we will have to distinguish between what is nice to have versus what is essential for the business. Dunn: Barclays Global Investors (BGI) has always been a believer in applying technology to the investment process and has invested in technology for a long time. We are using technology to reduce the costs of doing business by improving our internal processes. At BGI, we are using the Internet to improve our business processes and reduce the cost-to-income ratio of the business. Question: In terms of the alternative asset areas, how big will the hedge fund and private equity areas grow in your institutions? ©2001, AIMR®

Dunn: The search for alpha is behind this major trend toward greater investment in private equity and alternative assets. Alpha has become scarce in public markets. The saturation point for private equity and alternative assets will be reached when equilibrium exists between the ability of these asset classes to deliver alpha relative to the public markets. The basic problem is that there is a scarce supply of good private equity opportunities. Private equity and alternative asset class investment management skills are also scarce. Alternative assets will be a great business opportunity for a long time to come, but I wonder whether buyers’ expectations for returns and liquidity can be met. Reynolds: Fidelity Investments looks at it more from a distribution versus a manufacturing standpoint. The danger is that what worked yesterday may not work tomorrow. Question: How do you guarantee privacy even in slowdowns when the fees from selling customer information could be more useful or valuable? Reynolds: The U.S. government is working on privacy issues. Many people view privacy as a technology-determined achievement, but it’s really more of a process that varies with the type of business. Being able to guarantee privacy will be a tremendous marketing tool and the new way of doing business. More and more companies will likely follow IBM’s example of creating a chief privacy officer. Again, firms have a market-

ing opportunity if they can guarantee privacy and protect their valuable information on clients. Question: Has technology actually lowered the barriers small firms face? Dunn: Technology will make it possible for small firms to find distribution (which has traditionally been difficult for them) only if they have the product, which means the alpha. So, I still don’t think that the economic business model for small institutional asset managers has been transformed. It merely means that these small firms have a greater possibility of finding their way into a distribution channel—if they have the performance. Question: How can investment management have no “value for money”? Dunn: My point is that investors have not focused on getting value for money from investment management in the same way they do for other purchase decisions. Fees for public market investment products are not well correlated with returns and have remained at the same levels regardless of whether active investment managers have delivered alpha. Question: What evidence is there that quantitative investment management has outperformed handmade investment management? Dunn: The track records of quantitative investment managers are as varied as those of conventional asset managers, but the best have produced higher information

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Investment Firms: Trends and Challenges ratios—returns adjusted for risks—on a longer-term basis than conventional investment managers. This evidence is better available to investors than to investment managers, and a systematic, rigorous study performed independently is overdue from the industry. Question: Do you really think that online decision-making tools

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do not fundamentally change the way sponsors and institutional managers interact and how managers are hired? Dunn: I think online decisionmaking tools have made it easier to examine the track records of more managers and to conduct more efficient investment manager searches. But the decisions on which hiring is based haven’t fun-

damentally changed as a result of these tools. Client interaction has been greatly facilitated by technology, but success and failure in the institutional investment industry will not be fundamentally transformed by this: Everyone will use the Internet to communicate, but performance and relationship management will still drive longterm success.

©2001, AIMR®

Technology and the Investment Management Firm: Institutional Asset Management Patricia C. Dunn Global Chief Executive Barclays Global Investors San Francisco

Although technology has enhanced the ability of investment managers to collect and manage information, it has not changed the way information is used. Institutional asset management in particular is resistant to the effects of technology because the core value drivers—investment performance and client relationships—are not replaceable by technology. In the future, however, institutional asset managers will have to adapt to technology-driven changes in quantitative methods, distribution, and service and support models.

nstitutional asset management is the financial service that arguably has been least transformed by technology. This viewpoint may be unconventional, but in my opinion, it is supportable. Fundamental characteristics of the value propositions of institutional asset managers have protected the industry from being replaced by technology per se. It is not that technology has not had a significant impact on institutional asset management but that the impact has been greater inside institutional asset management organizations than in the general industry: The industry’s economic model still relies largely on direct relationships. In this presentation, I first explain why the fundamental economic business model of institutional asset management has changed so little as the result of technology, including the Internet. Next, I address the core value drivers in institutional asset management that have so far prevented technology from having far-reaching effects on the industry’s business model. Finally, I explain my prediction that the effects of technology on the industry’s competitive fundamentals will be more pronounced in the future than in the present.

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Editor’s note: The joint Question and Answer session of Robert L. Reynolds and Patricia C. Dunn follows this presentation.

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Technology’s Limited Impact Although technology has not yet exerted an overwhelming force on the business of institutional asset management, some areas have undeniably been changed. The research process in institutional asset management has been assisted by technology, but the fundamental research process—whether conventional securities research, market research, or strategy research—is largely unchanged from long-time practice. Technology has provided many more tools to gather and manage information, but how that information is used has changed little. Similarly, many aspects of the portfolio management process, which is at the core of institutional asset management, have been facilitated by technology but are essentially unaltered. Productivity may be higher now than before the onslaught of technological innovation because the automation allowed by technology enables managers to handle more accounts. Still, today’s portfolio managers follow much the same practices that they have in the past. In the trading domain, the securities markets and the capital markets have been transformed by technology, but in the typical institutional asset management organization, traders are performing much the same day-to-day tasks as they have for years, particularly at the front end of the process before the order 2001, AIMR®

Technology and the Investment Management Firm: Institutional Asset Management is passed to the broker. Post-trade processes have been substantially automated by technology, but this area is still the domain of individuals making decisions and negotiating trades. Technology has had only a superficial effect on sales and client service. Even with new technology, the same daily activities continue. Classical marketing is still a relatively rare capability in institutional investment management firms and does not garner significant resources, and marketing is indeed synonymous with sales in most institutional investment management firms. As a result, in such firms, marketing is also fundamentally unchanged by technological innovation. Institutional asset management may be fundamentally less amenable to transformation by technology than other elements of financial services. As Philip Evans and Thomas Wurster argue in Blown to Bits: How the New Economics of Information Transforms Strategy, every business must understand how its fundamental value propositions can be disaggregated into “bits” (e.g., replaced by actions that can be carried out by a computer).1 The core value propositions of institutional asset management—investment performance and relationship management —are relatively “unbittable” commodities. As the Internet has expanded its influence, managers have been considering how their businesses will be affected, and a default presumption has been that asset management would, along with other parts of financial services, be transformed by this new technology. At Barclays Global Investors, we have looked closely at how the Internet could affect our value propositions and how our business differed from B2C (business-to-customer)-based businesses, which are the businesses most affected by e-commerce. We considered whether the business-to-business (B2B) model would apply, given that institutional asset management seems to fit this model. We saw, however, that the “classic” B2B environment creates value by disintermediating middlemen, reducing search costs for products or services that are highly standardized, and/or creating buying power among otherwise unallied purchasers. Given that neither investment performance nor institutional client relationships, as core value propositions, are easily displaced by the Internet per se, we concluded that the Internet’s effect on institutional asset management will differ from its effect on the classic B2B model. 1

Philip Evans and Thomas S. Wurster, Blown to Bits: How the New Economics of Information Transforms Strategy (Boston: Harvard Business School Press, 2000).

©2001, AIMR®

Core Value Drivers The core value drivers of investment performance and client satisfaction in institutional management make the industry more resistant to technology’s impact. In institutional investment management, it is axiomatic that investment performance drives growth in assets under management in the short term and client retention in the long term. The fact that investment performance and relationship management are not replaceable by technology per se helps explain the relatively low impact of the Internet on institutional asset management. Other important value drivers in institutional asset management— such as reputation, innovation, stability of talent, and clarity of investment style and process—are also relatively intangible. These aspects of value creation are simply not highly “bittable.” Nonetheless, technology has a significant role to play in supporting excellence in investment performance and relationship management, and so far, technology has been underused in this capacity.

Future Effects In the future, institutional asset management will not remain as relatively untouched by technology as it has until now. For example, quantitative-based investment strategies, which are not the same as using computers to assist conventional investment decision making, will become much more common practice. On the business side, the industry will also be affected by the opportunity to distribute products to new segments through the Internet, and client service and support will also be significantly enhanced by technology. In the industry today, a wide gulf exists between the perception and the reality of portfolio management and the research that supports it. Portfolio management, in terms of investment decision making, is still a labor-intensive process. But systematic, rigorous, and repeatable approaches to portfolio management—approaches made possible by technology—have advantages that will drive the practice of portfolio management and the industry of institutional investment management toward more widespread quantitative approaches. These approaches will affect not only portfolio management but will also permeate the front end on the research side and the back end on the trading side. Fully integrated asset management approaches, beginning with research and ending with trading, will become more common. These fundamental changes will be driven by the growing demand by clients for “value for money” in investment management. The price–performance equation has, to this point, been a relatively

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Investment Firms: Trends and Challenges unimportant aspect of client “buying behavior,” but the demand is growing along with increasing sophistication and the expectation of lower future equity market returns. The institutional asset management industry will also be changed by the distribution of products outside institutional channels. This transformation will clarify the roles of product, channel, and distributor and will allow participants in the value chain to focus on their specific core competencies and value drivers. These core competencies vary remarkably from firm to firm, and maintaining a clear focus on the distinctions between the different value drivers in the different parts of the value chain is important. In the future, the service and support propositions of institutional asset management will be signif-

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icantly enhanced by technology. Our clients, by and large, operate with a general lack of information about what we do for them. For the most part, this lack of information benefits the suppliers of asset management services. But that benefit comes at the cost of understanding and has multiple negative effects: a lack of transparency, decreased client access to information, and limited client ability to make informed decisions about returns achieved for risks taken. Thus, the move toward open-architecture business models, in which investment products are distributed by many providers regardless of ownership affiliation, and the demand for transparency are two fundamental drivers of change in the institutional asset management industry.

