Asset management is a huge and extremely influential industry. It manages around $100 trillion in assets globally. Yet the economics of fund management are little understood by those outside it.
For the latest episode of The Investing Show, I’ve been interviewing ED MOISSON from the Financial Times Group. Ed has written about the fund industry for more than 20 years, including a book, published last year, called The Economics of Fund Management.
With Ed’s help we explore some key questions facing the industry and those who regulate it.
For example, why is asset management still so awesomely profitable when, in the long run, the vast majority of funds are unable to beat their benchmark index?
Although fees and charges have fallen in the United States, why are they still so stubbornly high in the UK and the rest of the world?
Why aren’t fund providers like Fundsmith willing to share some of the economies of scale with their customers?
And for how much longer can the gravy train rumble on?
Abraham Okusanya: Hi Robin, what have you been looking at this time?
Robin Powell: Hi Abraham. We’re going to focus in this episode on the economics of fund management. Here we have a huge and extremely influential industry, and yet it’s often little understood by those outside it.
Abraham Okusanya: That’s right. Much has been written about the individual fund managers and their investment styles, but the economic nuts and bolts of fund management receive far less attention.
Robin Powell: Indeed so, but a recently published book lifts the lid on fund management and explores in some detail how the business actually works. It’s called – appropriately enough – The Economics of Fund Management, and it’s written by Ed Moisson. Ed is a journalist at Ignites Europe, part of the Financial Times Group, who has written about fund management for more than 20 years.
Abraham Okusanya: I read The Econimics of Fund Management as well. So, you’ve interviewed Ed – what did you talk about?
Robin Powell: Well, I asked him to explain how the industry makes its money and why, in his view, the interests of fund professionals are in a sense misaligned with those of investors, but the first thing to understand is just how vast the global fund industry is. It manages around $100 trillion in assets. It’s also highly profitable.
Ed Moisson: Figures I’ve seen for the UK say that the profit margins – from the Investment Association – say that it’s around 30%. Figures from the regulator – the Financial Conduct Authority, in its previous study – said it was closer to 35, 40%. The only businesses that come close within UK listed companies are the likes of banks, real estate, software, and things like that. It is somewhat of an outlier.
Robin Powell: Just to put that in perspective, the profitability of the average UK company is somewhere around 10%. So the fund industry is between three and four times more profitable than the average. And what about salaries? Well, the median annual salary for all workers in the UK is between £27,000 and £28,000. What is the median salary for a fund industry employee? Remember: that’s not just the fund managers, but the admin staff and support staff as well.
Ed Moisson: When I looked recently across some of the largest publicly listed asset managers to have a look at – they disclose the salary levels which they get – we can see that the median pay and sort of total compensation that they get is above £100,000. That’s for the median employees – so that’s the guy in the middle of each of these businesses. Whether the stock market is going up or going down; the industry generally – 2022 was a tough year – but generally, the industry has managed to continue increasing its assets. And so, the money which they make, the salaries that they pay, continue to rise.
Robin Powell: One of the key points that Ed Moisson makes in The Economics of fund Management is that the interests of fund management companies on the one hand, and their customers on the other, are rather misaligned. Put simply: what’s good for the company is often bad for the consumer.
Ed Moisson: Inherently in the way mutual funds work, there is a tension between the asset manager that is managing the money, and wants to make themselves money from the fund. So they charge an annual fee as a percentage of those assets. The higher the assets grow – the pot of money that they’re managing – the fees which you generate, because you’re taking a percentage of it, the fees that you generate rise. The issue is: the higher the fees are, those fees come directly off the money which an investor receives. So as the performance of the fund might go up or down, the fees will continue to come out of the pool of money regardless.
Robin Powell: To put it another way, the fund manager always gets paid regardless of how well or badly they perform. And, as regular viewers of the Investing Show will know, very few funds outperform the market in the long run; and the most important factor is cost.
Ed Moisson: When I first came into the industry and someone was talking about the difference between 1 or 2%; as an investor, your immediate media reaction is to think, “but these numbers are tiny! Who cares about this?” The sort of magic mathematical equation comes in when you look at the compounding effect of charges – that, because these fees directly impact the return which an investor receives, that compounding effect over time is what really makes the difference. If you have a fund which has a 1% charge on an average annual return of about 7% a year, you have a a £50,000 pot of money. Over the course of 20 years, this could be around £25,000 of charges negatively impacting your returns.
Robin Powell: So, given that they make very large profits and that costs have a huge impact on the eventual return that their investors receive, the question is: could and should fund managers pass on economies of scale to consumers?
After all, the cost of managing £10billion in assets isn’t ten times greater than managing £1billion in assets. Also, as a fund’s size grows, its performance tends to worsen. Another reason for reducing fees.
