Investment Management Overview

Introduction

Do you enjoy following the financial markets, whether reading the Financial Times, watching Bloomberg or checking stock prices on the internet? Do you want to earn good money? If so, you may find a career in investment management appealing.

Investment management, also known as asset management, is pretty much what it sounds like: a client gives money to an asset manager, who then invests it to meet the client’s objectives. In other words, investment management seeks to grow capital and generate income for individuals and institutional investors alike. The potential clients of an asset manager can vary widely.

While there’s no black-and-white distinction between where retail and institutional clients invest, asset managers who manage retail funds, for example, typically manage money for retail clients, while asset managers at investment banks often invest money for institutional investors like companies or municipalities (often for pools of money like pension funds). Asset managers can also work for hedge funds, which combine outside capital with capital contributed by the partners of the fund, and invest the money using complex and sometimes risky techniques, with the goal of receiving extraordinary gains. Asset managers buy their stocks, bonds, and other financial products from salespeople at investment banks, who are on what is called the “sell-side.” (Asset managers are on the “buy-side.”) Because they make commissions on every trade they facilitate, salespeople provide information (research, ideas) to asset managers, in an effort to get the asset managers to trade through them. (This is why some salespeople often used to shower asset managers with perks like sports tickets and expensive dinners at fancy restaurants, a practice that has diminished hugely in recent years.) Investment management basically boils down to this: researching and analyzing potential investments and deciding where exactly to allocate funds.

These days, many investment banks are looking to grow their investment management businesses. Why? Because investment management is largely protected against the volatility of the market. Asset managers charge clients a fee based on the amount of money they are given, so they are guaranteed to make money as long as they attract investment. (Asset managers are generally paid a percentage of the entire amount they handle, whether they make or lose money for the client.) This guide will serve as an insider’s guide for careers in the industry. It will provide you with the knowledge to appropriately target your career search and a framework to handle the most challenging interviews. It will also break down the many different career positions that are available to both undergraduate and graduate students.c

History

The beginnings of a separate industry
The process of managing money has been around for some 200 years. At its outset, investment management was relationship-based. Assignments to manage assets grew out of relationships that banks and insurance companies already had with institutions – primarily companies or municipal organisations with employee pension funds – that had funds to invest.

These asset managers were chosen in an unstructured way, with assignments growing out of pre-existing relationships rather than through a formal request for proposal and bidding process. The actual practice of investment management was also unstructured. Asset managers might simply pick 50 stocks they thought were good investments as there was nowhere near as much analysis on managing risk or organising a fund around a specific category or style. Historically, managed assets were primarily pension funds. Traditional and alternative asset classes such as retail funds, hedge funds and private equity had yet to mature.

The rise of the retail fund
Historians cite the closed-end investment companies launched in the Netherlands by King William I during 1822 as the first retail funds, while others point to a Dutch merchant named Adriaan van Ketwich whose investment trust created in 1774 may have inspired the idea. The Boston Personal Property Trust, formed in 1893, was the first closed-end fund in the U.S.

The first modern retail fund was created in 1924, when three Boston securities executives pooled their money for investment, retail funds were normally used by financially sophisticated investors who paid a lot of attention to their investments. They really came to prominence in the early-to-mid 1980s when retail fund investment hit new highs and investors reaped impressive returns. During this time investor sophistication increased with the advent of modern portfolio theory and investment management firms began heavily marketing retail funds as a safe and smart investment tool, pitching to individual investors the virtues of diversification and other benefits of investing in retail funds.

Traditional versus alternative asset managers
By the early 1970s, the investment management industry had begun to mature as retail funds and other asset classes gained prominence. The dominant theme over the past decade has been the proliferation of alternative asset managers. It is necessary to make the distinction between traditional asset managers and alternative asset managers. Traditional asset managers, such as retail funds, are highly regulated entities that are governed by strict laws and regulations. The Financial Services Authority (FSA) is the principal governing body, and its rules are designed to protect investors and limit unnecessary risk-taking. Traditional asset managers have defined investment mandates that determine what types of securities and strategies they can pursue in a given portfolio. These strategies are discussed in detail in further chapters.

Alternative asset managers include assets classes such as hedge funds, private equity, venture capital and property. They are lightly regulated investment vehicles that do not always have defined investment strategies or risk tolerances. These asset classes are designed to be uncorrelated with the broad stock and bond markets and seek to provide “alpha” returns in a variety of economic situations.

Hedge funds, for example, have evolved into high-risk money managers that borrow money to invest in a multitude of stocks, bonds and derivatives. They use a large equity base to borrow more capital and therefore multiply returns through leveraging. Since alternative investments can be very risky, as well as lucrative, investors need to be deemed “accredited” – which is determined by net worth – in order to invest. Six figures is a minimum bank balance for any prospective investor.

