You’ve probably heard about passive investing or ETF investing: If you can’t beat the market (and most people can’t), why not just buy the market? It’s a lazy way to invest but you do outperform many people because you’re essentially getting market returns.
The recent boom in ETFs offer investors a multitude of choices to allocate their capital. You can invest in the well-known STI ETF (ES3 or G3B), S&P 500 ETF, various bond ETFs and even on triple leveraged (3x) Russia bull/bear ETFs. ETFs can offer anything from staid market indices to oil futures to fear itself (VIX ETFs and ETNs).
The indexation trend has been growing and more people are moving towards passive investing due to the growing visibility and popularity of index funds. It’s also due to increased volatility in global markets that have spooked investors. I’ve seen enough BlackRock and Aberdeen ads in public to know that this is a growing market, at least in Singapore.
Have you ever wondered how these ETF managers make their money? How do you value a fund (or asset) manager? If you’re a passive investor, you probably compare the fees between two or more similar ETFs to determine which one’s the cheapest. Chances are you’ve come across various asset managers such as Vanguard, BlackRock, State Street, Fidelity and other famous names.
Let’s take a look at how they make money on the fees they charge a passive investor, and how they compete amongst each other for a share of the indexation pie and the broad industry itself.
The economic moat of an asset manager
Asset management is a highly competitive market where fees are central to their earnings and those that can offer the cheapest fees with a strong brand name would win the game. It’s almost impossible to innovate in the asset management industry without a competitor following suit within weeks, how does one patent an ETF? You can start offering 3x Leveraged S&P 500 Bull/Bear ETFs, and soon enough a competitor comes along and offers the same thing but at 2x leverage.
The raw material in this industry is money and human capital — either of which can make or break a company in a matter of days unlike other industries. Two examples of how each can ruin an asset manager’s day:
- Key man risk (human capital) is huge in asset management as trust and reputation can sometimes lie on a single person and not the company. One great example of this would be the departure of Bill Gross from PIMCO. When he announced his departure, investors withdrew US$23.5 billion in a single month, causing PIMCO a loss of 10% of its assets. Obviously the money investors withdrew didn’t go into their bank accounts, they went into PIMCO’s competitors like Vanguard. What switching cost?
- Money flows is mostly due to sentiment, so when there’s high levels of fear amongst investors in a product or products of an asset manager, the outflows can be huge and swift. WisdomTree’s Europe Hedged Equity Fund saw massive withdrawals during market volatility, and BlackRock’s similar fund saw record inflows because they charged 0.1 percent lower fees.
This industry is cut-throat and having a key man at the helm shouldn’t be seen as a boon as the PIMCO debacle has proven otherwise. With intense competition and fear and greed dictating money flows, any small moment of weakness could bring about record outflows and destroy profitability in a matter of days. So how can such an industry have moats?
The asset management industry is no different from traditional industries despite the entire industry being almost intangible: what with all their products being holdings of financial assets. There can still be moats found and in the usual places: a very select few firms in an industry.
Some types of moats discussed in the earlier article can also be applied here:
Network effect & branding
This usually applies more towards traditional media, telecommunication and now social media industries. Basically, the more customers or users you have, the more they will attract others to use your product or service. Once a firm’s reaches a critical mass of users, its network effect economic moat starts to widen and it can start selling their product/services are a lower or higher rate to increase profitability. The economies of scale would be highly beneficial and soon you’ll start to see profit margins and returns on equity fatten, free cash flow becomes larger, and the company starts to become a cash cow.
In the asset management industry, how a firm gains the network effect is through its reputation and branding, also another intangible moat. For an industry that is so intangible, the asset manager must “tangiblize” the intangible by spending heavily on marketing and advertising. Its reputation is also key as investors are afraid of investing in unknown or shaky asset managers. Once an asset manager gains a sizable share of investors and reaches critical mass, they can essentially compete by slashing fees. This act alone would grab billions from other competitors into the firm’s own products and it can happen in an incredibly short span of time.
Many institutional investors, including sovereign wealth funds are very reluctant to invest in an unknown fund even if its performance record is superior to a well-known one.
The more investors in your funds means more money you can charge as a percentage. As that number grows, your revenues grow in lock-step and you’d have a margin of safety where you can cut fees without losing profitability. Unlike many industries, costs for an asset manager usually do not increase as quickly as its AUM, in fact it can remain the same. When an asset manager’s AUM doubles, it doesn’t need to hire twice the number of staff or buy one more property for “expansion”.
There are many funds out there, mostly closed-ended funds or hedge funds that can be run by less than five people but manage tens or hundreds of millions of dollars with of assets. One ETF, PureFunds ISE Cyber Security ETF (HACK), which tracks cyber-security stocks attracted $1.4 billion in less than 10 months, and it is run by one guy.
