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Developing sustainable competitive advantage in asset management


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Developing sustainable competitive advantage in asset management

  1. 1. Developing sustainable competitive advantage in asset management Peter Moles Senior Lecturer in Finance, University of Edinburgh Management School A casual survey of the financial papers will show that there Asset management are a large number of different asset management firms and Asset management firms provide a service, which is often a multitude of different funds available. According to the characterized as a process (as shown in Figure 1) or product Investment Company Institute Fact Book (2006), at the end that includes delegated and professional investment man- of 2005, there were 15,308 investment companies in the agement, fund administration, such as collecting dividends United States, which managed 8,454 mutual funds (including and other payments due on holdings, valuation, and custodi- funds that invest in other funds), 6,019 unit investment trusts, al services, and in areas where there are indivisibilities the 634 closed-end funds, and 201 exchange-traded funds. In benefits of economies of scale and scope. Many of these serv- contrast, the global number of auto manufacturers is about ices are generic and easily imitated and from a competitive 1700, with many of these subsidiaries of other firms; further- perspective fail to deliver sustainable advantages. Some ele- more about 30 global scale corporations dominate the indus- ments of the service offering can be usefully bundled; for try. The sheer number of asset management companies sug- instance, it makes sense for the asset management firm to gests that the competitive advantages of scale and scope also undertake the administration of assets under manage- that characterize a capital intensive and mass producing ment (AUM) even if the actual processing is delivered by a industry like automobiles do not apply in asset management. third-party service provider. So, while many aspects of the Studies of financial firms indicate that there are limits to process are required competencies from a business perspec- effective size in asset management [Hunt et al. (2005)] and tive, few back- or middle-office functions appear capable of that the normal levers of competitive advantage — such as generating lasting competitive advantages. Furthermore, the economies of scale, operational efficiency, revenue and cost existence of specialist providers for many of the administra- economies of scope, market structure and pricing power, and tive functions required to undertake the investment process other defining factors — operate both for and against indus- encourages competition between asset management firms. trial concentration in financial services firms [Walter (1999, Given that such providers can easily scale their operations 2003)]. The characteristics of the industry indicate that it is ever changing, has become increasingly complex and regu- lated, and is extremely competitive1. There appear to be few Customers switching costs or barriers to entry and apart from areas Premiums and contributions such as global custody, transaction processing, and clearing Products Pooling of funds and settlement and possibly also in distribution, few benefits and funds from size or diversity. Diversification, Asset management administration, and companies A key question, therefore, is how asset management firms fund management can develop sustainable competitive advantage in an industry where the norms of industrial organization are weak or non- Investment objectives: income existent. In his seminal work, Michael Porter (1985) proposed capital appreciation two generic sustainable strategies for developing competitive risk Asset classes advantage: cost and differentiation. This paper examines how asset management firms go about developing and exploiting Corporate Government Equities Real estate Other comparative advantages in the absence of opportunities to debt debt develop advantages using scale and scope. Figure 1 – Schematic of asset management process 1 Khorona et al. (2005) find that there are local factors which will affect the demand for asset management services. They find that the relative size of the 29 mutual fund industry in their sample of 56 countries depends on country-specific factors such as wealth, education, laws, regulations, investor protection, the preva- lence of defined pension plans, and the age of the industry.