The Industry Today

What’s really going on
The industry controls around $64 trillion globally (having grown by roughly 10 per cent annually over the past decade) and charges clients 1.5 per cent to 2 per cent for the privilege. Hedge funds charge 2 per cent management fees and typically 20 per cent performance fees.

No surprise then that operating margins in the investment management industry are more than 40 per cent, according to the Boston Consulting Group. The beauty of the industry, for its incumbents, is that as markets tend to rise over the long run their fees increase even though the cost of managing money doesn’t. Overtime, according to some estimates, fund managers raise their fees by double digits, up to around 15 percent a year.

The investment management industry is one of the few that broadly impact households all over the world, particularly now. As the population gets older in the core European Union countries, the old-age dependency rate is set to rise from 21 percent now to 50 percent in 2050 – and pension deficits have increased, more people than ever are planning for their future financial needs. As a result, the industry is increasingly visible. Investment management has become an increasingly important part of the financial services industry in Europe. London, for example, is now one of the leading international centres for investment management.

Still growing
In Europe assets under management grew by almost €400 billion in 2007: the UK alone now accounts for around 7 percent of global assets under management, the third biggest home for managed assets behind the US and Japan. Retail fund demand has continued to increase; nearly 50 million households had $24 trillion invested in retail funds as of June 2007, up from $1 trillion in 1990. Despite the credit crunch investment in alternative asset classes has also shot up. A survey by HedgeFund Intelligence said global hedge fund assets under management reached $2.65 trillion at the beginning of 2008, a massive increase of 27 percent from the same period in 2007.

But the credit crunch will bite
However, the adverse economic conditions of recent times have caused problems for the industry. The credit crunch will lower returns in the short-term because there will be less leverage available to fund managers, not to mention the effect of the crunch on global stock markets. Many big investment banks, such as Citigroup and Merrill Lynch, were already selling off their wealth management departments before the economic downturn. As the credit crunch continues to bite and push returns lower, more big players could downsize their investment management offerings.

The crunch may also bring about regulatory changes. In the US, for example, the Federal Reserve bailed out Bear Stearns because, if it failed, its entangled assets would have also brought down the edifice of modern finance. As a result harsher regulatory regimes will be introduced to ensure fund managers cannot topple a financial system that it has taken centuries to create.

The heat has also been turned up on fund managers who are making exorbitant sums amid a seriously tightening economy. While more people than ever are using food stamps in the US some asset managers, particularly hedge fund owners, are making massive profits.

Even multi-multi millionaires such as Bill Gates and John McCain have criticised the super-rich for cashing in on other people’s hard-times. John Paulson, a hedge fund manager, made $3.7 billion in 2007 primarily through shorting the risky CDOs that have brought misery to so many. Paulson beat the best-known fund manager, George Soros, into second place with an annual income of $2.9 billion. In the UK alternative assets managers, particularly short-selling hedge funds, have been seriously admonished by the FSA for spreading liquidity scare-stories about UK banks.

Pension reform and emergence of property
Throughout Western Europe, pension reform has become a politically explosive topic — and one being watched closely by the biggest banks in London, Frankfurt and across the Atlantic on Wall Street. Several European Union countries are facing pension crises, mainly due to an ageing population. Europe’s state pension schemes are based on a pay-as-you-go premise, which means that money paid into the retirement plan by today’s workers are passed through immediately to today’s retirees. That means much more responsibility is placed on the current crop of workers to pay for a disproportionate amount of pensioners: Older workers (aged 55 to 64) in the European Union are set to increase by 24 million between 2005 and 2030.

And here’s how investment managers might benefit in the years to come: the governments’ plan is to strike a new model that shifts more responsibility to workers and away from state-run pension plans. Nation’s like France, Germany and Italy are trying to increase the retirement age as a way to encourage workers to look after their own pensions through defined contributions. Meanwhile, requirements for defined benefit contributions are being increased. As pension reforms are passed throughout Europe, those that enter the investment management industry will benefit. It is one of the reasons why investment managers, from Deutsche Bank in Germany to UBS in Switzerland, are touting a variety of investment tailored to younger investors.

The show will go on
Investors will always desire yields, whether from short-term risky ventures or more secure longer-term investments. As a result, the industry can survive anything. After all, assets are always there to be managed. However, the next couple of years will be a tougher time for the industry as the risks surrounding financial markets and global economic growth remain on the downside. As a result investors, alongside other consumers, are tightening their belts to offset a drastically slowing global economy and a reduction in cheap credit: while this continues investors’ appetite for equity exposure and interest rate risk is likely to remain subdued. This will impact liquidity, meaning managers’ will have less cash in their funds than they have been used to over the last few years.

