Global fund management: caveat investor
By John M Mulcahy

"Mutual funds exist in a culture that thrives on hype and withholds important information in a cutthroat business that regularly misleads investors." Bridgeway Funds founder John Montgomery's submission to a US congressional committee last June reflects a schism in an industry that manages more than US$11 trillion in savings globally.

The fact is that the mutual-fund industry, if not the whole financial services industry, is in turmoil as a result of the three-year global financial collapse that began in 2000. Market dynamics are changing and swinging towards other investment vehicles. In the battle for the stewardship of the world's wealth, the extremists are on the rise, with absolute-return, actively-managed hedge funds trebling in size since 2000, while low-cost index funds now represent almost 13 percent of stock fund assets, up from 2 percent in 1990.

These are the "suits", the men and women who live on Victoria Peak in Hong Kong, in Westchester County, Connecticut, in the leafy parts of London or Paris, and commute into New York or down to Central or into the City, their IBM Thinkpads humming in the back seat of the Mercedes or on the train. Throughout the 1990s, they were the stewards of a huge amount of the world's investable money - some $8 trillion of which disappeared in the market crash. The degree of fury now directed at their industry is typically in inverse proportion to its performance. It is no coincidence that they are now under intense scrutiny. It may also have something to do with the way they are compensated.

As the investment world slowly leeches out the excesses of the 1990s, ground rules for investment banking and equity research have already been tightened and the spotlight has shifted to fund management. In good market conditions, when fund performances are surging, costs are ignored or tolerated. However, as markets plunge and fund performances deteriorate, expenses come under close scrutiny. Front-end loaded fees, extravagant annual management charges and bloated transaction charges are all being re-assessed. Outsourcing is in vogue as fund managers seek to mollify clients while protecting their own earnings.

Index funds, as opposed to active management, have also attracted attention as a result of the setbacks to investors in recent years. Statistics vary from market to market, but the fact is that a significant majority of actively-managed funds under-perform their benchmark indices. The obvious response for investors is to switch out of actively-managed funds and into index funds, but investors do not always think that way.

In fact, while the trend in the US is towards index funds, only 12 percent of individual funds are in index funds, although more than 25 percent of institutional money is invested there. The aggressive marketing of actively-managed funds by intermediaries obviously has some responsibility for this disparity, even though some fund managers prefer to blame investor greed. "It's not our fault if investors insist on believing they can beat the market," is the active fund manager's defense.

That may be part of the reason, but another aspect of human nature is also at fault. As markets surge, especially in the final stages of a bull market, money pours into mutual funds, forcing fund managers to invest at precisely the wrong point in the cycle - as the market is peaking. The reverse is also true, as investors tend to withdraw funds after they have collapsed, again forcing fund managers to sell into a sliding market.

It is this perversity in the fund management cycle that can persuade investors to seek out "absolute-return" fund managers. These are funds that do not use benchmarks, such as country or regional indices, but are judged by the actual return. Anyone who has invested in a mutual fund can identify with the frustration at a fund manager boasting about his or her performance against a benchmark, despite the fact that the investor has suffered a huge loss of wealth.

But the principal vehicles for absolute return, hedge funds, have not been a safe place to hide in recent years either. Total assets managed by hedge funds have grown from $200 billion to $600 billion since 2002, but they still represent a fraction (10-15 percent) of the huge equity mutual fund sector. Hedge funds have not been insulated from the troubles afflicting mutual funds. These funds rely on performance fees, generally 20 percent of the upside.

Contrary to conventional wisdom, performance is not the only source of income for hedge funds, which charge 1.5 percent to 2 percent management fees and, in many cases, subscription fees. According to Neil Behrmann, editor of MarketPredict.net, a hedge-fund watcher, many hedge funds are trapped below their high-water mark. This is a condition that requires funds to breach their highest-achieved net asset level before applying the performance fee.

In other words, if a hedge fund peaked at $150 million and has since dropped to $120 million, it will not receive a performance fee for the recovery to $150 million. The Economist recently quoted a British fund manager citing the characteristics of the best fund managers as "arrogant, competitive and cocksure". Unfortunately, these qualities are not necessarily the ingredients for efficient business management, just as the best quarterback or striker on a football or soccer team does not always make the best coach. Consequently, the business of fund management has performed as poorly as many of the worst funds.

In Asia ex-Japan, the fund management industry is concentrated in Hong Kong and Singapore, although the holy grail is China, which is opening its doors to foreign investors. The cultural resistance in Asia to fund management, as opposed to direct investment, which has curtailed the growth of the sector everywhere in Asia, will also act as a brake on the industry in China. But the need to mobilize savings to address the country's hopelessly under-funded pension sector (the shortfall is at least $150 billion) provides official impetus to the development of fund management in China.