2001, AIMR®

Technology and the Investment Management Firm

Question and Answer Session Robert L. Reynolds Patricia C. Dunn Question: What are the longterm trends in technology investments in your companies? Reynolds: Fidelity Investments puts about 20 percent of its revenue back into the firm through technology. Each area, such as the manufacturing side and multiple distribution side, has its own budget. In the money management group, we are spending to make sure the information gets into the right people’s hands in the least amount of time—arbitraging information is important. Fidelity is investing in trading systems as well to better implement investment decisions. We are also spending to lower trading costs and ensure best execution. This year, our budget on the Internet is in excess of a quarter of a billion dollars. Although being privately held helps us, in a severe downturn, even we will have to distinguish between what is nice to have versus what is essential for the business. Dunn: Barclays Global Investors (BGI) has always been a believer in applying technology to the investment process and has invested in technology for a long time. We are using technology to reduce the costs of doing business by improving our internal processes. At BGI, we are using the Internet to improve our business processes and reduce the cost-to-income ratio of the business. Question: In terms of the alternative asset areas, how big will the hedge fund and private equity areas grow in your institutions? ©2001, AIMR®

Dunn: The search for alpha is behind this major trend toward greater investment in private equity and alternative assets. Alpha has become scarce in public markets. The saturation point for private equity and alternative assets will be reached when equilibrium exists between the ability of these asset classes to deliver alpha relative to the public markets. The basic problem is that there is a scarce supply of good private equity opportunities. Private equity and alternative asset class investment management skills are also scarce. Alternative assets will be a great business opportunity for a long time to come, but I wonder whether buyers’ expectations for returns and liquidity can be met. Reynolds: Fidelity Investments looks at it more from a distribution versus a manufacturing standpoint. The danger is that what worked yesterday may not work tomorrow. Question: How do you guarantee privacy even in slowdowns when the fees from selling customer information could be more useful or valuable? Reynolds: The U.S. government is working on privacy issues. Many people view privacy as a technology-determined achievement, but it’s really more of a process that varies with the type of business. Being able to guarantee privacy will be a tremendous marketing tool and the new way of doing business. More and more companies will likely follow IBM’s example of creating a chief privacy officer. Again, firms have a market-

ing opportunity if they can guarantee privacy and protect their valuable information on clients. Question: Has technology actually lowered the barriers small firms face? Dunn: Technology will make it possible for small firms to find distribution (which has traditionally been difficult for them) only if they have the product, which means the alpha. So, I still don’t think that the economic business model for small institutional asset managers has been transformed. It merely means that these small firms have a greater possibility of finding their way into a distribution channel—if they have the performance. Question: How can investment management have no “value for money”? Dunn: My point is that investors have not focused on getting value for money from investment management in the same way they do for other purchase decisions. Fees for public market investment products are not well correlated with returns and have remained at the same levels regardless of whether active investment managers have delivered alpha. Question: What evidence is there that quantitative investment management has outperformed handmade investment management? Dunn: The track records of quantitative investment managers are as varied as those of conventional asset managers, but the best have produced higher information

www.aimr.org • 27

Investment Firms: Trends and Challenges ratios—returns adjusted for risks—on a longer-term basis than conventional investment managers. This evidence is better available to investors than to investment managers, and a systematic, rigorous study performed independently is overdue from the industry. Question: Do you really think that online decision-making tools

28 • www.aimr.org

do not fundamentally change the way sponsors and institutional managers interact and how managers are hired? Dunn: I think online decisionmaking tools have made it easier to examine the track records of more managers and to conduct more efficient investment manager searches. But the decisions on which hiring is based haven’t fun-

damentally changed as a result of these tools. Client interaction has been greatly facilitated by technology, but success and failure in the institutional investment industry will not be fundamentally transformed by this: Everyone will use the Internet to communicate, but performance and relationship management will still drive longterm success.

©2001, AIMR®

Ownership of the Investment Firm John H. Watts Chairman, Fischer Francis Trees & Watts, New York City Joachim Faber Member of the Board of Management, Allianz AG, Munich, Germany Hilda Ochoa-Brillembourg, CFA President and CEO, Strategic Investment Group, Arlington, Virginia William J. Nutt Chairman and CEO, Affiliated Managers Group, Inc., Boston

Ownership structure is, of course, a critical issue for investment firms. From questions of governance to scale to succession, the issues are broad and multifaceted. Four authors address ownership and management models from different perspectives: organizing effective combinations of firms, managing a global investment organization, determining the ramifications of a firm’s life cycle, and running an organization designed to solve succession problems for “Affiliate” firms.

Organizing Effective Combinations by John H. Watts cquisitions, alliances, and capital partnerships between banks or insurance companies and investment firms have increased in recent years. For 2000, the amount of acquired assets under management was estimated at more than $1.5 trillion worldwide; and for the past five years, the average annual amount of assets acquired exceeded $1 trillion. During this period, the annual average number of deals was about 200—two-thirds in the form of acquisitions and the balance in alliances and other types of combinations. Some of these combinations have experienced the anticipated investment and financial success; many have not. This inconsistency has led to an increased focus on the question of whether and how alternative arrangements of ownership affect success. This presentation outlines some issues relating to this question.

A

©2001, AIMR®

Recent History of Combinations As late as the early l960s, most institutional money in the United States was managed by banks and insurance companies. In the mid-1970s, spurred by ERISA (Employee Retirement Income Security Act of 1974) legislation, firms that specialized in investment alone were formed and grew rapidly in size and in their share of the market. Rightly or not, these independents were perceived to offer better returns, more specialized skills, and more responsive service. This perception led to rapid growth of the independent investment management industry—and also to attractive profits. As recently as 2000, margins, as measured by EBIDTA (earnings before interest, taxes, depreciation, and amortization), averaged more than 30 percent for a wide sample of firms. As firms grew, so did their need for capital to expand their markets and to cycle ownership participation to younger generations. At the same time, U.S. banks and insurance companies managed to shake off many of the constraints imposed by regulatory agencies and consolidated into much larger entities. Attracted by the presumed

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Investment Firms: Trends and Challenges talent and the attractive profit margins of the independents, banks and insurance companies accelerated acquisitions, partnerships, and alliances with investment firms. Other forms of combinations also arose—for example, groups of allied independent firms that shared some centralized services, such as marketing, mutual fund branding, and administration. These developments spawned a debate as to whether it is better to fully own and integrate an investment satellite or to leave a large degree of autonomy, or even clear control, in an independent affiliate. In the past decade, as the early bank and firm coventures have matured, successes and failures have occurred, in roughly equal numbers, in organizations that consolidated and in firms that kept ownership and control separate.

Effects of Ownership Arrangements Merger and acquisition activity in investment management has led investment banks and consulting firms to develop specialized analyst teams. As they and others reviewed the record, they found no simple answer to how and where ownership of an investment affiliate should locate. The bad or the good lies in the details of how ownership is arranged. Alternative ownership arrangements offer potential advantages. Some of these advantages can be made apparent by examining the objectives of the banks and the investment firms in the combinations formed to date. Ownership changes also have implications for key personnel and clients. Banks seek investment firms to grow their service-based revenues, to acquire investment talent that is otherwise difficult to attract, to fill gaps in investment offerings, or to build key capabilities for targeted client categories. Today, the targeted categories often include high-net-worth households and domestic and global corporations’ pension and treasury investments. In essence, banks seek investment units in order to fill strategic goals. Investment firms that form alliances with larger institutions often seek more permanent capital to fuel expansion, to invest in technology, to develop products, or to finance retirement of senior shareholders. They seek an ownership structure that facilitates attracting, motivating, and retaining key personnel. Firms also seek to cultivate innovation, careful risk taking, and entrepreneurial drive among investment staff. These characteristics have collectively been called the “proprietor’s eye” and appear to be associated with a significant level of ownership, or at least a genuine feeling of control.

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Recent research has shown that in successful investment firms, as in other successful service organizations, top producers rank a variety of factors as most important to their job satisfaction. Some of these relate to ownership. Key people want • to work with “eagles” (that is, first-rate people whom they admire); • to take pride in their organization’s reputation; • a sense of “ownership,” a stake in directing the organization, and an opportunity to build capital; • sufficient job scope to build something (a product, a team, or a performance record); • a supportive and stable environment (because good risk-takers often are personally conservative); • and good compensation (that is, fair compensation as compared with others in the organization and competitive within their marketplace). Although many of these factors are not related to ownership, the ownership environment and circumstances can dramatically affect the ability of an investment organization to provide such an environment. The other, often reluctant, participant in the consolidation arena is the client. Clients want solid, consistent investment results, and they want to work with people they know and in whom they have confidence. Institutional clients in particular are faced with an increasingly complex set of policy choices and thus need more from their investment advisors than simply good results. As the global investment environment evolves, clients are requiring more from investment professionals in all aspects of a wide range of services. For example, clients are placing greater emphasis on performance attribution and on risk measurement. Clients also value stability among the personnel with whom they interact. Ownership circumstances within an investment unit can influence the unit’s ability to provide a professional staff that can satisfy these client needs.

Conclusion In order to increase the chance of success with the affiliation of a bank and an independent firm, two core attributes of ownership can be separated. The first attribute is strategic control. Institutional partners typically require control over the overall strategies, broad business plan, basic capabilities, other affiliations, capital structure, and top leadership of an investment operation that provides a key part of their strategy. This control can be accomplished in several ways without interfering with the second aspect, which is operating independence. 2001, AIMR®

Ownership of the Investment Firm Most investment teams flourish best when the power to hire, fire, and compensate their staff is retained within the unit. Likewise, the ability under the broadest strategic umbrella to design product and price services and to choose suppliers of services (such as systems support) other than those from their institutional partner all contribute to staff motivation and the acuity of the proprietor’s eye. Again, once this objective is shared by both sides of an alliance, implementation can take many forms. But the sepa-

ration and the certainty of local operational control needs to be clear and permanent. Many other important and complicated parent– affiliate issues—such as cross-marketing, branding, and whether to allow competing products within a group—are beyond the range of this discussion. But once the principles for separating strategic and operational control are agreed on and implemented, the firms involved have a much greater chance of finding a successful solution.