  2. 2. and generally incur low marginal costs means that new asset Selectivity management firms can easily enter the market without inher- ent cost disadvantages in these areas compared to incum- philosophy bents. It is perhaps in the intangible sphere of brand and rep- Buy & hold Actives utation that incumbents are best able to establish barriers to entry. However, even here brands and reputation seemingly Trading philosophy Passive Active fail to provide a dominant strategy and sufficient competitive Investment advantage to allow for the evolution of dominant firms. Indexing Quant (technical) Reliable information on the revenues, costs, and profitability of asset management is hard to come by. Many of the largest Screening firms are subsidiaries of larger groups and share common Figure 2 – Topography of asset management categories costs, others are private firms or partnerships and disclosure is minimal. Pye (2006) reports that for European firms the average net revenue is 35 basis points (bp) of AUM, with costs earned and costs. Apart from specialization in different sec- equal to 14 bp, giving an average operating profit of 21 bp. tors of the capital markets, such as equity, money markets, or However, this varied greatly by country. Spain and Portugal bonds, funds also differ in how funds are managed, with were highest in terms of revenues at 53 bp and lowest on costs investment strategies ranging from indexation, broad and 11 bp; Germany the lowest on revenues with 23 bp, while the narrow active management strategies, and geographical U.K. was highest on costs with 17 bp; and hence operating prof- and/or sector specialization. In addition, some firms compete it varied from a low of 9 bp for Germany to a high of 42 bp for by providing specialist investment expertise in particular Iberian firms. Specialization also affected revenues, costs, and areas, such as distressed securities, emerging markets, spec- operating profits. Equity fund management costs were twice ulative debt, and other special situations. those of fixed income funds and five times those of money market funds. Many factors contributed to this variation: the When seeking to compete and develop competitive advan- types of assets under management (equity fees were higher tage, a particular asset management firm will compete in two than fixed income), investment styles (active management had overlapping but linked dimensions: in information advantage higher fees than indexing), customer segments (fees for man- or intensity and its attitude to trading its portfolio. We can aging retail funds were higher than those for institutional consider the first to embody what Damodaran (2002) funds), the existence of revenue sharing agreements, the abil- describes as investment philosophies; that is, the way that ity to generate hidden fees, the transparency of the service investments are selected. provided, and the stage of development of the market all had an impact on cost and revenue structures. While there are potentially many ways for appropriate securi- ties to be chosen for inclusion in a portfolio, these can be dis- The competitive landscape tilled down to two approaches: selectivity and screening3. The Across the industry, the principal way firms compete is in the first is based on developing proprietary informational advan- way they offer to provide investment management to deliver tage through analytic skill. Generally this involves examining performance against a benchmark at a competitive cost to individual or groups of securities in some depth in order to clients2. Hence, the key service offering is in the way AUM is understand their potential for delivering superior returns invested and what that means in terms of both revenues over some time horizon. Typically such an analysis may use a 2 We can see this in the way star managers who leave a particular asset manage- 3 The investment literature often discusses security selection in the context of fun- 30 ment company are able to easily establish themselves as independent firms and damental and technical analysis. However, the assumption behind both these tech- even take mandates from their former employers. niques is that by performing the analysis, the investor is aiming to achieve superi- or returns. Hence both these could be seen as selective techniques.
  3. 3. range of different analytical tools or simply rely on informed The buy and hold (B&H) category (selectivity/passive) judgment to work out the securities’ prospects. In contrast, involves careful stock selection but very low levels of trading. screening involves mechanically filtering the universe of The strategic rational for firms in this quadrant is to provide available securities according to predetermined criteria or long-term outperformance while at the same time minimizing using a variety of pre-set screens to find acceptable invest- the drag on performance from trading the portfolio. The best ment opportunities. On the whole and depending on how known example of such a long-term stock picker is Warren screening is carried out, since it largely relies on publicly Buffet’s Berkshire Hathaway. The active management available information which will have been taken into consid- (actives) category (selectivity/active) involves detailed stock eration by the market, it may have little or no informational selection but assumes superior return opportunities are rela- advantage. An example of information-less screening arises tively short-lived and hence the need to aggressively trade when securities are chosen for benchmark matching or repli- the portfolio to maintain superior performance. Note that this cation4. While these two approaches are polar opposites, in category includes most hedge funds. The third category practice some firms may rely on a mixed approach where (screening/active) involves a quantitative or technical selectivity decisions are made from a list of pre-screened approach that relies on low-cost filters to identify short-run securities. excess return opportunities. The main difference between actives and quant funds is in the way in which information is The second dimension relates to the manager’s trading phi- processed. Both depend on an analytical differential: actives losophy, that is, whether the fund is active or passive in the rely on stock selection whilst quant firms depend on exploit- way securities in the fund are treated. Funds that score high- ing technical factors, such as momentum, and developing ly on the active grade are those which need to trade on time- screening efficiencies. Since these technical factor-driven sensitive information in order to generate superior perform- opportunities tend to be short-lived, firms following