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Institutional fund management

 

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Institutional fund management is fund management conducted by large financial firms such as banks, insurance companies and major investment organisations (e.g. Fidelity or Vanguard).

Table of contents

The Businesses
The activity of institutional fund management has several facets e.g. employment of professional fund managers, research (e.g. of individual assets and asset classes), dealing, settlement, marketing, internal audit, the preparation of reports for clients. The largest financial fund managers, or institutions, are complex financial firms with all the complexity that their size demands. Apart from the people who bring in the money (marketing) and the people who invest it (the fund managers), there are compliance staff (to ensure that no laws or financial market regulations are broken), internal auditors of various kinds (to examine internal systems and controls), financial controllers (to control the institutions own money and costs),computer experts, and the "back office" (the people who track and record transactions and fund valuations for sometimes literally hundreds or thousands of clients per institution).

Key Problems of Running such Businesses
Key problems include:
  • revenue is directly linked to market valuations, so in the event of a major fall in asset prices revenues decline precipitately relative to costs;
  • it is difficult to sustain above-average fund performance and at times of poor performance clients may not prove patient;
  • successful fund managers are expensive and may be headhunted by competitors;
  • above-average fund performance requires the flair of good fund managers and yet clients usually want to hear that they are hiring a firm (with a single philosophy and internal disciplines) rather than the skills of one or two young men/women;
  • evidence suggests that size of investment firm correlates inversely with fund performance i.e. the smaller the firm the better the chance of good performance.

The most successful investment firms in the world have probably been those that have been separated physically and psychologically from banks and insurance companies. That is, the best performance and also the most dynamic business strategies (in this field) have generally come from independent investment management firms.

Representing the Owners of Shares
Institutions control huge shareholdings. In most cases they are acting as agents (intermediaries between owners of the shares and the companies owned) rather than principals (direct owners). The owners of shares theoretically have great power to alter the companies they own...via the voting rights the shares carry and the consequent ability to pressure managements, and if necessary outvote them at annual and other meetings.

In practice the ultimate owners of shares often do not exercise the power they collectively hold (e.g. because the owners are many and diverse each with small holdings), and the financial institutions (as agents) may or may not choose to do so. There is a general belief that shareholders, by which is often meant the institutions acting as agents, could and should exercise more active influence over the companies they hold shares in (e.g. to hold managements to account and to ensure that Boards function effectively). This would mean that there would be another effective pressure group (additional to the regulators and the Board) overseeing management.

Some institutions have been more vocal and more active in pursuing such matters than others. Some institutions have believed that there were investment advantages to building up substantial minority shareholdings (e.g. 10% or more) and then bringing pressure on managements to change the way firms were run. Another widespread tactic is for institutions to effectively collude to force management change. Perhaps more widespread is the sustained pressure that large institutions can bring to bear by talk and persuasion as they liaise with managements over time.

The national context in which shareholder representation considerations are set is variable and important. The USA is a litigious society and shareholders use the law as a lever to pressure managements. In Japan it is traditional for shareholders to be low in the 'pecking order' and for managements and work forces to some extent to operate as mini-clubs able to ignore the rights of the ultimate owners. In Japan we may say that there is more of a stakeholder mentality where it is felt appropriate to seek consensus amongst all interested parties against the background of strong unions and labour legislation.

Philosophy, Process and People
If a client is to have confidence in an investment manager, then there have to be reasons why the manager is going to produce above average results. These reasons tend be found in the 3-P's of philosophy, process and people.
  • Philosophy refers to the over-arching beliefs of the investment organisation. For example, does the manager buy growth or value shares (and why), does he believe in market timing (and on what evidence), does he rely on external research or does he employ a team of researchers. It is helpful if any and all of such fundamental beliefs are supported by proof-statements.
  • Process refers to the way in which the overall philosophy is implemented. For example, which universe of assets is explored before particular assets are chosen as suitable investements; how does the manager decide what to buy and when; how does the manager decide what to sell and when; who takes the decisions and are they taken by committee; what controls are in place to ensure that a rogue fund (one very different from others and from what is intended) cannot arise;
  • People refers to the staff, especially the fund managers. The question is who are they, how are they selected, how old are they, who reports to who, how deep is the team (and do all the members understand the philosophy and process they are supposed to be using), and most important of all how long has the team been working together. This last question is vital because whatever performance record was presented at the outset of the relationship with the client may or may not relate (have been produced by) to a team that is still in place. If the team has changed greatly (high staff turnover), then arguably the performance record is completely unrelated to the existing team (of fund managers).