Ownership of the Investment Firm: A Management Model

There are organizational segmentations according to client groups, portfolio management styles, product types, and regional considerations. Therefore, in our model, each company works as a profit center and has its own individual compensation program. In the future, our individual compensation schemes will also include incentive plans based on overall group performance to promote an aligned group interest. The Allianz Group, of course, has the functional elements of a global operation—such as institutional sales, account servicing, operating infrastructure, and retail distribution. Each of these elements spans the various business divisions.

by Joachim Faber he Allianz Group demonstrates the opportunities that a global organization offers. Allianz has a market capitalization of roughly €100 billion. It is doing business in more than 75 countries, has about 60 million clients, and has assets under management of €750 billion. So, Allianz’s global presence creates opportunities. Still, taking advantage of these opportunities in the context of asset management is difficult. Like all global organizations, Allianz is interested in the benefits of worldwide distribution. We are keen to expand the business to create economies of scale as well. But we also face the challenge of capturing the entrepreneurial spirit demonstrated by local and smaller partnerships. Professionals at smaller firms have direct financial incentives and must maintain dedicated client contacts. As this presentation depicts, our business model seeks to create a hybrid organization that draws on the global strengths of a large group and the entrepreneurial dynamism of local firms.

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Global Structure Our structure is based on the core competencies of the different financial services subsidiaries within the Allianz Group. Allianz began more than 100 years ago as an insurance company but has expanded into a broad financial services group. In expanding around the world, Allianz has always adhered to the philosophy that local management typically knows more about its business than the head office. So, our group organization is decentralized, and this structure is well suited to the asset management world.

©2001, AIMR®

Global Fixed Income. In the global fixedincome division, PIMCO (Pacific Investment Management Company) has the overall management responsibility and continues to run its U.S. business as it did before the acquisition. We have established a joint European venture between PIMCO and Allianz Asset Management, and we plan to expand this model to Asia in 2001. PIMCO has been a member of our group for nearly a year, and PIMCO’s corporate culture has not been negatively affected as a result of the acquisition. None of the managing directors or major players at PIMCO has departed. Clients have remained loyal, and since the deal was announced, PIMCO has produced consistently strong performance. Our partnership is off to a good start. Global Equity. We are managing money under three dedicated styles in our global equity division: the core style, growth style, and value style. The core style is the style Allianz Asset Management has been using for the past 10 years; therefore, Allianz Asset Management is running this particular style. Also involved in the core style is Cadence Capital Management, a Boston-based asset management firm that was part of PIMCO Advisors L.P., particularly in the U.S. institutional business. Our recent acquisition of Nicholas-Applegate Capital Management in San Diego adds the growth style to our repertoire.

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Investment Firms: Trends and Challenges Oppenheimer Capital in New York and NFJ Investment Group in Dallas run the value style. Global Retail. The Allianz Group sees great opportunities in the retail business, both in Europe and the United States. The retail investment firms within the Allianz Group are Allianz Asset Management in Germany, AGF Asset Management in France, RAS Asset Management in Italy, and PIMCO Equity Advisors in the United States. To enhance our European retail presence, we are also selling our products and services through wholesale and direct salesforces specialized in financial products. This effort is complemented by our already extensive European network of 47,000 agents. We intend to capture what is, in our view, an unprecedented opportunity in the European retail investment business as Europe embarks on a fullfledged retirement funding spree. In the United States, the investment industry has grown significantly in the past 10 years, driven mainly by developments in pension law and the development of 401(k) plans in the early 1990s. Because Europe is now entering exactly the same phase, we believe it is important to have such partners as PIMCO and Nicholas-Applegate. Both have superior investment management technology know-how and a strong desire to take their skills abroad.

Guiding Principles Our foremost guiding principle is to achieve value creation for the client, the asset manager, and the group. We put great store in developing and maintaining our most valuable asset, our human capital. Because the Allianz Group includes companies in disparate businesses, we place an emphasis on designing the right compensation structures for each type of company. Despite a high degree of decentralization, we have a strict model for the investment process. Each individual asset class and each individual portfolio management style follows a consistent global investment process regardless of where, or by whom, it is managed. Our principle is to maintain an integrated investment process that is adhered to by all of our asset managers and firms. Another major principle that governs our decision making, and in which we have invested heavily and will continue to do so, is the development of a state-of-the-art operating infrastructure. Such an infrastructure is central to the global distribution system we are building because it will allow us to leverage online distribution channels with offline

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distribution channels for both the institutional and retail businesses.

Management Model When a global investment management organization is formed through partnerships with local investment management firms, the conglomerate benefits from the strengths of its individual components. The large, multinational organization has strong global distribution and sales networks, broad brand awareness, financial strength, business risk diversification, and economies of scale in marketing, research, and operating platforms. On the other hand, the local firm is associated with entrepreneurial spirit, innovation, autonomy, direct financial incentives, a focused product range, familiarity with the local environment, and close customer contact. Preserving the strengths of both types of organizations is a challenge but quite achievable. The Allianz management model attempts to build on the strengths of its component organizations and expands these traits through a global framework to benefit the whole. The Allianz model leverages the groupwide growth opportunities while retaining the individual companies’ identities. Our model has two levels: the group level and the company level. At the asset management group level, three principles are at work. First, the investment process must be cohesive throughout the different regions where we operate. Second, the information technology infrastructure should be managed at the group level. Third, global asset management should be directed by a management committee that consists of representatives from each of the major member companies. At the company level, three principles are at work as well. First, compensation should be driven by local company results combined with the performance of Allianz Group stock. A second basic principle is maintaining and building the strong local brand awareness of each of our member investment firms— PIMCO, Nicholas-Applegate, and Oppenheimer Capital. Each brand is highly valuable, and attempting to re-brand them globally would not be desirable. Third, we want to maintain the outstanding reputation in account servicing and sales that these acquired companies have demonstrated historically. These principles all together should, if well implemented within the organization, help to achieve our two main objectives: superior alpha generation in our portfolio management and superior client services leading to high client satisfaction.

2001, AIMR®

Ownership of the Investment Firm

Life Cycle and Ownership by Hilda Ochoa-Brillembourg, CFA he past 15 years have brought a wave of mega capitalism, thanks to technological innovation and an incredible global bull market. As a corollary to the tremendous growth in global capitalism, the question that faces investment management firms is whether size is critical to success. The answer to this question will determine the optimal ownership structure for investment management firms. A review of the life cycle of a firm is a good way to frame the answer to this question.

T

The Life Cycle The first 10 years of an investment management firm’s life are a time of high growth in assets and profitability, with the greatest asset growth rate (as high as 80 percent annualized) experienced in the first 5 years. Profitability will grow, on average, by an even higher rate. In this period, the firm generates the highest added value both to owners and clients and clients go in search of the firm, not the other way around. In the United States, such a firm manages $1 billion to $5 billion in equities and $5 billion to $10 billion in fixed income. Obviously, in smaller, local markets, these numbers may not be as large. In the next phase of a firm’s development, the bloom may be off the rose. In a 10-year period, a firm has a 90 percent probability of being humbled by the markets, possibly more than once. During this time, the client is likely to have suffered a loss of some kind—either in faith or money. And as the firm’s glory fades with time and the firm is perceived as being “just like all the rest,” competitive pressures are able to make new inroads, shrinking the firm’s profit margins if not top line revenue. When the investment managers no longer appear to walk on water, the clients will be less inclined to help keep them afloat, and fee revenue will suffer. At this point, firms must begin searching for broader markets and new products, and they have to start actively selling their products. Although manufacturers are generally not the greatest marketers, the investment management firms have to start thinking of creating a brand name. Distribution channels also become crucial to the continued success of the organization. Once a firm matures and reaches the age of 10 or more years, with assets under management of around $15 billion, strategic mergers are often the answer to prolonged life expectancy. As an alternative, the investment management firm could choose to aggressively develop multiproduct lines concurrently with

©2001, AIMR®

a global distribution system; this task is not easy to do but is possible. Particularly for smaller, entrepreneurial firms, reaching this stage of the organization’s life cycle mandates succession planning to increase the future life expectancy of the organization.

Richness versus Reach Investors search for alpha in choosing an investment management firm, but investment firm alpha fluctuates over the life cycle of a firm. Philip Evans explains this dichotomy when he talks about richness versus reach.1 Therefore, richness and reach are just another way of looking at the life cycle of a firm and what changes occur as the firm ages. Richness is the stage when firms provide such an incredible product that their clients eagerly search for it. Having found the firm, the client takes great pride in having found the product or service rather than having had it sold to them. “Rich” firms are delivering a consistent alpha for the management style that caused the founders to be enthusiastic, energetic, and optimistic enough to start the business in the first place. Client service is provided by the principal of the firm, and agency problems are minimal. “Reach” is the state when the firm has been humbled by the market and has become a victim of that vicious law of entropy in which firms either grow or perish. At this point, they have to develop multiple product lines and branding and must reach for new product markets, rather than relying on the luxury of being found. At this time, firms begin searching for serial “apparent” alphas, choosing or diversifying into a broader range of management styles. The firms become momentum players. They begin to diversify and develop different product lines so that they will look good in one product line or another if not all of them. The firms have to adopt second- and third-tier institutional and individual market penetration strategies to replace shrinking margins. In the reach stage, the firm’s focus becomes more “institutional”, so the service the firm provides must be “templated.” Investment services are “packaged” for mass consumption. At this point, firms also begin to have some agency conflicts. In some cases, agency conflicts are abundant because the firm is no longer doing what it really does best because it has been forced to reinvent itself in various ways. The firm does what it can to grow and prosper and sells the products it can market to maintain its growth. 1 Philip Evans and Thomas S. Wurster, Blown to Bits: How the New Economics of Information Transforms Strategy (Boston: Harvard Business School Press, 2000).

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Investment Firms: Trends and Challenges The investment alpha that originally created the richness of the firm in its earliest stages is replaced by other forms of alpha now that the firm has moved into the reach stage. Alpha now means services for a broader mix of clients and branding that makes clients feel comfortable, but not necessarily because of the performance results, which are no longer unambiguously good. Firms have to develop other sorts of comfort for their clients, so the educational function of the investment firm becomes increasingly important—for both the employees and the client.