this strat- ance. Although such firms will seek to mitigate trading costs egy need to actively trade the portfolio in order to achieve whenever possible, this cannot be a primary objective. In con- consistent above-average performance. The last category trast, a passive approach will seek trading cost reductions by (screening/passive) is similar to the first except that the per- keeping the amount of trading to a minimum, and when trad- formance benchmark is a third-party index and hence funds ing, to do so in such a way as to minimize the overall trans- in this category seek replication efficiency. They differ from actions costs. B&H in that they rely on mechanical screens for portfolio selection, which has no informational advantage, and from The way firms compete and seek competitive advantage quant firms in that they have low screening costs and, in so through investment and trading strategies is shown in far as this is possible, will seek to reduce or eliminate trading Figure 2. What Figure 2 illustrates is that the two dimensions costs. Hence this category of firm is cost-driven and will rely lead to four generic approaches on how asset management on economics of scale and scope for competitive advantage. firms manage the investment process and this, in turn, trans- Typically, since there is little differentiation in the products lates into the types of competitive strategies being followed offered by firms in this segment, they tend to compete large- and hence how they position themselves in the competitive ly on price. environment. Note that the strategy the firm considers appropriate is determined by whether the firm considers While the above categorizations are general they do indicate itself most likely to benefit from informational (i.e., be able how asset management firms are, in fact, seeking to exploit to differentiate itself from competing firms through above- the two generic competitive strategies of cost and differen- average performance) or cost advantages. tiation. 4 Examples of screening as a way of choosing which securities to hold include many technical investment strategies such as market-to-book or value-growth, price 31 momentum, market capitalization or size, and earnings revision.
  4. 4. Generic strategies in asset management of AUM. For example, with large amounts of money under The competitive advantage sought by each of the general management providers of index funds can avoid significant categories of asset management firms depends on how the transaction costs by internally matching investor inflows and firm is positioned in terms of its reliance on information or outflows from funds. At the same time, the cost of index repli- cost advantage. This determines whether the primary source cation falls while its efficiency increases when fund size of competitive advantage is differentiation (that is, whether increases. That this segment benefits from such economies is the firm can represent itself in terms of its skill in investment reflected first in the fact that only a relatively small number management) or cost (that is, it can provide its service at a of large firms by AUM occupy this segment and that the typ- competitive cost). Figure 3 shows how the two generic strate- ical fees for index funds are very low at around 20 bp6. To be gies map onto funds’ competitive positioning as described in successful firms that compete by providing indexed products the previous section. need to ruthlessly drive down costs and exploit as far as pos- sible the benefits of economies of scale and scope. That such Asset management firms in the lower left hand quadrant of firms compete on costs in providing a commodity product is Figure 3 follow pure cost-driven strategies, provide a largely seen by the steps taken by Fidelity in August 2004 to build commoditized product, and compete almost exclusively on market share by cutting fees on some of its index funds to cost, that is, the level of management fees5. For indexers just 10 bp and committing itself to not raise them subse- (screening/passive), who are seeking replication efficiency quently. With costs of around 6 bp and a thin operating prof- and trading and overhead cost reduction, many aspects of it, indexers need to take full advantage of even the smallest the asset management process are either fixed costs or eas- benefits of size and be ruthless about pruning costs. ily scalable; hence this segment does benefit from some economies of scale and scope. If the primary purpose of The other generic strategy involves differentiation and is rep- indexers is to emulate a benchmark index, the key to com- resented by the top right hand quadrant (selectivity/active), petitive advantage is operating scale. With scale come cost which is inhabited by active managers and hedge funds. advantages in replication and in spreading overheads and These firms rely on developing and exploiting informational other establishment and marketing costs across large pools advantages. Firms here are competing by differentiating their investment management process and, of critical importance Weak reliance on Strong reliance on in selling their services, in providing superior performance. information differential information differential Consequently cost management by limiting search and trad- DIFFERENTIATION Selectivity ing costs is a secondary consideration as timing matters. Hence firms engaged in informational advantage strategies philosophy Buy & hold Actives cannot necessarily minimize costs for AUM. The costs of pur- suing a differentiation strategy include information gather- Trading philosophy Passive Active ing, processing, and the resultant transaction costs from exe- Investment cuting active strategies. Inevitably there is significant portfo- Indexing Quant (technical) lio churn as firms need to add and delete securities from the portfolio when exploiting informational advantages. COST Screening High reliance on Low reliance on Figure 3 also indicates that there are two hybrid strategies, cost differential cost differential namely buy and hold and quant, which are both partly differ- Figure 3 – How asset management firms compete on cost and differentiation entiation and cost driven strategies. While there are asset 5 Interestingly enough asset management firms not only have to compete on price 6 The index fund market is dominated by a small number of very large firms, such 32 with other firms offering the same or similar indexed products but also with alter- as Barclays Global Investors, Fidelity, State Street, and Vanguard to name but a natives such as exchange traded funds. Hence there is wide choice and, with low few. switching costs and few differentiators, the market is highly competitive.
