Asset Management

• Article photo, courtesy of CEPR

In the ever-evolving world of finance, asset management plays a pivotal role in helping individuals, businesses, and governments grow their wealth while managing risk. With markets becoming increasingly complex, asset management firms offer expertise to navigate financial waters effectively. These firms manage assets across various financial products and strategies, providing solutions tailored to clients' needs. This post explores the intricacies of asset management firms, their operational models, and recent developments shaping the industry.

What is Asset Management?

Asset management refers to the professional management of a variety of financial products—such as stocks, bonds, real estate, and other securities—on behalf of individuals, companies, or government entities.

How Asset Management Firms Operate

Asset management firms vary in their scope and offerings, often managing the investments of high-net-worth individuals, pension funds, insurance companies, and governments. Many are standalone firms, while others are subsidiaries of larger financial institutions like banks or insurance companies.

These firms manage a wide range of account types, including:

Regulated Investment Companies

Regulated Investment Companies (RICs) are financial intermediaries that sell shares to the public and use the proceeds to invest in a diversified portfolio of securities. These companies are managed by asset management firms and are subject to various U.S. securities laws.

Each share sold by an RIC represents a proportional interest in its portfolio, which is managed on behalf of the shareholders.

The value of each share, known as the net asset value (NAV), is determined using the following formula:
\( \text{NAV} = \frac{Number of shares - Liabilities}{Market value of portfolio}\)

The NAV is calculated as follows:
\( \text{NAV} = \frac{430,000,000 - 30,000,000}{20,000,000} = 20 \)

The NAV is calculated only at the close of the trading day. There are two main types of RICs managed by asset management firms: open-end funds and closed-end funds.

If the portfolio’s value changes during the day, the NAV will also change accordingly. For example, if the portfolio value rises to $320 million by the end of the day, new investments and withdrawals will be processed at the new NAV of $32. The $5 million investment will result in 156,250 new shares ($5 million / $32), and the $2 million redemption will remove 62,500 shares ($2 million / $32). The total number of shares will be 10,093,750, and the portfolio’s value will be $323 million, resulting in an NAV of $32.

Costs to Investors in RICs

Investors in RICs generally incur two types of costs:

1. Shareholder fees, often called sales charges, which are one-time charges.
2. Annual fund operating expenses, typically called the expense ratio, which includes the management fee paid to the asset management firm for managing the portfolio.

RICs are available with various investment objectives and may invest in different asset classes, such as stock funds, bond funds, and money market funds. They can also be passively managed, tracking a market index like the S&P 500, or actively managed, where the fund manager seeks to outperform the index.

Hedge Funds

Hedge funds are often seen as the investment vehicle of choice for the wealthy and well-informed. As Cliff Asness of AQR Capital Management puts it:

They are more interesting and fun to discuss than your Vanguard index fund.

Despite their popularity, U.S. securities law does not provide an official definition for these pools of investment funds managed by asset managers. As of this writing, hedge funds remain largely unregulated. George Soros, chairman of Soros Fund Management, a firm that advises a privately-owned group of hedge funds (the Quantum Group of Funds), defines a hedge fund as:

"Hedge funds engage in a variety of investment activities, cater to sophisticated investors, and are not subject to the regulations that apply to mutual funds aimed at the general public. Fund managers are compensated based on performance rather than a fixed percentage of assets. 'Performing funds' would be a more accurate term." (Soros, 2000, p. 32)

The President’s Working Group on Financial Markets, in its April 1999 report Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management, defines hedge funds as:

"The term hedge fund is commonly used to describe a variety of different types of investment vehicles that share some common characteristics. Although not statutorily defined, the term refers to any pooled investment vehicle that is privately organized, administered by professional money managers, and not widely available to the public."

Similarly, the United Kingdom’s Financial Services Authority, the regulatory body overseeing financial services providers in that country, offers the following explanation:

"Hedge funds are typically private investment partnerships or offshore investment corporations that:

• Employ a wide variety of trading strategies, taking positions in various markets;
• Utilize trading techniques such as short-selling, derivatives, and leverage;
• Compensate managers with performance-based fees;
• Have a high minimum investment limit (often set at US$100,000 or higher);
• Cater to wealthy individuals and institutions."

Some common strategies used by hedge funds include:

1. Leverage: The use of borrowed funds to increase the potential return on investment.
2. Short Selling: Selling a financial instrument that the fund does not own in anticipation of a price decline.
3. Derivatives: Using these financial instruments to gain leverage and manage risk.
4. Arbitrage: Buying and selling related financial instruments simultaneously to profit from price discrepancies.