Examining Core Competencies Firms must evaluate their core competencies at all times. As older firms reinvent themselves to stay profitable, the firm’s management should periodically review these changes and examine how they have affected the firm’s core competencies. We use this approach at Strategic Investment Group. With each review, we make a judgment about where our firm is in the life cycle of an investment firm. We also redefine the firm within the context of what we are currently doing and what we want to do in the near future. It is often at the school of hard knocks that a firm’s core competencies are developed and honed. Firms must play the hand that fate deals them, as much as they may try to change a little bit at the margin. For example, we have chosen to be a niche player. We have become a sophisticated, one-stopshopping investment management firm and a bestof-breed outsourcer for institutional investors and high-net-worth family groups. We can cover both plain vanilla strategies, multiple managers, and the alternative investment field, which includes real estate, private equity, hedge funds, and many other asset classes. The other path to our firm’s growth has been the highly successful manager incubation program. So far, we have incubated four alpha-driven firms that have become leaders in their field. We prefer to build rather than buy because we know how to build. This approach is one of our core competencies and has minimized agency problems.

The AMG Approach by William J. Nutt t Affiliated Managers Group (AMG), we approach the continuity, succession, and change-of-ownership issues facing the asset management industry in a way that is different from other firms. We are the institutional equity partner of a

A

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Who Will Own the Business? In answering this question, the life cycle of a firm is determinative. In the early stages of a firm’s life, when the firm can be defined in terms of richness, the entrepreneurs and strategic partners will be the owners of the investment management business. As the investment firm matures and reach replaces richness, the banks and the insurance companies will be the owners of the business. These large financial institutions are able to template financial services. They are able to provide customers with a sense of comfort, and they have deep pockets. At some point, despite failed attempts in the past to take ownership in the investment management business, retail service providers will make successful inroads in owning a significant part of this business. Many investors have a feeling of foreboding about their financial situation looming beyond the horizon. These people would rather deal with entities that have deep pockets than with entities that have shallow pockets. In a sense, mutual funds are currently the most dangerous place to be in the investment management business. They are potential nuclear waste sites; that is, they are loaded with potential future litigation in a scenario of poor market performance. In a crisis scenario, there could be a run on mutual funds. The run could come from different investor types. Taxable investors, who face tax liabilities as well as market losses, could sue because they have not been informed appropriately of what kind of “waste” they are buying in terms of unpaid taxes; 2001 could be a test year. The retail investors in the United States, where people are used to suing and getting their money back for faulty or unwanted merchandise, could (rightly or wrongly) start class action suits based on incomplete and misleading information from the mutual funds. A run on mutual funds could ensue under such a scenario, so if I were a buyer of investment management firms today, I would not target mutual fund firms.

number of growing, midsize asset management firms, which we call our “Affiliates.” Our primary role as a majority investor is to help these firms deal with the issues of succession—that is, replacing the skill set of the founder/owners of each firm with one or more individuals who can ensure continuity of ownership and creating the right ownership structure for the particular business.

2001, AIMR®

Ownership of the Investment Firm

Methods and Structure In our view, for the types of firms we deal with, direct equity participation, rather than a 100 percent acquisition, is the best way—for economic and governance reasons—to motivate and achieve good investment performance, product development, client service, and growth. When we invest in a firm, we do not seek to create a firm with every possible capability; instead, AMG prefers to design a solution for each particular firm in terms of the rotation or recycling of equity. We have been fortunate in building a diverse group of Affiliates because diversity among Affiliates provides a balanced cash flow stream. As a business, we grow both internally through the growth of existing Affiliates and externally by making majority investments in new ones. Since we went public in November 1997, the 15 firms in which we have invested have been diverse in terms of distribution channels, equity style, and geographical location. The distribution channels served by these firms are about 50 percent institutional funds, 23 percent mutual funds (mostly noload direct sale), and 27 percent high-net-worth accounts. The institutional channel is almost equally divided between large, consultant-driven plan sponsors and foundations/endowments. When creating AMG in 1993–1994, we looked at the alternatives available to asset management firms when the founders reached an age that succession and continuity became concerns. Such firms need to develop strong, talented individuals so that the firm can continue to grow. In the early 1990s, there were two choices: Do nothing except set up some sort of internal equity transfer, or sell 100 percent of the business. Both choices had problems. An internal equity transfer was becoming more and more difficult to accomplish as the value of independent investment management firms rose and negative tax consequences ensued. Selling the entire stake in the company resulted in the principals giving up not only autonomy but also participation in the future growth of the firm. AMG has chosen a middle approach to deal with succession and continuity issues in mature investment management firms. We seek not only to lead ongoing, direct equity participation in the firm but also to spread the equity among the senior and junior members of the firm. This equity participation must include the ability to participate in the governance and future growth of the firm and to create a degree of liquidity. In other words, the participants need the ability to sell their equity interest back to the firm and thus rotate it to the next generation. This structure has worked well, although it is not necessarily the ©2001, AIMR®

right approach for every firm. In particular, this structure may not be suitable for larger firms that wish to go public or firms that wish to sell to a much larger organization. Firms in the universe we are concerned with, however, will generally find this structure appropriate because it preserves an ongoing economic incentive for the management team. The structure also clearly aligns the interests of the client with the management team and the founder/ owners, which can include an institutional equity partner. Our basic approach is straightforward, as shown in Figure 1. First, a new Affiliate is created out of the S-Corp, C-Corp, LLC (limited liability company), or limited partnership that is seeking a new shareholder, member, or partner. The new entity’s form is either an LLC or a partnership because such an arrangement works best for tax purposes. This approach also makes it possible to separate ownership in a financial sense from governance. All of the day-to-day operating decisions are allocated specifically to the management team. A revenue sharing agreement is entered into in which each dollar of revenue coming into the firm is divided into two parts—the operating allocation and the owners’ allocation. The operating allocation is the amount (50 percent) that is necessary to pay the ongoing expenses of the firm plus a cushion. The largest of these expenses is salaries and staff bonuses, but occupancy, research, and distribution are also provided for in the operating allocation. Any excess operating allocation is retained by management owners. The second allocation of revenues is divided between AMG and the individual owners of the firm. If the management team has, say, 20 members, perhaps 10 will own equity today, but the plan is for all of them to own equity in the future. AMG buys the $6 million of cash flow shown in Figure 1 for an up front cash payment to the individuals who sold their interest, and the retained equity (the $4 million) can be sold back to AMG beginning on the fifth anniversary of the sale. The ability to sell a retained equity interest back to the firm reflects the expected growth in the firm both in terms of revenues and in terms of operating allocation. It is the understanding that managers in the firm can do what they wish in the future regarding the sale of their equity in the firm. When the firm acquires an equity interest, it is rotated to the next generation. This keeps the financial incentive and motivation, the vitality of the firm, alive for the professionals working at the firm. After the acquisition, AMG actively participates in helping firms rotate the equity. Of our 15 firms, 11 have had a reallocation of equity after the initial transaction for a further revitalization of the ownership structure.

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Investment Firms: Trends and Challenges Figure 1. Example Investment Structure: AMG

Salary, Bonuses, and Other Operating Expenses Operating Allocation

50% Affiliate

$10

Revenue Sharing Agreement1 50%

$10

s' ner Ow ation c llo 40% A $4

Affiliate Management Equity Holders

Owners' Allocation 60%

$6 Ow All ners' oca tion

AMG

Note: Example assumes an operating allocation of 50 percent, an owners’ allocation of 50 percent, and ownership of 60 percent by AMG and 40 percent by Affiliate management. 1

Revenues = $20 million.

Affiliate Development

Conclusion

After our investment, AMG works with these firms to help them with strategic support, marketing, distribution, and operational efficiency. When we choose to invest, however, our primary purpose is to solve the issues of succession of the firm’s founders by providing ownership continuity for the next generation of management. All other assistance is icing on the cake. We do not invest in firms that need an infusion of capital or are looking for help. We invest in firms that have demonstrated success but that want to find succession/continuity solutions and benefit from an affiliation with a larger organization that offers the range of strategic and operating support AMG can provide. AMG does not try to transport our corporate culture or, more importantly, the culture of any one Affiliate to those of the others, except insofar as it relates to best practices. We invest in firms that have an established, strong culture, and we want to avoid changing that culture at all costs.

The good news from our perspective is that our target universe is growing. An increasing number of firms will need to address succession/continuity issues in the future. Not only is the number of midsize firms growing, but the age of the founders/owners is reaching a critical point. They realize that they need to recognize significant value for the equity they have developed, but they also need to put in place a mechanism that solves this problem not only for today but forever—while avoiding a 100 percent sale. In the next 5–10 years, a significant number of firms (we believe the number is currently about 1,300 in the United States) will be facing the succession issue head on. Outside the United States, many firms will also be confronted with this issue as their founders/owners reach an age at which succession/continuity issues become important. Owners realize that if they can solve these issues without selling 100 percent of their interest, they can retain operating autonomy with participation in future growth. Our Affiliates’ ownership structure provides one solution that has so far proven viable. Our Affiliates are AMG’s best references.

