What investors should look for in a fund manager (2023)

As Australia's wealth management industry continues to evolve, it is important that the highest standards are required of companies tasked with managing the savings of others.

Australia's mandatory superannuation system has provided a fertile environment for fund management companies. The barriers to entry are relatively low for a business model that is lightweight and highly scalable.

This backdrop has seen the emergence of numerous business structures, from more traditionally diversified financial institutions to highly focused boutiques with a single strategy. The scenario continues to change, with major mergers between listed companies and industry pension funds, and there seems to be no shortage of high-end startups directly backed by specialist 'incubator companies'.

Faced with such a wide and changing range of options, investors must consider which fund management model will provide the best framework for generating long-term alpha.

At Morningstar, we address this question in our Core Pillar assessment, which is an important contribution to our overall assessment framework.

This article outlines the key attributes we believe investors should look for in a fund manager and examines the different fund management models in Australia.

What makes a good fund manager?

The most important characteristics we look for in a parent company are strong management and the ability to deliver positive net alpha to investors over the long term.

There are many factors that drive this, including:

• A sustainable business model that will be available to investors in the long term
• A culture of putting investors first
• Thoughtful and applied capacity management
• Focus on creating centers of excellence in investment
• The ability to attract and retain investment talent

Let's examine each factor in more detail.

A sustainable business model

To succeed, investors must take a long-term view. Therefore, it is vital that any fund manager is considered to be in it for the long term.

With low barriers to entry, many people will try to manage funds, but to build a long-term and sustainable business, a certain level of scale and profitability must be achieved.

Larger, more established companies have an advantage here, but to handle the business risk of new ventures, many startups will seek backing from a well-funded equity partner who can provide a working capital guarantee for a period. Indeed, Australia has seen the emergence of the "boutique incubator model" to address this issue.

For more established companies, investors should consider the risk of customer aggregation. Large acquisitions (such as by institutional investors) can jeopardize the financial viability of the company.

It is important for investors to review and understand the financial backing and risks associated with the fund manager itself to ensure that they will be around for the long term and not be extinguished prematurely due to lack of profitability.

A culture of putting investors first

To be a good manager of investment capital, fund management firms must have a strong culture of putting investors first.

Unfortunately, there are conflicts of interest in any business, but investors should have a clear understanding of how they are managed.

One of the biggest conflicts is the company's desire to maximize profits, which will come at the expense of investor returns. Fund managers derive their income from investment management fees, which are deducted from investment returns.

As mentioned above, corporate profitability is important to ensure long-term sustainability, but above a certain level fund managers should seek to share economies of scale with investors through lower fees.

Fund management firms may also seek to maximize profits through asset growth and new product development. This needs to be handled carefully so as not to distract or detract from existing offers (see capacity management below).

While all super fund managers and board members of accountable entities have a fiduciary duty to act in the best interests of shareholders, boards of listed companies also have a duty to maximize shareholder returns. That doesn't make them more contentious than private companies, which have their own shareholders to consider, but the profitability drivers of listed companies are more visible because of reporting requirements.

This public corporate transparency can actually be useful, allowing investors to gauge whether the right balance has been struck.

Industry funds are best placed to maximize shareholder interests as profits are reinvested for the benefit of members. However, it is still important to ensure that costs are properly managed and that good management practices are in place.

Capacity management considered

A key component of good governance is well thought out and executed capacity management.

There is a limit to the level of assets under management that a firm can effectively manage before the cost of market impact adversely affects investor returns.

If a fund manager is less conservative in terms of capacity, it may be a sign that they are seeking to accumulate assets to maximize profits rather than protect the interests of existing investors. Since successful businesses tend to attract the highest levels of cash flow, closing or shutting down a new cash flow strategy to maintain capacity can be a difficult decision, but it is an important discipline to maintain.

The other major driver of asset growth in recent years has been consolidation, particularly in the pension fund industry.

The merger of Sunsuper and QSuper took the Australian Retirement Trust's assets to more than AUD 200 billion, joining AustralianSuper in what is being called a "mega-fund". This is a double-edged sword, as potential economies of scale are balanced by capacity management challenges, especially when combined with internalizing the investment management function.

Unfortunately, there is no standard measure of a company's capability and it is often treated as an art rather than a science. The least useful measure most often praised by fund managers is looking at strategy size as a percentage of total market capitalization. This number has little meaning for active managers who seek to concentrate their investments in specific sectors of the market rather than simply copy the overall market.

Far more useful are the two metrics we focus on: days to trade and significant holdings.

Days to Trade is an objective measure of the time it would take to liquidate an individual position or an overall portfolio based on the average trading volume for that security. As a general rule of thumb, we believe that a fund can trade 25% of average daily volume without undue impact on price. The less time it takes to liquidate a position, the better, as it allows the fund to be flexible to market changes. Less than 10 days to trade represents a very liquid portfolio, but after 30, 60 and 90 days, questions about capacity management begin to arise.

For stocks, we also track the number and weight of significant holdings (above 5% of issued capital). A large number of significant holdings or individual holdings in securities representing more than 10% of the issued capital are indications that capacity management should be considered.