Ed Moisson: There is the potential for firms to pass on greater economies of scale. We see that – number one – because in the States, we see firms doing it a lot. In the UK, we have seen firms start to do it, so we know it’s possible. The profit margins certainly suggest that there’s some wiggle room there for firms to maybe trim their profits a little bit in order to help clients. I would say there’s also an issue there, which comes back to this issue of the tension of the potential conflict of interest between how asset managers operate. An asset manager has effectively two clients. One: the clients in its funds, and if you were solely focused on those clients, you’d be reducing your fees once your assets raise a certain level, because that has a positive impact on the returns which those clients receive. But also if an asset manager has another client – if you’re a publicly listed asset manager, you have shareholders in the company itself. Or if you are maybe an asset manager that’s part of a another financial organisation, you have bosses that want you to be improving your profit levels. That’s an inevitable part of a capitalist economy and of a company wanting to grow. It creates a tension between your two client bases. And I think that is where the issue lies and why we haven’t seen more significant movements on issues like economies of scale.
Robin Powell: So what of the future? Will UK fund managers reduce fees as aggressively as their counterparts in the US have done? Ed Moisson doesn’t expect change to happen fast. One of the main reasons he says is groupthink. In other words, fund managers struggle to think what is accepted industry practice.
Ed Moisson: An asset manager is used to seeing that fees charged by the industry are at a certain level. Why would I, as an asset manager, break out from what other firms are doing in reducing my fees? Either as assets rise, or in order to potentially take advantage of a competitive difference from peers, or even just because they think it’s in the best interest of clients to do that. And generally firms – you know, I’ve worked at an asset manager for a few years. Generally, the view is: this is the way the industry works. This is what my peers are doing. Why would I break out from the box?
Robin Powell: So, Abraham – nobody wants to break out from the box. Groupthink is a problem in many industries. Is Ed Moisson right to identify it as a major obstacle to positive change in fund management?
Abraham Okusanya: I’m afraid it is. Fund management is primarily an inward-looking industry where everybody copies each other. The definition of success is often about the size of the assets that they manage. And so therefore, fund managers emulate each other and they copy each other. And if you are going to deviate from what has been accepted as the norm in the industry you’d better be ready to face a lot of opposition.
Robin Powell: As we heard Ed saying there, it’s an inevitable aspect of the capitalist economy that companies want to maximise profits for shareholders. But as Jack Bogle famously pointed out, you could argue that that’s the problem with fund managers! That they’re expected to serve two masters.
Abraham Okusanya: Indeed. Asset management is unlike any other business because it is a a fiduciary business. And the legendary Jack Bogle dedicated his entire career making this point to the industry and regulators alike. And the key to being a fiduciary is that the beneficiary’s interest must come first. Asset management can’t just be about profit maximisation. Sadly, asset managers don’t always behave in this fiduciary way. And we can leave this to market forces to sort them out, but this takes time. It takes a long time – decades. Especially in an industry where most asset managers, as we said, behave in in very similar ways.
Robin Powell: As I touched on earlier, given the economics of fund management, there’s a strong argument for fund managers to share economies of scale; not just because of their profit margins, but also because, as funds grow in size, their performance tends to falter. Can you just explain to our viewers very briefly why that is?
Abraham Okusanya: Asset management is incredibly scalable and profitable, and that’s because fees are charged as a percentage of the assets. And so: the more the asset grows, the higher the fee revenue to the asset management fund. Now, the bigger the size of the fund though, the more the fund manager is under pressure to deploy this money. And the result of that – the inevitable result of that – is that they become less nimble, and you might see they become a victim of their own success because they get more competition, right? You know, there are other fund managers who would launch similar funds to compete with them because they’d seen that this fund has been so successful; and you ultimately end up with this problem of too much money chasing too few ideas, and research after research has shown this. Now: we should stress that this is a problem with actively managed funds who are claiming to outperform the market. This is not a problem for index funds.
Robin Powell: Finally, Abraham: as Ed Moisson says, UK fund providers have so far shown much less enthusiasm than those in the US to reduce their fees and charges. Fundsmith, for example – one of Britain’s most popular fund houses – recently said it had no intention of doing so, but eventually they’re going to have to reduce their fees and charges, aren’t they?
Abraham Okusanya: Absolutely. And what I like to say is that the US was lucky! They had Jack Bogle! And this guy dedicated his entire career relentlessly making the case, and ultimately created the Vanguard group. And there is this thing known as the Bogle effect or the Vanguard effect, which is in essence that, in every sector that Vanguard launched a fund, you see the competition actually reducing their fees. We’re at the point today in the US where index funds account for over 50% of the mutual fund industry. The UK though is behind in this regard, because we don’t have Jack Bogle. Maybe you will be our Jack Bogle, Robin — but the point is that actually we’ve made incredible progress. As of the end of 2022, about a quarter of mutual funds in the UK is index funds. And that has increased, more than doubled, over the previous decade. And so my point is that we’re already on that track, and the gravy train of the giant asset management industry, I’m afraid, is going to grind to a halt.
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