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2001, AIMR®

Ownership of the Investment Firm

Question and Answer Session John H. Watts Joachim Faber Hilda Ochoa-Brillembourg, CFA William J. Nutt Question: What percentage of new investment management firms succeed, and do you think this is a good time to build a firm? Ochoa-Brillembourg: In the past 15 years, probably a good number of them have succeeded, but I have no idea how many will succeed in the next 15 years. Now is an excellent time to build firms— not because markets are going to deliver fantastic returns but because we are in a market environment similar to what existed in the mid-1970s. Then, the market was dominated by large money center banks that couldn’t deliver richness. Again today, there are large money center management firms that can’t deliver richness. In my opinion, the majority of them cannot even deliver service. In such an environment, many clients look for someone who can deliver the goods. If the market rotates away from the large-cap growth stocks to mid-cap and small-cap stocks, active managers will be able to deliver alpha—and those who are small, beautiful, and talented and who provide good client service will inherit the earth for the next 5 to 10 years. Question: How important is having real equity participation in the firm versus some type of quasiequity, phantom equity, or other equity participation? Nutt: We believe that real equity participation is necessary. Real equity does not necessarily mean common stock. Real equity participation must have a number of fun©2001, AIMR®

damental characteristics—such as participation in governance, the ability to be liquefied, and the ability to get capital gains treatment at some point in the future. Whenever you’re talking about structuring ownership and dealing with compensation issues, a trade-off always exists between current cash compensation and another form of compensation that is retained for a long period and will hopefully have a capital value in the future. Faber: In our case, particularly because we typically own 100 percent of the company, our subsidiaries are not publicly listed anymore and thus real equity is not available. Using William Nutt’s criteria, however, firms can develop, and have developed, a quasi-equity interest, and we believe doing so is important. Quasi-equity participation is a major element in the various companies we own. Watts: In our firm’s experience, actual equity that is set up correctly has advantages. It helps to create the commitment and focus that can come with being an owner and manager of the business. And if equity includes meaningful participation in determining a firm’s environment and incentives, it can have strong motivational value. We have found, however, that incentive compensation works well in combination with equity, options on equity, and bonuses based on an ex ante share of profits. There also seems to be room, or even a need, for some old-fashioned, discretionary bonuses as recognition for unusually strong

contributions. What is more important than equity, however, is that the key people feel part of a team and that the team has the full latitude and responsibility to hire, fire, and compensate staff; to design and price products; and to set the internal environment. Ochoa-Brillembourg: In addition to money, quality of life has to be important, although money is a large component of quality of life. People don’t like to have other people deciding how much money they will make, and this natural resistance is where equity comes into play. People want to have a certain control of their work program, their inventiveness, their creativity, and the money that goes with these qualities. They do not want an authority figure to dictate their future. The form of ownership is less relevant than the fact that people want to have a sense of ownership in their environment. Question: How much of the value of the larger controlling organization is related to crossselling products, and how is the marketing of the different products coordinated? Faber: At Allianz Group, the institutional sales organization crosses the various investment styles in equity but also has a coordination function with the fixedincome salesforce. This arrangement is intended to take advantage of opportunities that arise when customers rebalance their portfolios away from growth to value or away from value to fixed income.

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Investment Firms: Trends and Challenges Nutt: From our standpoint, we don’t try to have marketing overlap among our 15 Affiliates. The management partners of each Affiliate retain a direct equity interest in their firm and the responsibility for their firm’s growth. This responsibility is recognized through their direct ownership, the value of which grows as the firm grows. We will, however, provide an environment in which different Affiliates may collaborate, for example, to provide a balanced product. They may market the product, if they do not have mutual funds, through our mutual fund distribution platform. The Managers Funds is an Affiliate that also serves as a platform for other Affiliates to launch mutual funds, which they can operate in a subadvisory capacity. The Managers Funds handles all of the administration and, most importantly, the product distribution. In my view, top-down direction of cross-marketing efforts does not work well. If people are given the right incentives, they’ll find ways to work together. Question: Is there any crossmarketing involved with BNP Paribas and Fischer Francis Trees & Watts? Watts: We spend a lot of time throughout the firm trying to maximize cross-contributions of our specialized marketing team as well as our bank partner’s wide network of relationship officers. The task is complicated, and progress requires close communication and collaboration. Simply sending the bank’s calling officers out to the field with descriptions of our products doesn’t work. For example, to close a mandate for a specialized global bond portfolio that includes credit exposures, it is necessary to have the specialist portfolio manager involved early on. In those cases, however, the bank can play

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an essential role of identifying its client institutions that may have interest in such a product. In the case of mutual funds, good communication and materials can enable specialized and generalist salesforces to make significant progress in cross-selling successes. The investment firm and the bank in a partnership have to make clear to all hands what the transfer prices or sales fees are for each category of a grid of products, client types, geographical location, and forms of delivery, such as via funds or mandates. This task is not easy. We have found great opportunities for cross-partnership business development but have also found that success requires ongoing, careful management.

Watts: This issue is where the “rubber meets the road” in terms of the details of ownership and control of a firm. Our experience suggests that compensation not only needs to suit a particular market but also should fit appropriately with all the other major aspects of employee motivation, not only with equity. If an independent investment unit perceives that its environment, which includes but by no means is limited to compensation, is determined externally, then much productive incentive is lost. Compensation has to be about more than only salaries, bonuses, and stock.

Question: Do you attempt to coordinate compensation among firms, and if so, how?

Ochoa-Brillembourg: We are opportunistic. We recently closed on a deal in the value area. We are funding international equity firms that specialize in the mid-cap area, and we will fund global fixedincome firms. Eventually, with the acquiescence of the California Public Employees’ Retirement System (CalPERS), we will be funding hedge products. Some interesting real estate opportunities are available as well. We are not funding high-tech firms, at least not yet, and we are not funding large-cap growth firms. Global high yield is also very attractive.

Faber: Compensation should be driven by the local market environment and value creation. So, compensation may differ among firms and regions, particularly between Europe and the United States. Nutt: In our organization, each firm determines its own approach to compensation. The only role we may have is in helping Affiliates understand market comparables and best practices. In addition, we hold three Affiliate forums each year—one for CEOs and chief information officers, one for finance operations and technology, and one for the marketing distribution functions of the Affiliates. We get them all together to share best practices, and we bring in the best speakers that we can find for a given topic. Also, we hold roundtable meetings among Affiliates. People are surprisingly willing to share their successes and failures. We leave the decision entirely with the firms, but they can learn from others about best practices.

Question: What areas are attractive for acquiring or starting firms?

Faber: In a group like ours, one needs to be careful not to build the entire business through acquisitions. We have good quality in the various asset classes and management capabilities and would have difficulty trying to fit in another company and another style without causing disruption, because the biggest threat to the employees in former independent partnerships that have become part of a larger group is lack of autonomy. We are presently not looking at external acquisitions. Asia, ©2001, AIMR®

Ownership of the Investment Firm however, is an unsolved issue for us, and we are not sure whether we can build on our own there. Most of the other segments of the market that we find attractive are alternative investments. Watts: Several products in our field—global bonds, euro bonds, and currency—have been especially active recently. For the past two years, we have seen renewed interest in a more comprehensive approach to currency hedging. In response, we have worked out an approach with our bank partner in which our firm offers the hedging approaches, which we previously had done only when we also managed the assets. The bank has acquired a firm that has experience principally in currency overlay, and we have formed a joint venture with this firm. We are accepting mandates both jointly and separately. Alternative investments also have shown renewed growth. Although we have had institu-

©2001, AIMR®

tional clients in this area for 25 years, recently we have seen completely new categories of prospects and clients. For example, European pension funds and private corporations have recently exhibited sharply increased interest in alternative assets. Many of our competitors are offering new alternative investment products. Emerging market debt and high-yield bond portfolios, both of which suffered in the past few years, seem to be making a slow comeback. Nutt: We would like to add to our high-net-worth component. We like no-load direct sale funds. We like wrap and separate account management, broker-sold separate accounts, private partnerships, and alternative-fee activities. In terms of asset classes, almost everything we’ve done to date has been traditional stock and bond asset management. We have not ventured into real estate, timber, or oil and gas. We also have not

invested in firms outside the United States, but Europe is about to experience a pension market explosion, so growth opportunities will exist there. We also face the decision of whether it’s more appropriate to expand in a particular area by making an investment in a new firm or by encouraging the existing firms in the organization with the capability to expand in the particular area of our interest. For example, we will first encourage those firms who are institutional or high-networth oriented that want to expand into the mutual fund area to do so through the Managers Funds’ platform. Alternatively, we will encourage those firms that have limited capacity in a particular product, such as small-cap growth stocks, to build that capacity in an alternative way, perhaps a private partnership, and help them develop that area. So, in part, we’ll look at where the new opportunities are to build with existing Affiliates.

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Investment DNA: Critical Success Factors for Chief Investment Officers Susan B. Fowler Managing Director Russell Reynolds Associates, Inc. New York City Richard S. Lannamann, CFA1 Managing Director Russell Reynolds Associates, Inc. New York City

Investment DNA consists of five traits shared by outstanding chief investment officers and other senior investment officers. Many firms, however, struggle to find individuals who combine these traits with the necessary investment management expertise. A competency model based on these five traits, combined with behavioral interviewing, can help firms identify promising candidates for these key leadership positions.

n the Investment Management Practice at Russell Reynolds Associates, our clients look to us to help them assess and address their needs. We have discovered that one of our clients’ biggest challenges is finding talent that combines investment management expertise and leadership skills. We know great chief investment officers (CIOs), but what makes them great? To help us answer this crucial question, we recently conducted a study to identify the critical success factors for chief investment officers. We believe the results of this study are particularly interesting for those individuals who are managing investment management firms. As a result of this study, we discovered what we are calling “Investment DNA.” The benefit derived from identifying what constitutes Investment DNA, and using behavioral interviewing to test for it, is the ability to better identify those individuals who are great CIOs and those with demonstrated potential.

I

1 Richard S. Lannamann and George R. Wilbanks, managing direc-

tors of Russell Reynolds Associates, contributed greatly to the original research and Richard S. Lannamann contributed to the writing of this presentation. This material was presented at the conference by Susan B. Fowler.

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Why, How, and Who Russell Reynolds Associates conducted this study because we determined that within the investment management industry a critical need exists for outstanding investment professionals who can successfully lead, motivate, and develop other investment professionals—and who also enjoy doing it. Why Did We Do It? Our interest in competency models and behavioral interviewing heightened our interest in determining what makes these great investment professionals tick. As a result, we wanted to uncover the necessary information to identify the critical success factors that great chief investment officers share. How Did We Do It? Our first step was to conduct an internal brainstorming session—led by Richard Lannamann, George Wilbanks, and myself— with the senior members of our Russell Reynolds Associates Investment Management Practice. Our collaborator was Lynne M.H. Rosansky, a Ph.D. in social and cultural anthropology, who is a competency measurement expert. Rosansky has her own consulting firm and teaches at the university level. 2001, AIMR®

Investment DNA Together, we developed an initial list of traits that we have seen in successful chief investment officers as well as in heads of equity and fixed-income groups. We then wanted to test those traits through behavioral interviewing of CIO role models. To Whom Did We Talk? During the initial brainstorming session, we nominated people who we felt were outstanding CIO role models. The individuals we selected for this study collectively oversee assets under management of more than a trillion dollars. The participants come from organizations, both domestic and international, that run the gamut of investment management services. These individuals manage major mutual fund companies, investment counseling firms, banks, insurance companies, and other institutional investment organizations. Rosansky conducted a behavioral interview with each of our CIO role models and probed into the how’s and why’s of what they do on a daily basis. We analyzed the information collected in these in-depth interviews and tried to identify consistencies among the individuals’ responses.