Focus on investment centers of excellence

When it comes to money management, it's better to be good at one thing than average at many. This is one of the key advantages of the boutique wealth management model – a singular focus on one area of ​​expertise rather than suffering the distractions of a diverse product offering.

Larger, more diverse companies can overcome this problem by developing individual centers of excellence under a single corporate umbrella, but it's not easy. The rise of the boutique wealth management model has increased competition for talent. Large diversified companies must continue to evolve to create an environment that cultivates and maintains investment expertise.

Industry funds are increasingly turning to internalizing investment groups. This is a significant change in approach and a significant challenge to maintaining a strong investment culture in every asset class.

The ability to attract and retain talent

Fund management is an industry that depends on human capital and individual talent.

The appearance of the boutique model was due to famous fund managers who wanted to be masters of their own companies and masters of their own destiny. The list of portfolio managers who left large, diversified asset managers to open their own boutiques is long.

While boutiques have an advantage, diversified financial services firms and industry funds are evolving their business models to address the talent retention problem. Revenue-sharing models and parallel share arrangements have become more common as large firms try to replicate the financial benefits of the boutique structure. There are other benefits that a larger, diversified company can bring, such as greater distribution, compliance and administrative support. But this is where boutique incubator models come into play to simplify the business owner experience and allow fund managers to focus on the alpha generation.

The biggest downside to the industry's reliance on individual talent is key person risk.

Recent history shows that despite all the incentives for shares and profit sharing, portfolio managers can opt out for unexpected and personal reasons.

All fund managers should have a clear succession plan. The onus is on the board and management to ensure that contingencies are well thought out and implemented

An overview of capital management structures in Australia

When it comes to providing the best platform for investor success, the various fund management models in Australia have many advantages and disadvantages that you should consider.

We broadly categorize the market in Australia into three different fund management models:

• The diversified financial company
• boutique
• Member-owned and member-profitable industry funds

The diversified financial company

Diversified financial firms are those that provide investment management services across a range of asset classes, as well as managing their own compliance, marketing and distribution internally.

These are full-service firms, with many historically going so far as to be vertically integrated into consulting.

These companies once dominated the Australian fund management scene. Perpetual and AMP were industry powerhouses, followed by Pendal (formerly Bankers Trust). Major offshore players have also entered the Australian market, either directly (Vanguard, Fidelity, BlackRock and T. Rowe Price) or through acquisitions (Nikko).

The advantages of diversified finance companies are scale, diversification across asset classes and products, and financial strength. Such companies should have longevity when properly managed, although this is not guaranteed, as we have seen in Australia, especially if a company's culture changes course.

The core strengths of the business model have the potential to turn into weaknesses. Size and scale bring complexity and lack of focus, and success can turn into arrogance. As in any business, leadership is key.

Diversified financial companies are able to leverage significant resources not only in investment capacity, but also in product development, customer service, and environmental, social, and governance investments. The downside is the lack of focus on a single area of ​​investment expertise.

It has historically been difficult to retain talent, where talented individuals are attracted by the potential of the more lucrative store ownership structure. Diversified financial firms can handle this in a number of ways. They can make the company bigger than the individual, as happened with Fidelity and Perpetual, or increasingly seek to offer talented individuals equity-equivalent packages, such as revenue-sharing deals.

boutique

Shops have boomed in Australia over the past 30 years. The allure for talented leaders to strike out on their own and control their own destiny is strong. The stores have made many people extremely wealthy.

Platinum Asset Management and Magellan Asset Management are two of Australia's most successful boutique investment managers that have grown into major businesses.

The challenge of starting a new business has been tempered by the rise of boutique incubators like Fidante and Pinnacle. These companies receive a minority stake in the new store in exchange for providing seed capital as well as distribution, marketing and administrative support.

While a single focus is the boutique model's strength, it can also reveal weaknesses.

The success or failure of a store can depend on one or two key people, resulting in significant key person risk.

The viability of the business may also be threatened by the concentration of assets among a few key customers.

Several boutiques have closed in Australia for personal or business reasons, even when a boutique incubator is involved.

Member-owned and member-profitable industry funds

Member-owned and member-owned businesses reinvest profits back into the business for the benefit of all members.

Vanguard has been the poster child for the member ownership model for the past half century, with economies of scale reinvested at lower fees.

In Australia, industry superannuation funds are set up for the benefit of the member and have a similar ethos of passing on full economies of scale to investors.

The success of industry super funds in Australia has brought its own challenges as they have become giants themselves. Capacity management is a key challenge, especially as many funds have internalized the investment function. One solution has been to increase investment in alternative asset classes and unlisted investments, which carry additional liquidity risk.

Industry funds are undergoing a cultural shift as they move from asset managers and allocators to full investment managers.

conclusion

While fund management firms come in many shapes and sizes, the characteristics that make them effective stewards of investors' capital are not unique.

There is no one model that has all the answers. Instead, investors should examine companies on their own merits and identify where they maximized their strengths and minimized their weaknesses.

Effective management and culture cannot be taken for granted and require ongoing effort by a company's management and board to ensure that interests are aligned and that there is the greatest likelihood of generating long-term net alpha.

Morningstar is committed to helping investors make an informed assessment of their fund managers through Key Pillar Ratings.