These strategies are often applied across various markets, including the cash markets for stocks, bonds, and currencies, as well as the derivatives markets.

Additionally, investors in hedge funds focus on absolute returns—the actual return achieved—rather than relative returns, which measure performance against a benchmark or index. This differs from the approach used in evaluating traditional asset managers.

Finally, hedge fund managers typically earn compensation through a combination of a fixed fee based on assets under management and a share of the profits. The latter, known as an incentive fee, is a performance-based reward that aligns the interests of the managers with those of the investors.

Exchange Traded Funds (ETFs)

Open-end funds, commonly known as mutual funds, face two key criticisms as investment vehicles. First, their shares are priced and traded only at the end-of-day or closing price. This means transactions—whether purchases or sales—can only occur at the closing price, not at intraday prices. Second, although we haven't explored the tax implications of open-end funds in detail, they are considered inefficient tax vehicles. When some shareholders withdraw their investments, it can trigger taxable capital gains for shareholders who remain invested.

In addition to being able to trade throughout the day at current prices, ETFs offer flexibility with various types of orders, including limit orders, stop orders, short selling, and buying on margin—none of which are possible with open-end mutual funds. Furthermore, ETFs overcome the tax disadvantages of open-end funds, although we won’t delve into those details here. Today, there are ETFs that invest in a broad range of asset classes, with new ones being introduced regularly.

Separately Managed Accounts (SMAs)

Rather than investing directly in stocks or bonds, or through alternatives like mutual funds, ETFs, or hedge funds, asset management firms offer individual and institutional investors the option of investing in separately managed accounts (SMAs), also known as individually managed accounts. In these accounts, investments are tailored to meet the specific objectives of the investor. SMAs provide a customized investment vehicle that overcomes many of the limitations of Registered Investment Companies (RICs). However, they tend to be more expensive due to higher management fees.

Pension Funds

A pension plan fund is established to provide retirement benefits. The entity that creates and manages the plan is known as the plan sponsor, which can take several forms:

• A private business entity (corporate/private plan) for its employees,
• A government body (public plan) for its employees,
• A union (Taft-Hartley plan) for its members, or
• An individual (individually sponsored plan).

There are two primary types of pension plans: defined benefit (DB) plans and defined contribution (DC) plans. Additionally, a hybrid plan, known as a cash balance plan, combines features of both.

1. Defined Benefit Plan

   In a defined benefit (DB) plan, the plan sponsor commits to providing specific dollar payments to eligible employees upon retirement, as well as benefits for beneficiaries in the event of an employee's death before retirement. The DB plan's obligations represent a debt liability for the plan sponsor, who assumes the risk of maintaining sufficient funds to meet its payment obligations to current and future retirees.

   Plan sponsors have several options for managing the plan's assets:

   • Internal management: The sponsor’s own investment staff manages the assets.
   • External management: The sponsor hires one or more asset management firms to manage the assets.
   • Combination of internal and external management: Some assets are managed internally, while the rest are managed externally by asset management firms.

   Asset managers of defined benefit plans are typically compensated through management fees.

   Pension plans are regulated by federal legislation under the Employee Retirement Income Security Act of 1974 (ERISA), which is administered by the Department of Labor and the Internal Revenue Service (IRS). ERISA establishes fiduciary standards for trustees, managers, and advisors involved in pension funds.

2. Defined Contribution Plan

   In a defined contribution (DC) plan, the plan sponsor’s responsibility is limited to making specific contributions on behalf of eligible participants, often based on a percentage of the employee's salary or employer profits. Unlike DB plans, the sponsor does not guarantee any specific retirement payout. Instead, the retirement benefit depends on the growth and performance of the plan's assets. Plan participants typically choose from a range of investment options provided by the sponsor. Defined contribution plans come in several legal forms, such as 401(k) plans, money purchase pension plans, and employee stock ownership plans (ESOPs).

3. Hybrid Pension Plan

   A hybrid pension plan combines features of both DB and DC plans, with the most common type being the cash balance plan. In this plan, future pension benefits are defined rather than employer contributions. The plan bases retirement benefits on a fixed annual employer contribution and a guaranteed minimum investment return. Each participant’s account is credited with a dollar amount—typically determined as a percentage of salary—and is also credited with interest tied to a fixed or variable index (such as the consumer price index, or CPI).

   Most cash balance plans offer benefits in the form of lump sum distributions or as an annuity.