What We Discovered We discovered the following five categories of professional traits that distinguish outstanding chief investment officers—traits that together represent Investment DNA. An outstanding CIO (1) fosters a culture of intellectual curiosity and analytical rigor, (2) has the ability to interact with respect, (3) develops investment capabilities, (4) captains the investment process, and (5) seizes the moment. Fostering Curiosity and Analytical Rigor. This first category of traits concerns the ability to foster a culture of intellectual curiosity and analytical rigor. CIOs with this ability • create an environment of respect and collaboration, • shape and articulate the values of the group and, most importantly, exemplify these values, and • promote a meritocracy in which good ideas rule and learning is continuously encouraged. These individuals also are approachable, understand the impact of particular members on a team, and know how to distinguish and acknowledge the performance of individual team members. Interacting with Respect. The second category of traits is the ability to interact with respect. CIOs with this set of traits • persuade rather than command, • sharpen the organization’s focus by bringing together seemingly unrelated issues to give the team an end vision, and ©2001, AIMR®

• inspire with compelling thought leadership. These individuals create and maintain an open dialogue with all members of the team. They also encourage expression and listen to others. These people communicate a clear goal and can explain why that goal is important and why/how it can be achieved. They are able to link the interests of the investment team with the organization’s business interests. People with this set of traits show a high degree of business acumen and savvy. Developing Investment Capabilities. The third category is the capacity to develop others’ investment capabilities. It is not enough to lead and motivate; a CIO must also develop the people on his/her investment team. With this third ability, CIOs • stimulate insight, • elevate judgment to an art form, • lead a thought process, and • coach and mentor. But most importantly, these CIOs have an insight into individuals that allows them to help these individuals grow and develop their professional skills. These CIOs welcome intellectual engagement and challenge and are eager to listen to new ideas and perspectives; they think critically and demonstrate a healthy skepticism. They also demonstrate a high level of confidence in their team members and firmly believe that each member has the wherewithal to make a decision and accept the consequences. Captaining the Investment Process. The fourth category is the ability to “captain” the investment process. These people have the ability to • establish a philosophy and a framework for investing, • articulate core investment tenets, • require consistency in the application of investment discipline and establish meaningful performance metrics, and • set and hold high standards while demonstrating an instinctive appreciation for the challenges and difficulties of managing money. They also apply a distinctive logic to the investment process and are able to demonstrate savvy in persuading others—up, down, and sideways in the organization—to embrace the investment logic. Finally, they are able to balance quantitative analysis and qualitative approaches. Seizing the Moment. Finally, the fifth category involves the ability to seize the moment. CIOs with this set of traits • assess probabilities and are pragmatic with respect to risk and reward,

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make timely decisions in the face of ambiguity, and • assume personal accountability and hold others accountable. These individuals are respectful of the market and competition within the industry. They make quick, crisp decisions and have the wisdom to understand that there is a point beyond which time is actually more important than getting additional facts. Moreover, although they are sensitive to risks, they also have sufficient confidence in their own decisionmaking abilities and possess a strong desire to win.

Competency Model With these five categories of traits, we have developed a competency model to help us identify superior leaders: outstanding chief investment officers and heads of equity and fixed-income groups. We can use this competency model to create a measurable, quantifiable method to assess and compare individuals, thereby establishing a reliable litmus test to evaluate an individual’s competence through behavioral interviewing.

Behavioral Interviewing Behavioral interviewing involves asking specific questions of individuals to elicit stories about relevant past performance. It involves getting people to tell their stories so we can discover what makes them tick. It illustrates what people actually did in a particular situation, not what they think they ought to have done. And it probes behind their answers— getting into what they thought, observed, and

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learned. The most important thing, however, is finding out what they actually did. Behavioral interviewing establishes a common vocabulary to compare and assess individuals whose backgrounds may differ.

Conclusion Two important benefits result from applying the criteria of Investment DNA with behavioral interviewing. The first, which is especially critical, is that the Investment DNA model gives an organization’s senior management the ability to look at its people and identify internally the outstanding investment management professionals who demonstrate significant leadership capabilities and/or potential. It is important to note that once a company identifies these individuals, these individuals must then be given the opportunity to reach their potential and show what they can do; otherwise, the company will be wasting a valuable resource. Investment DNA is a developmental tool; it is a tool for identifying and promoting the next CIO or the next department head of fixed income or equities in an organization. The second benefit is that if these people are not found within an organization, senior management will have a roadmap to use in looking outside for this combination of investment management competence and leadership. At Russell Reynolds Associates, applying the criteria of Investment DNA and using behavioral interviewing are tools we use in identifying the critical success factors for chief investment officers and other senior managers of investment professionals.

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Investment DNA

Question and Answer Session Susan B. Fowler Question: How do you determine whether an individual has managerial skills in addition to pure investment skills, and if you can’t find both skill sets, which one is more important? Fowler: On the investment side, there are various performance metrics that enable you to determine who has been able to demonstrate a successful investment record. We don’t have benchmarks and performance metrics for determining particular leadership skills or the ability to motivate or develop other people. Deciding which skill set is more important is a challenge. To some who lead investment management firms, investment skills may be the most important trait for a CIO, especially if the firm has a significant investment problem and must turn around performance. Most of our clients, however, are looking for both traits. Investment expertise is not enough; our clients also want the leadership skills and the motivational and developmental skills. Unfortunately, few people are strong in both categories. Many outstanding investment professionals are not good people managers and prefer to leave that area to someone else.

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Question: What components are necessary for establishing a meritocracy? Fowler: One of our role models said that a good CIO creates an environment where good ideas rule and learning is continuously encouraged. Such managers let people demonstrate what they can do, and they not only reward successful individuals but also try to help develop those who are not meeting the bar. One of this study’s most interesting findings comes from Rosansky asking each of the role models about a situation in which he or she had to fire someone and what led to the decision. It was interesting to see how they handled their respective situations; some situations they were able to turn around, and others they could not. Question: Do many of your clients actually do anything to develop leaders, and is the investment management industry behind other industries in this regard? Fowler: More of our clients are starting to make efforts at developing leaders. One client in particular has recently taken an individual who demonstrates the

five categories of traits and has put this individual into a senior position in anticipation that this person will become the next CIO. This firm is extremely interested in succession planning but may be an aberration in the industry. Unfortunately, it is likely that too few firms are trying to look within and determine who they can develop. Question: Can a good fixedincome manager with the leadership qualities you outlined lead an equities group? Fowler: Interestingly, two of our role models were individuals who started their careers as fixedincome portfolio managers, and because of their leadership qualities and ability to interact effectively with others, they moved into a position of CIO and successfully managed equity professionals as well as fixed-income professionals. The key characteristics that make a good CIO are maintaining open communication, respecting individuals, and showing an appreciation for the knowledge and abilities of individuals. Such asset class crossovers, however, are not always successful.

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Alternative Fee Products Langdon B. Wheeler, CFA President and Chief Investment Officer Numeric Investors Limited Partnership Cambridge, Massachusetts Anne Casscells Chief Investment Officer Stanford Management Company Menlo Park, California Joseph C. McNay Chairman and Chief Investment Officer Essex Investment Management Company, LLC Boston

Although the basic purpose of performance fees is straightforward—aligning the interests of investment managers and clients—implementing performance fees raises complex issues. To address some of these issues, three authors examine various aspects of performance fees. Langdon B. Wheeler, CFA, discusses the rationale for performance fees and defines an effective fee structure. Anne Casscells addresses the challenges of designing a fee structure that enhances value generation. Because performance fee products are often expensive, Joseph C. McNay examines some of the alternatives available to investors.

The Rationale for Performance Fees by Langdon B. Wheeler, CFA anager compensation is one of the biggest sources of fiduciary and agency conflict for investment professionals. Fixed fees, the most common form of compensation for investment managers, encourage managers to build their asset bases so that fee income will grow. Having larger amounts of assets under management, however, almost always interferes with a manager’s ability to add value for his or her clients. Performance fees do a better job of aligning the interests of manager and client because such fees encourage managers to earn higher excess returns for their clients (instead of merely growing

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their assets under management). Given clients’ appreciation of the cost efficiency of indexing to earn the return of the market, I believe that active managers must earn excess returns to justify their higher fees and thus remain in business.

Vicious Circle/Virtuous Circle Investment firms are caught in a vicious circle. By adding value, they attract more assets, and by attracting more assets, they reduce their ability to add value. A great deal of empirical evidence shows that because markets are highly efficient, most active managers do not actually add value. In fact, it is impossible for the average manager to beat the market averages. As Charles Ellis has shown, investing before transaction costs are taken into account is a zero-sum game in which the winners balance out the losers and

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Alternative Fee Products the average manager’s return is the market average. In order to play in the market, however, investors must pay transaction costs and management fees.1 The result is that the average active manager has difficulty delivering the market average return. André Perold argues facetiously that the best manager is the manager with no assets under management because such a manager incurs the lowest transaction costs.2 According to Perold, gross alpha represents the manager’s inherent insights into the investment process and transaction costs represent the price to be paid for enjoying the benefits of those insights. He argues that managers’ informational advantage, which can be substantial, is overwhelmed by increasing transaction costs when managers recklessly expand their business. The result of the growing transaction cost burden is that net alpha decreases as the size of the asset base increases. Wayne Wagner and Mark Edwards have shown that, because transaction costs increase with the size of the trade, the larger a firm is, the less value it adds per trade.3 Indeed, studies of mutual fund returns show that the larger the fund, the lower the rate of excess return. In the vicious circle of fixed fees, those managers who successfully add value attract more assets to increase their fees; but with increased assets, their ability to add value decreases. The fiduciary conflict is particularly acute because existing clients incur a small reduction in their rate of excess return whenever the manager takes on an additional client. The reason is simple: Transaction costs increase for all clients as the business grows. Thus, increasing assets under management creates a fiduciary conflict, because adding new clients harms the interests of existing clients. Fixed fees promote this vicious circle. Clients pay managers fixed fees as a percentage of total assets under management. Thus, fixed fees encourage managers to build their asset management base in order to increase their fee revenues. But as I have described, the impact of larger and larger trades—a result of the growing asset base—on transaction costs is toxic to the manager’s ability to add value. Performance fees, by contrast, draw a virtuous circle. In this virtuous circle, a manager develops a strategy that works, sells the strategy only up to the asset capacity for which it was designed, and then closes the strategy to additional investment. Clients 1

Charles D. Ellis, “The Loser's Game,” Financial Analysts Journal (January/February 1995):95–100. 2 André F. Perold, “The Implementation Shortfall: Paper vs. Reality,” Journal of Portfolio Management (Spring 1988):4–9. 3 Wayne Wagner and Mark Edwards, “Best Execution,” Financial Analysts Journal (January/February 1993):65–71.

