Asset Management: Investing Essentials

Here's how the asset management business works.

Aug 4, 2014 at 2:43PM

The asset management industry thrives on the concept of "other people's money," generating billions of dollars in fees for managing trillions of dollars in worldwide wealth.

As an investor, you have likely used the services of an asset manager before, whether it's through investing in a mutual fund or relying on a pension for future retirement spending.

What is the asset management industry?

Put simply, asset managers invest money on behalf of their clients.

Asset managers range in their investment strategies. Some invest only in stocks. Some invest only in bonds. A few invest in anything from real estate to precious metals. The strategy depends entirely on the company's expertise, its fund choices, and its clients' needs.

The industry thrives on the fees for managing other people's money. In general, asset managers are not in the business of making money by making investments with their own money.

How big is the asset management industry?

Around the world, asset managers managed $62.4 trillion in wealth in 2012. In North America alone, asset managers reported $30.3 trillion in managed wealth, or roughly half of the world's assets under management.

The size and scope of the asset management industry has grown on the back of growing world wealth. From 2002 to 2012, managed assets nearly doubled, from $32.6 trillion to $62.4 trillion.

Asset Management

Growth is expected to continue. PricewaterhouseCoopers estimates that global assets under management could swell to as much as $102 trillion by 2020.

How does the asset management industry work?

The business model for a traditional asset management company is relatively simple. Asset managers pool capital from thousands of investors, then do the work of investing in different opportunities. For this service, the managers charge a variety of fees.

Mutual fund asset managers often manage billion-dollar funds that invest largely in stocks and bonds. For this service, a mutual fund asset manager will debit a management fee from their customers' accounts, often ranging from 0.5%-2% of assets each year. 

Private equity and hedge fund asset managers, however, charge two sets of fees. The first is a management fee, similar to a mutual fund. The second is a performance fee, which rewards the asset manager for success. A typical structure in this niche is called 2-and-20, or 2% of assets under management each year, plus 20% of the returns of the fund.

What are the drivers of the asset management industry?

There are three big drivers in the asset management industry. The biggest, and most important, is the amount of client money a firm manages. The more money a firm manages, the more revenue it can generate by way of fees.

Conveniently, the positive return expected from investing provides a natural way for the industry to grow. As stock and bond prices have only gone up over long periods of time, the amount of managed assets has also risen.

Keep in mind, though, that subpar returns will ultimately break any asset management business. This is considered a "winner-take-all" industry in which the best-performing firms attract more client money and top talent. Poor performers slowly lose assets under management to the best-performing companies.

The second key driver is the average fee an asset manager can collect from its clients. In very competitive markets such as passive funds or exchange-traded funds, asset managers cannot charge much more than a fraction of 1% of assets under management. An index fund might charge only 0.10% of investor money in fees each year.

In less competitive markets, or where specialized knowledge is more important, fees grow larger. Distressed debt funds, for instance, can charge 2-and-20 fee levels that can tally up to 4% of invested funds annually.

This leads perfectly to the last driver: costs. The biggest expense is the people -- portfolio managers, analysts, and lawyers -- who expect big paydays for a good track record. Million-dollar salaries necessary to retain top-performing portfolio managers can put a big dent in a firm's earnings.

The takeaway on asset managers

The top asset managers have provided incredible returns to investors. In many cases, the asset manager's stock has performed better than its own line of funds!

Over time, the industry will assuredly grow with rising wealth. But that doesn't mean investing in an asset manager is an obviously good investment. A combination of elements -- fee levels, employee compensation, and the performance of asset prices (the stock market included) -- ultimately determine the returns investors can expect.

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Jun 12, 2015 at 5:01PM

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David Hanson owns shares of Berkshire Hathaway and American Express. The Motley Fool recommends and owns shares of Berkshire Hathaway, Google, and Coca-Cola.We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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