In Fooldom, our focus is on empowering individuals to make their own investment decisions. This can mean picking great individual stocks and building a rock-solid portfolio, or, as in our Champion Funds newsletter, it can mean picking the right manager(s) for your hard-earned money.

But I want to talk about the crossroads of those two ideas -- namely, investing in the folks that manage other people's money.

A first bite at asset management
Compared to some other segments of the financial sector, asset management is a very straightforward business. At a basic level, asset managers make money by managing other people's money -- and the more money they manage, the more money they make.

As an industry, there's no doubt that asset management shows a lot of future potential. According to AG Edwards, mutual fund assets grew at a rate of 14.4% annually between 1990 and 2006. At the end of 2006, total equity assets under management were at $10.4 trillion. But the number of mutual funds out there has also doubled in the past decade, so to be an investor in the industry you need to know how to separate the wheat from the chaff.

Thought it may be a conceptually simple industry, you need go beyond the basics so you can figure out what separates the high quality asset managers from all the also-rans. So what is it that makes some asset managers a cut above the rest?

Performance is key ...
This may seem obvious, but fund performance simply has to be there for an asset manager to be successful. With companies like Morningstar (Nasdaq: MORN) out there making it easy to benchmark one fund against the next, it's crucial for an asset manager to have funds that actually do what they're supposed to do -- make money for their investors.

In fact, according to Morningstar, funds that they have rated five stars see more than triple the industry average organic growth, and four-star funds grow at nearly double the average pace. Meanwhile, funds that it has put at three-stars basically stagnate, while those less than three stars see high levels of capital outflows.

Products are key ...
Just as Nike didn't create the Air Jordan and close down the design shop, asset managers grow by finding new areas and new investing strategies that they can offer to investors. Building out a broad offering of funds in various asset classes -- domestic equity, taxable fixed income, small-cap equity, money market, etc. -- is one obvious way that asset managers do this.

Venturing into entirely new product areas has also been very rewarding for some companies. T. Rowe Price (Nasdaq: TROW) and some of the other big managers, for example, have been able to pump up growth in recent years through the use of life-cycle (a.k.a. target date) funds. Others have jumped on the growing interest for 130-30 funds, which uses a combination long and short investment strategy.

And diversity is key
Just as investors in individual stocks are encouraged to keep a diversified portfolio, so do asset managers benefit from maintaining a diversified set of offerings. Equity funds typically provide the most profit potential, but managers that have exposure to fixed income and money market funds have a cushion against the inevitable cycles that the stock market goes through.

Similarly, sub-asset-classes tend to go through market cycles. Small cap stocks, for instance, have had a great run over the past few years, but have hit the skids far harder than the rest of the market in the recent downturn. An asset manager that has products that cover large-cap, small-cap, value, growth, global, emerging markets, technology, retail, energy, and so on, will be better able to deliver more consistent results through a range of market conditions.

Get down with the metrics
As with any company, there is an almost endless amount of research that you can do on an asset manager. But before you get into the nitty-gritty -- like how well the small-cap fund manager did in his high school economics stock market game -- there are a few metrics to take note of right off the top.

Assets under management (AUM) is the first place to look. This is the stuff that's going to put cash in the bank, so a manager's AUM will tell you a lot about what you can expect. Managers with higher AUM tend to be more mature and likely have a more diverse and stable business, while a smaller AUM might imply more room to grow. Considering the growth in AUM -- both from appreciation of funds under management as well as new capital inflows -- is just as important to check out from the get-go.

It's likewise important to know the fee levels of various managers. For a given level of AUM, a manager of primarily equity funds will typically earn more than one with mostly fixed income funds. Even on the equity side, fees can vary widely, so it's crucial to know how much the manager is actually earning off the AUM.

Similar to any other business, investors only get to keep the money that actually makes it to the bottom line. For this reason, a manager's operating margin is an important gauge of efficiency -- operating margins in the industry typically fall in the mid-20% to the mid-40% range. Since compensation is generally the largest of an asset manager's expenses, compensation as a percentage of revenue can also be a useful metric.

And of course we don't want to forget those fund ratings. As I pointed out above, an asset manager will have a hard time getting off the ground with a pile of third-rate funds. Fortunately, it's very easy to poke around on Morningstar's site and get a pretty good idea of how well the company's funds are performing. You're also likely to hear management tout its funds' ratings on earnings calls if they are doing well.

Where to start
If you're ready to start digging into asset managers, here are a few industry leaders to begin with:

Company

Assets Under Management

Market Cap to AUM

Trailing Twelve Months P/E

Legg Mason (NYSE: LM)

$999 billion

1%

14.4

Franklin Resources (NYSE: BEN)

$644 billion

3.6%

13.6

T. Rowe Price

$397 billion

3.3%

22.5

Janus Capital (NYSE: JNS)

$207 billion

2%

23.7

Eaton Vance (NYSE: EV)

$162 billion

2.4%

23.0

Data from company filings and Yahoo! Finance, as of most recent quarter.

While I've mainly focused on "traditional" asset managers here, there are also alternative asset managers like Brookfield Asset Management (NYSE: BAM) and Fortress Investment Group (NYSE: FIG). The types of investments that these funds hold may be somewhat different, but the basic business model is very similar.

Further financial Foolishness:

Brookfield Asset Management is a Global Gains recommendation and Legg Mason is an Inside Value pick. You can test drive any of The Fool's newsletters free for 30 days.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned. The Fool's disclosure policy has never once been caught with its pants down. Of course, it doesn't actually wear pants ...