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pay only a modest base fee but share a substantial percentage of the excess returns with the manager through a performance fee. For the manager, this creates stronger incentives for performance than for asset growth. The theory of the virtuous circle is that managers will not try to manage more than the optimal amount of assets for a given strategy because they are conscious of the impact of size and transaction costs on their ability to earn performance fees. Asset limits are surprisingly low for high-turnover strategies. For example, at Numeric, we have a limit of only $200 million in our microcap strategy and only $1 billion in our small-cap growth strategy. Through the virtuous circle of performance fees, managers increase their revenues by increasing the excess returns they deliver to their clients, rather than by increasing their assets under management. Managers are acutely aware that adding assets will decrease their ability to add value, so asset growth is automatically limited. By creating stronger incentives for performance than for asset growth, performance fees align the clients’ interests (high excess returns) with the manager’s interests (high fees).

Fee Structure A thoughtful performance fee structure should be designed so that there is little economic incentive for the manager to grow the assets under management beyond the level at which the performance fees max out. Aggregate performance fees are the product of the assets under management and the rate of excess return. Increasing assets reduces the rate of excess return, so aggregate performance fees increase with increasing assets when assets are small but then peak and decline when transaction costs overwhelm the gross alpha of the strategy. The performance fee should be structured to achieve four main objectives. First, it should handsomely reward a proficient manager for excess return earned over the measurement period. Second, it should control portfolio risk. Third, it should contain fair but significant consequences for manager underperformance. Finally, the performance fee agreement should be explicit in its description of the fee structure—to eliminate client misunderstandings and properly frame client expectations. Reward for Return. The proper structure for performance fees arises from a notion of basic fairness: Clients should be willing to pay managers handsomely for their skill. Managers’ skill is valuable because alpha is scarce. If a manager’s skill is correctly measured—that is, if the excess return is correctly isolated from the informationless return of

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Investment Firms: Trends and Challenges the benchmark—the alpha the manager captures is precious and the manager should be rewarded for generating that alpha. Because most managers cannot deliver excess returns, clients who enter into performance fee arrangements should be willing to pay a lot for real alpha. Control for Portfolio Risk. Without the proper structure, performance fees can motivate managers to take on too much risk. To avoid this situation, clients should • establish carefully defined investment guidelines, • understand how these guidelines are incorporated into the investment process and reflected in the portfolio’s structure, • be confident that this investment process can achieve its goals, and • monitor the process regularly to see that the guidelines are being followed. By encouraging clients to monitor the manager’s investment process, the manager can increase the client’s confidence and potentially attract more of the client’s assets. To achieve this result, managers should show clients at least the structure, if not the holdings, of their portfolio with some frequency. For example, the World Bank is keeping track of all of its hedge funds by downloading the hedge funds’ positions into a database. Although the database does not reveal individual positions, the ability to see the long–short portfolios’ aggregate risk structure is so comforting that the World Bank has been willing to invest more in long–short strategies than it otherwise would have. Ten years ago, Amoco (now BP Amoco) built a similar program into which its long–short managers downloaded their positions every night, permitting Amoco to see the basic structure of each portfolio and analyze the risk of the combined portfolios in the aggregate. Consequences for Underperformance. Another aid in controlling risk is to design the performance fee structure so that significant consequences are imposed for underperformance. Highwater marks are useful, because when a manager does poorly one year and outperforms the next, the client will not owe a performance fee on the overperformance until the underperformance is recouped. Thus, managers are aware that an ill-fated bet today may ruin their ability to earn performance fees for years to come. Some clients even ask for “claw backs”—whereby a manager who underperforms in the future will return to the client some percentage of the fees the manager has already received from the client. Numeric has never agreed to take such a draconian stance.

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Document the Fee Structure. Finally, when structuring performance fees, the operational and legal aspects of the agreement must be considered. The documentation of the performance fee structure must be so precisely worded that when individuals read the agreement at a later date, they can clearly understand its intent. On more than one occasion, we have earned a big performance fee only to have the client say, “You mean there is an additional fee on top of the base fee? We don’t have that in the budget.” If the documents are clear in the first place, this type of problem should be avoidable. Sample Fee Structure. Suppose a client brings us $100 million to manage. For a long-only strategy, we would estimate the fee on that amount to be about 65 basis points. The base fee could be as low as 15 bps; the remaining 50 bps (to equal the normal fixed-fee yield of 65 bps) would be captured in the target alpha of the management strategy. If we believe that the strategy should produce a 4 percent excess return, to recover the 50 bps we gave up in the fee structure, the slope of the performance fee would have to be roughly 12.5 percent. There are a variety of ways we could structure the performance fee arrangement for this client. For example, we could define excess return as the return earned over and above the benchmark return and after the base fee of 15 bps and calculate the slope of the performance fee on that basis. Or, we could specify a slightly lower performance slope and specify that performance is measured above the benchmark before deducting the base fee. Some clients prefer to pay almost nothing in base fees but are willing to pay as much as 28 percent of the excess return in performance fees. On the other hand, some performance slopes are less than 10 percent, but those accounts operate with higher base fees. At Numeric, when we negotiate a performance fee structure with a client, we consider many factors before finalizing an agreement. These factors include the optimal asset limits for the investment strategy, the client’s preferences and level of investing sophistication, and the expected excess return for a strategy in the anticipated market environment. When we set an investment objective for a strategy, we actually set that objective a little lower than our expectations. Thus, we expect a performance fee structure to generate a slightly higher fee yield, on average, than our normal target fixed-fee yield. Business Implicat ions. The use of performance fees has distinct business implications. As the example of the confused Numeric client that had not incorporated performance fees into its budget shows, 2001, AIMR®

Alternative Fee Products performance fees can create hurdles within a manager–client relationship. Simply getting the fee structure down in writing is difficult enough, but the relationship can be further complicated when clients realize the large amount of fees they will owe the manager if performance results are very good. In the long term, however, properly constructed performance fees should enhance the partnership between the firm and the client because performance fees focus the firm’s objective on dollars of excess return generated, not on dollars of assets under management. In addition to complicating the manager–client relationship, performance fees complicate the task of managing an investment management firm by making the firm’s revenue stream more volatile than it would be if fees were fixed. Volatile earnings make planning more difficult and reduce the value of the firm to a potential acquirer. Clearly, to survive in rough times, the firm’s base fees within the performance fee structure must be large enough to cover the firm’s fixed costs (overhead).

Managing the Managers by Anne Casscells tanford University has invested in private equity since 1979 and in hedge funds since 1989. We agree that properly structured incentive fees align the interests of investors and managers. So, we are comfortable with the idea of sharing with the managers some of the value they create. The challenges come in defining “value creation” and in designing a fee structure that enhances value creation in the portfolio.

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Defining Added Value The task of defining added value differs with the strategy of the manager. Measuring added value, or alpha, is fairly straightforward for a market-neutral strategy. In this instance, the client could define alpha as a certain percentage of profit exceeding a hurdle rate—LIBOR, U.S. T-bills, or a higher risk-adjusted rate. Defining added value for other types of strategies, however, such as hedge funds (particularly long-concentrated hedge funds), is much more difficult. For example, consider a long-concentrated portfolio benchmarked to the Nasdaq or the S&P 500 Index. The problem is that one could potentially pay a 20 percent carry (percentage of excess return paid to the manager) that is entirely driven by the market. One way to address this problem would be to charge a performance fee only on performance relative to the benchmark. Realistically, clients are unlikely to agree ©2001, AIMR®

Conclusion Performance fees make sense, both from the perspective of the individual management firm and from the perspective of the industry. Active managers exist to add value, but most fail to do so. Becoming a large manager makes adding value even harder. Clients understand the benefits of indexing, and more and more are doing it. Thus, active managers must manage all aspects of their business so that they consistently add value for their clients above the return of indexing, or the manager’s business risks irrelevancy. Performance fees offer a rich reward to managers who can add value, and they align the interests of managers and their clients. The performance fee structure encourages investment firms to run their strategies at optimal asset levels that permit the maximization of dollars of excess return. In this way, firms can increase their overall chances of success by generating higher returns rather than increasing assets under management to increase revenue.

to such an approach because they could end up paying performance fees even when absolute returns are negative—that is, when the manager has outperformed the index but lost money. Perhaps an option is for clients to pay performance fees only on the “ups” (when performance is positive and beats a benchmark). Alternatively, one could charge on net performance over a long period of time. Such an approach, however, could be challenging because many governance structures prevent clients from operating in an elongated time frame. The alpha of long–short hedge funds is a much more difficult proposition to judge than that of market-neutral funds or even of long-only portfolios. An improvement over current practices would be for hedge funds to follow the lead of the market-neutral funds and use a hurdle rate—T-bills or LIBOR. I do not expect this change, however, until a prolonged downturn in the market occurs. In the meantime, traditional investment management firms that are starting hedge funds to retain management talent should consider establishing hurdle rates from inception. Investors would appreciate the fact that the investment management firm thought about aligning its interests with theirs from the beginning. Private equity investments have similar challenges. Investors are often paying a carry on returns that are partly, or perhaps entirely, derived from the market. For example, some might argue that in the past few years, venture capitalists have essentially enjoyed an override on a levered version of the

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Investment Firms: Trends and Challenges Nasdaq. Furthermore, with both the private equity industry and the hedge fund industry having grown so large, managers must consider whether or not they can exploit enough inefficiency to cover carries of 20– 30 percent and still deliver added value to investors. Another issue is that the base management fees in private equity have grown as the funds have grown. As a result, investors are starting to ask whether base management fees need to be lowered. A few firms have shown some restraint—such as New Enterprise Associates, which has a budget-based management fee and a system that pays annual bonuses to partners only on realized profits. At many other firms, however, excessive management fees are becoming a source of large hidden bonuses every year. Finally, we are concerned about the trend toward “top-tick distributions”—that is, distributions-inkind right when a stock peaks. The client of the fund often cannot realize the value that was imputed to the stock at the time of distribution. For example, if a stock is distributed to an investor at $200, it could drop to $150 before the investor could sell it.