Fund Managers and Portfolio Structures
At the heart of institutional fund management however are the fund managers whose job it is to invest and divest client monies. Typically, if we take the example of a segregated account run for a single client (as opposed to a pooled account run for several or many clients), then the fund structure has to be determined and implemented. Briefly, for any given type of client there should be an agreed concept of the type of structure that the client thinks will make sense (given the institutions advice) and e.g the fund might be invested in several asset classes including bonds and equities. A great deal of thought then needs to go into the asset allocation and changes to the allocation over time, not least because a great deal of research and experience shows that the asset allocation is the prime determinant of long term returns.

The skill of the successful fund manager consists in constructing the asset allocation, and separately the individual holdings, so as to outperform the peer group of competing fund management organisations, and the bond and stock indices (appropriate to the client's objectives and preferred style).

Long term returns and asset allocation
A good deal of importance tends to attach to the evidence about long term returns to different assets, and to holding period returns (that is the returns that accrue on average over holding periods of different length). For example, over very long holding periods (say over 10 years) in most countries and in most time periods equities have generated higher returns than bonds, and bonds have generated higher returns than cash. According to financial theory, this is because equities are higher risk (more volatile) than bonds which are themselves more risky than cash.

Diversification
Against the background of the asset allocation, fund managers consider the degree of diversification that makes sense for a given client (given its risk preferences)and construct a list of planned holdings accordingly. The list will indicate what percentage of the fund should be invested in each particular stock or bond. The theory of portfolio diversification was originated e.g. by Markowitz (see below) and effective diversification requires consideration inter alia of the correlation between the asset returns and the liability returns (relevant e.g. if the assets are held against some long-term final salary pension obligation), as well as issues internal to the portfolio such as the volatility of the returns of individual holdings and cross-correlations between the returns.

Investment Styles
There are a range of different styles of fund management that the institution can implement. For example, growth, value, market neutral, small capitalisation, indexed, etc. Each of these approaches has its distinctive features, adherents and, in any particular financial environment, distinctive risk characteristics. For example, there is evidence that growth styles (buying rapidly growing earnings) are especially effective when the companies able to generate such growth are scarce; conversely, when such growth is plentiful, then there is evidence that value styles tend to outperform the indices particularly successfully.

Performance Measurement
Fund performance is the acid test of fund management, and in the institutional context accurate measurement a sine qua non. For that purpose, institutions measure the performance of each fund (and usually for internal purposes components of each fund) under their management, and performance is also measured by external firms that specialise in performance measurement. The leading performance measurement firms (e.g. Frank Russell in the USA) compile aggregate industry data e.g showing how funds in general performed against given indices and peer groups over various time periods.

In a typical case (let us say an equity fund), then the calculation would be made (as far as the client is concerned) every quarter and would show a percentage change compared with the prior quarter (e.g. +4.6% total return in US dollars). This figure would be compared with other similar funds managed within the institution (for purposes of monitoring internal controls), with performance data for peer group funds, and with relevant indices (where available) or tailor-made performance benchmarks where appropriate. The specialist performance measurement firms calculate quartile and decile data and close attention would be paid to the (percentile) ranking of any fund.

Generally speaking it is probably appropriate that an institution should persuade it's clients that performance be assessed over a longer period e.g 3 or 5 years to smooth out very short term fluctuations in performance and the influence of the business cycle. This can be dificult however and, industrywide, there is a serious pre-occupation with short-term numbers and the effect on the relationship with clients (and resultant business risks for the institutions).

Absolute versus Relative Performance
In the USA and the UK, two of the world's most sophisticated fund management markets, the tradition is for institutions to manage client money relative to benchmarks. For example, an institution believes it has done well if it has generated a return of 5% when the average manager has achieved 4%. In other markets however, e.g. Switzerland, the mentality is different and clients and fund managers focus on absolute return management, i.e. returns relative to cash (e.g. Swiss franc or Yen cash) where (performance) fees are payable only if the return exceeds some absolute figure (e.g. 10% per annum).

References
  • Rex A. Sinquefeld and Roger G. Ibbotson, Annual Yearbooks dealing with Stocks, Bonds, Bills and Inflation (relevant to long term returns to US financial assets).
  • Harry Markowitz, Portfolio Selection: Efficient Diversification of Investments, New Haven: Yale University Press
  • S.N. Levine, The Investment Managers Handbook, Irwin Professional Publishing (May 1980), ASIN 0870942077.
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