This is beauty of the asset management industry wherein costs can easily be managed, allowing fund managers to focus on fee slashing or introducing newer products.
5 key questions to ask when investing with asset managers
- How diversified are the firm’s offerings? WisdomTree’s stock tanked because it didn’t offer a diverse range of products to investors, so they have concentrated risk to a region (Europe). Fund withdrawals from that ETF wrecked WisdomTree. Compare that with BlackRock, Vanguard or State Street’s offerings, where you can invest in securities from most countries around the world with different strategies, even with targeted retirement funds. So an outflow in one ETF wouldn’t be an issue to a well-diversified asset manager.
- Key man risk? Is Larry Fink like Bill Gross? I highly doubt so as BlackRock is huge in the passive investing industry, where it simply rebalances its holdings according to indices. Who’s the key man in Vanguard since Bogle’s departure? Is he like Bill Gross where investors’ monies flow wherever he goes? Vanguard’s bigger than its manager and that is good.
- Reputation? What’s their track record like? Is there significant volatility in flows in their existing funds? How are the returns in general for most of their funds and are investors easily spooked during volatile times? Have they been successful in raising money for new funds? How fast can they raise money for new products? This is important as fund raising is the single biggest contributor of revenue, growth in fees and ultimately profits for an asset manager.
- Compensation? How under or overcompensated are the managers themselves (the individuals not the entities)? Are they charging exorbitant fees to line their pockets?
- Growth? Are they expansionary in a sense that they rapidly hire sales personnel to sell their products? How big is their marketing budget? What is the trend like? How is their AUM growth?
How to value a traditional asset manager
Here’s one highly simplistic way to value an asset manager:
Earnings ÷ Assets under Management
This metric is the be-all and end-all of asset managers and measures how well an asset manager monetizes its AUM. There’s no point growing your AUM if your earnings as a percentage of AUM is stagnating or decreasing. A great asset manager would be able to achieve high AUM growth and even faster earnings owing to cost efficiencies, which would then translate to widening profit margins.
Once you have a clear direction on trend of how a particular asset manager grows its business, you can use a normal discounted cash flow model to forecast its earnings like any other company.
Using BlackRock as an example: it’s the largest asset manager in the world with about $4.65 trillion in assets under management (AUM) as of FY2015, showing a clear network effect moat as investors pick the best and cheapest name on the Street to invest their monies. It’s very difficult to compete against a cost leader when it can cut costs to compete and yet be highly profitable.
Its revenues of $11.4 billion and net profit of $3.3 billion give them an astonishing 30% profit margin. As mentioned in my previous article on moats, clears sign of a strong economic moat are fat profit margins and good returns on equity (12% for BlackRock).
Looking at BlackRock’s numbers (2006-2015):
- Their earnings/AUM is 0.071%, it sounds paltry but that’s from $4 trillion.
- Nine-year average earnings/AUM (%) is 0.06%, and it has increased by a CAGR of 10.2% from 0.03% in 2006.
- Net profit margin has also increased by a CAGR of 7.5% from 15.8% in 2006.
- AUM CAGR since 2006 grew an exceptional 17% from $1.12 trillion.
- Revenues grew in lock-step with AUM with a CAGR of 20%, with net income CAGR at 29%.
You can clearly see the network effect moat supercharging Blackrock’s earnings throughout the years, and then its cost efficiencies led to the widening of margins for the company. Going forward, it’ll be tough to continue at this rapid rate of expansion but they still have a considerable moat. This is an example of how an asset manager exploits its growing AUM by lowering fees to entice more investors, and as a result reaps the sweet reward of having a dominating market share in the ETF industry and high profitability.
How about private equity?
The asset management industry however has a multitude of other asset managers like private equity funds such as Blackstone, KKR, Carlyle, and Apollo. These alternative asset management firms although driven by fees, are an entirely different animal compared with traditional asset managers like BlackRock and Vanguard:
The drivers of the private equity industry aren’t the same, as they hunt and create their own drivers by investing in assets that are typically out of reach for amateur investors. Earnings are very lumpy as it is dependent on the time horizon of their investments and exit strategies.
It’s extremely difficult to value private equity asset managers as you must segregate each fund that the general partners (GPs) like Blackstone have a stake in, and estimate the fees they’ll earn (management fees and carried interest fees). Blackstone for example, has tens of different closed funds, each invested in a specific asset class or industry, most of which can’t be publicly valued – the companies they hold are private and they’re not legally required to disclose.
Although private equity is a very exciting industry making news headlines with eye-popping buyout numbers and paying high albeit unstable dividends, it’s best we as regular investors stay in our circle of competence and invest in things we can fully understand.
Asset managers in Singapore
To name a few asset managers listed in Singapore: ARA Asset Management, Global Logistics Properties, and iFast Corporation; it’ll be interesting to try to find if these asset managers exhibit any “moaty” qualities mentioned above.