Deciding the Proper Structure To align the interests of investors and managers, incentive fees must be structured properly. We believe that performance contracts should include high-water marks, and we insist on them in each of our partnerships. We also believe that our investment management firms should limit the size of their assets under management to prevent erosion in alpha caused when assets are allowed to grow too large. We use claw backs for our private equity managers, which is the standard in that industry, and for

Alternatives to Performance Fees by Joseph C. McNay lients can invest in a variety of asset classes and strategies that charge performance fees. These asset classes include market-neutral funds, hedge funds, bankruptcy funds, deal arbitrage, managed futures, and venture capital. The pricing of alternative product strategies is relatively straightforward. The standard fee for most of these products is 1 percent plus a 20 percent carry (percentage of excess return). Some funds, however, charge 2 percent plus a 25 percent carry. And the hot venture capital funds are asking for 3 percent plus 35 percent carry.

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some of our hedge fund investments. In the case of hedge funds with claw backs, managers get their carry over three years—that is, they vest one-third each year. If they start losing money, they lose 20/80 just as they gained 20/80 on the way up. In one case, the use of claw backs saved us a fortune. Properly structured, a claw back that expires over time can be an even greater aligner of interests between the manager and the client.

Conclusion If and when the demand for hedge fund and private equity investments wanes, limited partners may ask for terms that would include • a return of all management fees before there is any carried interest (once a prevalent industry provision but much less prevalent now), • the use of trading averages on the days before and after distribution for use in the valuation of the distribution to calculate the carry, and • cumulative hurdle rates on most products, with catch-ups wherein a manager can be paid a performance fee on the entire profits if the rate of return is high enough. Hedge funds and private equity have become institutionalized with a lot of momentum behind them. But disappointing performance could cause a significant retrenchment of demand from investors that might shift the balance of power from the general partners to the limited partners. If this comes to pass, perhaps new structures could be created that would do a better job than the current ones of aligning general partner (manager) interests and limited partner (investor) interests.

Does the Fee Justify the Return? Performance fee structures with 25 and 35 percent carry can work out to be tremendous fees. Such large fees raise the question, which I call the “clients quandary”: Does the return justify the fee? The simple answer is that if investors achieve their objectives after expenses, the fees are justified. If the product delivers poor performance, it is not worth a low fee; in fact, it is worth no fee at all. Thus, fees should be directly related to providing what the client wants. Fee justification lies in the complementary roles of the return delivered by the product and the ability of the manager to deliver excess return to the stated client objective. Thus, the analysis should assess the appropriateness of the alternative product within the client’s asset allocation mix and then the manager’s added value after subtracting the performance fee. 2001, AIMR®

Alternative Fee Products The first step for an investor in analyzing whether a fee is justified is to determine whether the product or strategy fits within the investor’s asset allocation plan. Is the asset or strategy needed in the client’s portfolio to provide diversification, excess return in a certain market environment, or exposure to a market that the investor thinks will improve return for risk or increase returns for the whole portfolio? The next step involves analyzing whether the active manager will add value after the fee expense. One of the risks in investing in alternative assets or strategies is the shortage of true capability in the management of some strategies. For example, finding true managers of risk arbitrage strategies, true buyers of bankruptcy deals, or truly risk-adjusted hedge fund operators is difficult. The most difficult manager to find is a true short seller. So, as with most things in the world that are in shortage, investors should expect to pay more for skilled managers of these strategies. Whether that payment will ensure that the goods are delivered is another issue. There are those who can deliver and those who cannot.

Alternatives to Performance Fee Products Investors do have alternatives to the expensive performance fee products. The investor can choose not to invest in performance-fee-priced strategies. If the client does want to participate in the alternative asset classes, the client can choose to invest selectively in enhanced, high-value-added strategies, which require a high degree of due diligence to thoroughly understand performance expectations. A third avenue to reduce fees and still benefit from alternative products is to create a synthetic exposure. There are several ways to do this, such as by using a long–short mutual fund or derivatives or hiring both a long specialist and a short specialist. Each course of action has pros and cons. Historically, the pros have included lower fees. The cons for mutual funds are the potential for conflicts of interest in the investment approach because of lack of flexibility, pro rata trading policies, and trading restrictions, as well as less potential for compensation incentives for superior management talent. If the client opts to hire separate long and short managers, the pro is that the investor should find excellent talent on both sides of the equation. The con is that the investor, not the manager, is the person who must make deci-

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sions about asset allocation and how to deal with offsetting a long position with a short position in a certain area. Size limitation is another important consideration when choosing a strategy and controlling performance-based fees. In most asset classes, size dilutes returns. As mutual funds grow, they tend to become mediocre because the larger the fund, the more difficult to execute an investment idea. Therefore, a sliding scale develops: As the mutual fund grows, excess return (alpha) shrinks. The world is full of investment ideas that succeeded too well; in other words, so many investors jumped on the boat of a successful strategy that the boat sank. Each year, two or three funds go out of business, and we will continue to see this phenomenon. Therefore, the best way to avoid this fate is to limit asset size under management. One way for the investor and manager to deal with diminishing marginal excess return as asset size increases is to implement an incentive fee structure that incorporates this phenomenon. An example of this type of structure could be the following: • 1 percent plus 20 percent carry; $100 million– $500 million in assets. • 1 percent plus 15 percent carry; $500 million– $1 billion in assets. • 1 percent plus 10 percent carry; $1 billion– $2 billion in assets. • 1 percent plus 5 percent carry; $2 billion and greater in assets. The adoption of such a structure can control large, unbudgeted performance fees and avoid the overextension of a good idea until that idea devolves into mediocrity.

Conclusion For investors to successfully implement an alternative investment strategy, they must focus not on fees but on the complementary aspects of the product itself and on the capabilities of the managers and the riskadjusted, after-fee return of the strategy. There are alternatives to a performance-based fee structure that I have discussed, and each alternative asset class and strategy has pros and cons. But the important issue in choosing an alternative product is whether that product is a good fit for an investor’s portfolio and if the manager hired to manage it is truly proficient.

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Investment Firms: Trends and Challenges

Question and Answer Session Langdon B. Wheeler, CFA Anne Casscells Joseph C. McNay Question: Why aren’t more firms using performance fees? Wheeler: Many managers are reluctant to use performance fees. If the entire industry shifted to performance fees, one of the things that might happen is a reduction in fees in general. If two-thirds of the managers underperformed, they would draw one-third of their normal fees. If one-third of the managers outperformed, they would draw four-thirds of their normal fees. The industrywide fees would be cut by a third. Another issue is that clients think they can pick good managers and, if they do, they can pay them fixed fees and save money. They are not thinking broadly about what a better world it would be if people were paid only for what they deliver. If you pay managers a fixed fee, you are giving them a license to build their business. If you pay them a performance fee, you are entering into a contract with them under which they will not overbuild their business. If you successfully pick active managers that add value and you pay lower fees, you will not in the long term create the incentive scheme for those managers to deliver the good alpha you need because they will overbuild their business. Casscells: Performance fees seem to require that I, as a client, be even more successful at picking managers than if I am paying fixed fees. Setting aside market-neutral funds where we know how to benchmark, consider the longbiased funds for which no real benchmark exists and people are

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getting 20 percent of all the “ups” in the market. In a normal world, if you as a manager are charging 50– 100 bps plus transaction costs, you have to deliver a lot of alpha for the client to come out even. As a client, my rough guess is that I have to be good enough to be able to pick topquartile equity managers just to break even on the transaction costs and fees. Now, suppose I trade that situation for one in which I’m paying 20 percent to a hedge manager on returns that are roughly 60 percent derived from the market. My fees on that kind of fund might go up to an average of 3 percent. In this case, I might have to pick somebody who’s in the top 5 percent or so of skill in order to earn back all the fees and transaction costs. So, I have just traded a dart game that I used to win if I got into the three closest circles for one in which I’ve got to score a bull’s-eye to break even. Why would I have more confidence in my ability to pick really good hedge fund managers than to pick regular equity managers?

mance fees are what they need to keep their most talented people.

McNay: I think the industry’s move to hedge funds is simply a response to perceived market demand, not an expression of the belief that we’ve actually got something to sell of substance. Many diversified investment management companies are beginning to start hedge fund divisions that have performance fees. So, some segments of companies are moving to performance fees. Of course, such decisions create potentially big conflicts within the company, but the companies believe perfor-

Casscells: Structured properly, performance fees make a lot of sense for the investor and the manager if added value is properly identified. Then, the client and manager are simply entering a profit-sharing plan, and profit sharing is effective in aligning incentives. The problem with performance fees comes when you don’t structure them properly— that is, if the client is giving a manager fees based on something other than added value. That is not sustainable.

Question: What are some of the erroneous myths about performance fees? McNay: One myth is that managers try harder for their clients that are on performance fees. I know we don’t do that. Another myth is that the better managers are more willing to be on performance fees because they have more confidence that they will deliver their alpha. I don’t agree. I also don’t agree with the myth that performance fees cause more risk taking. They don’t if they are properly structured and properly monitored. Relative to fixed fees, performance fees encourage clients to be more patient. When a client can send the manager a small check instead of a large check during a period of poor performance, the client tends to wait around for an improvement in the market’s synchronization with the manager’s style.

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