Consolidating
There have already been well over 150 mergers in the investment management industry in the last 20 years. Recent consolidation activity includes the merger of BlackRock and Merrill Lynch Investment Management, buyouts of Jupiter from Commerzbank and of Gartmore from Nationwide Mutual.

A further spate of consolidation is in the offing amid tough economic conditions. Experts believe institutions with low price-to-earnings ratios, or struggling with poor asset quality, will sell-off their investment management businesses to find more capital. The credit market turmoil has already sidelined some private equity deals and could lead to fire sales of distressed assets.

Indeed, M&A activity within the investment management industry was at an all time high from January to March 2008 in terms of deal volume. In the first quarter of 2008 53 deals were announced at a cost of around $9.6 billion. The acquired assets under management totalled over $704 billion. By contrast in the same period of 2007 45 deals were announced representing $544.9 billion in acquired assets under management.

Convergence
The European investment management sector is currently experiencing massive convergence between traditional and alternative investment styles. Hedge funds, private equity funds and traditional asset managers are competing increasingly closely as the lines between the asset classes become blurred. Investors increasingly understand how to invest and which investments could generate higher returns in a regulated environment. Regulators have realised this and are now offering traditional asset managers new flexibility as long as investors remain protected.

The search for the alpha has aided the process. Traditional asset managers have been buying hedge fund boutiques for some time. But now the difference between these businesses and their core investment strategies are disappearing. Long-only managers are also using regulatory devices such as UCITS III to offer hedge fund products for retail investors and other products to widen the choice for their institutional investors.

Meanwhile, alternative asset managers are reaching a wider audience among investors through regulated fund vehicles and eschewing offshore domiciles of the Caribbean and the British Isles for EU member states such as Luxembourg. The Alternative Investment Management Association (AIMA), the international hedge fund industry body, recently suggested “Hedge funds are now considered part of the mainstream of the investment management industry”.

There is even convergence among alternative assets. Private equity houses and hedge funds are frequently adopting similar investment strategies. Cheap credit, low volatility and rising equity markets encouraged hedge funds to enter the private equity market until the middle of last year.

More strategically, hedge funds are increasingly ring-fencing capital for illiquid investments, similar to those made by private equity. Recently they have deployed these investments up and down the capital structure, including second lien and mezzanine debt products. Private equity houses have acquired undervalued assets and businesses through public market deals. Many experts suggest this could lead to further growth in “hybrid” alternative investment firms. We will expand upon this in more detail in Chapter 2.

The shift from equities to bonds to equities
After the dotcom bubble burst at the turn of the millennium, equity markets became erratic as stocks were challenged by a mixture of corporate scandals and weak economic growth. As a result funds moved from equities to bonds. According to some estimates, pension funds moved £40 billion from equities to bonds in 2004. However, strong economic growth and weakening bond yields since then has instigated a shift back to equities.

But, experts suggest, investors in stocks lulled by periods of low volatility can be hit hard. As the recent economic crisis has shown, things can change quickly and even the strongest of stocks can plummet. In the UK during the 1970s – the last time stagflation hit and editor of The Sun Larry Lamb immortalised 1979 as the ‘Winter of Discontent’ – equities on the whole performed very poorly. Then, as now, investors flocked to more secure bond funds, primarily investing in government debt as opposed to risky junk bonds.

Still, bonds aren’t always a safe-haven in times of strife. The trick for investors, says one fund manager, is to “Keep a diversified portfolio comprised of stocks and bonds. Even 100 percent safe products aren’t always safe, as most managers will tell you. The trick is to spread the risk.

The challenge of exchange traded funds
Described as the “Wal-mart” of the business, exchange traded funds (ETF) are increasingly undermining the traditional business model of investment management funds. According to Morgan Stanley, ETFs had $74 billion in assets under management in 2000, but by 2007 this was up to $700 billion. The growth will not stop there, with Morgan Stanley estimating that $2 trillion will be invested in ETFs by 2011. And it is no surprise. Nearly anything investors believe will perform well in the future can be bought in the form of an ETF, which is a portfolio that can be bought on the stock exchange and costs much less than a traditional investment management firm. The more investors pay in charges, the less money they are likely to make according to experts. As a result, ETFs will remain extremely attractive to investors.

More than just investment
More than ever investment management companies are focusing on more than just investing. Business decisions such as marketing and distribution, global growth, and technology integration are becoming increasingly important factors in the success of investment management firms. While this Guide will focus mainly on developing a career on the investment side of the investment management industry, we will also spend some time discussing the growing alternative career opportunities relating to these “non-investment” business issues.