China's pension-fund assets under professional management are expected to exceed $50 billion by 2005, from zero now. Hong Kong has about $400 billion under management, although only a third of that is actually Hong Kong money and 95 percent of the authorized funds in Hong Kong are domiciled and managed elsewhere. Hong Kong's fund-management sector has been battered in recent years, with falls in Hong Kong-authorized equity funds (all markets) of 16 percent in 2000, 17 percent in 2001 and 17.4 percent in 2002. The poor run follows a 58 percent rise in Hong Kong-authorized funds in 1999.

According to a survey conducted by Russell Reynolds and Associates, the median salary for portfolio managers running global equity funds is $114,150, and median total compensation is $160,000. Fund managers in the UK rank highest in compensation (average $166,865) followed by US-based managers ($148,000). However, managers based in New York earn 16 percent more than their peers in London and 53 percent more than the global average. In Asia, fund managers in Japan earn the most, at an average of $131,750, followed by Hong Kong's average $91,150 and Singapore's $60,420.

At the top end of the compensation scales, hedge-fund managers in the 90th percentile earn an average US$1 million, while hedge-fund managers across the world average $225,000-240,000. One disturbing aspect of the Russell Reynolds survey is that the overall profitability of the fund-management company is more important than individual fund manager performance in determining compensation. In other words, fund managers have an incentive to maximize their employers' profitability above all else, including returns to investors.

An analysis of profitability in the European fund management sector by the McKinsey consulting group noted that 20 percent of these companies operated at a loss in 2001, the latest available statistics. According to McKinsey in a report published in June this year, "some European asset managers have made sharp adjustments, but investment strategies geared to growth are still common and not all of the companies have their costs under control".

Fund management's biggest competitor is direct investment by individuals in stock markets, a process that has been streamlined in recent years, partly by the advent of online trading, and also by reductions in commissions charged to retail punters. Asian mutual funds/unit trusts have not supplanted direct investment and are unlikely to do so when stock market commissions are 0.25% and lower, while retail charges for mutual funds include a front-end load of 5 percent, as well as annual management fees.

The fund management industry is not as transparent as it might be, especially given the shareholder activism of many institutional managers. In submissions to the US congressional committee, Montgomery of Bridgeway Funds said that he would be "willing and happy" to disclose his funds' trading costs, provided all funds were required to do so. And, in a case involving UBS PaineWebber, the broker has agreed to pay a Nashville, Tennessee municipal pension fund $10 million after an audit accused the firm of overcharging by way of a "soft-dollar" arrangement with various brokerage firms.

In its analysis of the European fund-management industry's 2001 performance, McKinsey concluded that the smallest and the biggest companies were the most profitable. The bigger firms, managing at least $100 billion, benefited from economies of scale, while smaller managers (less than $11 billion under management) focused on specific asset classes or client segments.

The mid-size fund managers, managing an average $40 billion, were forced to compete with the biggest players, incurring average costs more than 30 percent higher than the biggest players and more than 15 percent higher than the smaller managers. McKinsey found the biggest managers had total costs of 15.8 basis points (0.158 percent of funds under management), mid-size firms had total costs of 11.4 basis points and smaller firms' costs were equivalent to 18.2 basis points.

Within Asia, as in the rest of the world, pressure on stockbroking commissions has intensified, while outsourcing of back and middle-office operations is also reducing costs. A London-based Asian fund manager told AsiaTimes Online that his firm has reduced transaction costs to 15 pounds sterling (US$24)per trade from 40 pounds by outsourcing settlement, clearance and data-processing operations. In the process, this mid-sized firm has cut out its back office altogether, and reduced staffing in its middle office to 10 people from 60.

This trend will continue, as will the growth of index funds and of low-cost mutual funds. The US Securities and Exchange Commission (SEC), in its reply to a request for information from the Congressional Committee examining the investment management business, noted that three of the biggest fund-management groups (American Funds, Fidelity and Vanguard), recognized as having low costs, have increased their share of total fund assets in the US from 17 percent in 1990 to more than 26 percent.

The preference for low-cost funds, combined with the huge growth in index funds over the same period and the more recent expansion in hedge funds, all point to more testing times for actively-managed mutual funds, which have emerged from the shakeup in the markets with their reputations most damaged.

The question is whether Asia will learn from the experience of the US and Europe, and leapfrog the less-efficient characteristics of asset management by concentrating on containing costs and on index funds. Unfortunately, this is unlikely, as the fund management industry will opt for the model that most suits its own profitability, rather than the investment mechanism that best suits investors. That is how fund managers are rewarded, and that is how they will operate, if allowed.

John Mulcahy has been covering Asia for 20 years, as a journalist with the South China Morning Post and Far Eastern Economic Review and as equity research head at Vickers da Costa, Peregrine and UBS.

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