  5. 5. management firms which compete in both these quadrants, depending on whether they are cost or differentiation driven. the strategies present some special challenges. For the buy For cost orientated firms, the key competencies relate to the and hold category it is identifying sufficient securities with investment process management and, in particular, an ability genuine long-term outperformance characteristics while at to manage down costs. The typical core skills of such firms the same time being able to demonstrate to potential clients will lie in information technology and systems management. an adequate track record in the short-term. A similar problem For those firms pursuing a differentiation strategy, the key arises for quant firms who need to develop effective screen- competencies will lie in information analysis and to a lesser ing criteria that can stand the test of time and which are not extent in risk management. The typical core skills of these subject to competitor predation strategies due to their inher- firms can be the traditional investment management (that is, ent transparency and predictability. In addition, there may be stock picker skills) or more quantitative skills that make use relatively few genuine opportunities for developing sustain- of formal mathematical models. able superior performance. For the above reasons there are relatively few asset management firms which successfully Finally, the structure of the asset management industry poss- compete in these two categories. es some hard questions for clients, both retail and institution, and their advisors and plan consultants. The very large choice Implications of available funds and asset management firms makes selec- Ten years ago it was predicted that only the very largest or the tion difficult, a problem compounded by the way funds tend to very smallest asset management firms would survive, but this promote themselves exclusively on past performance and a has not happened. McKinsey (2006) argue that the winners in lack of transparency in the investment process. Understanding the next few years will be those firms that can exploit available how asset management firms compete and the basis for their economies of scale and which respond best to changing cus- competitive advantage is useful when deciding on awarding tomer demands. Our analysis suggests that differentiation mandates and in reviewing performance. strategies rely more on actual or perceived performance than through driving down costs, although successful firms will cer- References • Damodaran, A., 2002, Investment Philosophies, New York: John Wiley & Sons tainly do all they can to minimize these. Furthermore, we con- • Hunt, D., J. Revell, N. Szmolyan, and R. Wunster, 2005, “Asset management: ‘mega- tinue to see new funds being created and offered on a daily size’ is not the only solution,” McKinsey Quarterly, February basis and the explosion in the number of hedge funds and • Investment Company Institute, 2006, Investment Company Factbook, 46th Edition, • Khorana, A., H. Servaes, and P. Tufano, 2005, “Explaining the size of the mutual AUM in this segment of the industry has had a remarkable fund industry around the world,” Journal of Financial Economics, 78:1, 145-185 impact. Hedge funds have moved from being an exotic niche • McKinsey & Company (2006). The Asset Management Industry in 2010, www.mckin- investment category into the mainstream7. The preceding • Porter, M. E., 1985, Competitive Advantage: creating and sustaining superior per- analysis partly helps to explain the continued fissiparous formance, New York: Free Press • Pye, R. P., 2006, “The Asset Management Industry in EU Zone,” Universidad ESAN, nature of the industry. Only if firms pursue a cost-driven strat- Working Paper egy are they likely to benefit from significant size effects. In • Walter, I., 1999, “The global asset management industry: competitive structure and performance,” Financial Markets, Institutions & Instruments, 8:1, 1-78 fact, the ease with which new funds can be created and sold, • Walter, I., 2003, “Strategies in financial services, the shareholders and the system: is and poorly-performing ones terminated, restructured, or bigger and broader better?” Brookings-Wharton Papers on Financial Services merged undoubtedly masks the significant failure rate in firms pursuing a differentiation strategy. The analysis also indicates that the core competencies of asset management firms will be significantly different 7 The fee structure that is the norm for hedge funds while partly a result of the high costs to base fee revenues for firms which engage in information advantage 33 strategies also suggest that firms are able to demand significant premiums for offering hard to replicate differentiated products.