A Marketer's Guide to Fund Management
Plus: Apple, Clearing Houses, Payment For Order Flow
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An experienced editor at a leading finance publication once advised me never to write about ESG. “No-one will read it,” he said.
Rather than writing about ESG, then, I’m going to write about marketing – specifically, marketing in the fund management industry. All businesses need a good marketing plan, but for fund managers, it’s an especially important part of the business model. Two reasons:
First, fund management is a highly competitive industry. There are over 10,000 mutual and exchange-traded funds in the US alone, with many thousands more overseas. Add in hedge funds and other investment partnerships and the choice balloons. Distribution is hard, but the barrier to entry for a new fund is surprisingly low.
Second, fund management companies sell a rather abstract product: a promise – a promise to at least preserve and preferably to grow customers’ wealth. Their challenge is that it’s impossible to quantify the value of that promise at the point of sale. Will the fund be up 110% year-to-date like the Odey European hedge fund or down 53% year-to-date like the ARK Innovation ETF? Few other categories of product have as wide a variance of outcomes.
In past issues of Net Interest, we’ve discussed the tension at the heart of the fund management business model. Customers want to see investment performance optimised but owners of the business want to see profits optimised. Although there ought to be a relationship between the two, it can be a loose one. In this issue, we’re going to put that tension to one side and just consider the business side of fund management. Because profits typically derive from the volume of assets managed, the business goal is to maximise assets. So how do fund management firms achieve that?
Unless you’re Renaissance Technologies’ Medallion Fund where customers would line up and pay hefty fees if you ever opened up to outside capital (not that it would be as good a proposition in those circumstances; the fund limits capacity for a reason) you likely need to go out and promote your fund to potential customers. This is a big part of most managers’ budget. US active mutual fund managers allocate around a third of their revenues to marketing. The spend can make a difference: One research paper concludes that marketing is as important as performance and fees in determining a fund’s size. Its authors estimate that a one basis point increase in marketing expense leads to a 1% increase in a fund’s size.
Over the years, fund management companies’ marketing strategies have evolved. Distribution has remained a big part. In Europe, tied distribution of mutual funds largely through banks explains a big part of the competitive landscape. The largest fund management company in Europe, Amundi, has historically generated around 40% of its assets from affiliated banks. But other elements are important too, including past performance and cost.
Past Performance is No Guarantee of Future Results
Traditionally, investment firms promoted their products based on past performance. The strategy makes sense: Past outcomes constitute an important component of decision-making in most walks of life, including many purchase decisions. The reliability of a car or a washing machine, for example, can be ascertained by how it has performed in the past. This is consistent with human psychology – people accumulate experience by observing outcomes associated with past actions and take this experience into account when considering future actions.
The problem in the fund market is that it doesn’t work. Odey’s European hedge fund was down over 50% in the seven years leading up to January 2022; ARK’s Innovation ETF was up over 300%. Yet so alluring is the notion that past performance is indicative of future results that funds are required to post a warning disavowing it.
That doesn’t stop them exploiting it, though. Over the years, funds have become concentrated in the hands of fewer fund management firms. There are various reasons for that including their ability to extract economies of scale. But one reason is their capacity to incubate new funds, releasing them onto the market once they have built up a worthy track record of past performance. According to one research paper, nearly a quarter of US domestic equity funds released in the twenty years prior to 2005 were incubated. These funds came out of the gates with a ready made performance record, only to disappoint as they picked up assets.
Putnam’s Research Fund is an example of an incubated fund – it was set up in October 1995 with assets of $3 million, seeded by Putnam. It outperformed other funds over the next few years and was released onto the market in mid-1998. Its past performance helped it accumulate assets of almost $2.5 billion by the end of 2000 (by which time, its performance had begun to falter). In contrast, a Latin America Fund, also set up by Putnam, didn’t perform well in incubation in the period 1998 to 2001 and was promptly shut down. 1
In addition to past performance, funds also emphasise cost. Part of the appeal of passive funds is their low cost. Increasingly, customers are giving up trying to value the “promise” of active management and are settling for the security of a benchmark return at lower cost. As a leading passive fund manager, Vanguard heavily promotes the cumulative advantage of a low cost fund. In his memoir, founder John Bogle calculates that aggregate savings for Vanguard’s customers between 1974 and 2018 amount to $217 billion.
Star Fund Managers
A third differentiating factor is personality. While fund management firms have ultimate responsibility for customer assets, customers often have affinity to the person managing their money. Peter Lynch was one of the first mutual fund managers to attract a personal following. He made Fidelity into a household name, growing assets from $18 million to $14 billion over the 13 years he ran his fund.
Since Lynch’s time, though, fund management firms have been less keen on using personality to anchor their marketing efforts. That’s because it entails a trade-off between the marketing benefits and the cost of rent-sharing with the individual fund manager. It is also a risky strategy if the firm has ambitions to remain in the market longer than their employee. Fidelity managed the hand-over from Peter Lynch well; other firms have managed transitions less well. When Neil Woodford quit Invesco in 2013, £1.9 billion of assets followed him out the door in the first year. Over the following six years another £8.6 billion flowed out of a fund that once managed £12.9 billion. (Not that it worked out much better for Woodford.) Similarly, Pimco lost $74 billion in assets in the two months following the exit of “Bond King” Bill Gross in 2014.
In a trend that goes back two decades, firms increasingly promote anonymous teams rather than star fund managers to front their funds. According to one research paper, the fraction of actively managed mutual funds anonymously “team managed” increased by a factor of 4-5 between 1993 and 2004. A similar trend is becoming evident today among hedge funds, where multi-strategy funds have gained share at the expense of well-known managers. Last year, multi-strategy funds took in $21 billion of flows, while the rest of the industry lost $7 billion. Across both mutual funds and hedge funds, the brand of the individual manager gave way to the brand of the firm.
One current exception to this trend is Cathie Wood of Ark Invest, who has a huge personal following (1.4 million Twitter followers). As Ark’s largest shareholder, she is more synonymous with her firm than portfolio managers at other firms. But it is not clear that Ark Invest has value beyond her. Part of her appeal is that unlike other managers, she gives guidance on the value of her funds’ “promise”. In the past, she has said that her funds would deliver annualised returns of 15%; in April this year, she doubled down: “Now we think 50%.” Judging by the continued inflows she is seeing in spite of weak performance, customers like the assuredness, however incredible.
As well as past performance, cost and personality, there are a range of niche techniques that fund management firms employ. One of my favourites is the reverse psychology employed by Mark Walker of Tollymore Partners. He has a slide in his pitch deck, “Reasons not to invest.” It lists attributes other customers might find appealing: you want smooth returns, you cannot take a five year view of performance, you believe the investment performance is the most important information in this presentation.
And So to ESG
Sometimes a niche technique can go mainstream. Which brings us to ESG. The idea of constructing portfolios based around principles of responsible investing was born in the money management side of the business. In the late 1960s, Robert Zevin managed family money while also teaching economics at Columbia and running an anti-Vietnam War movement. While fundraising for the movement, Zevin met wealthy individuals who asked him to manage their wealth in ways that didn’t conflict with their values. Other investment managers did likewise. Robert Schwartz was an investment manager at Amalgamated Bank, which had been founded by a labour union for garment workers. Schwartz discovered the union’s funds were being invested in companies with anti-union policies. He reversed that and built an ethical-investing business at the bank.
Over time, demand for funds managed along similar lines grew. Marketing departments were quick to take note. The trend coincided with the rise of passive management and opened up an alternative route for firms to market actively managed funds. They couldn’t compete on cost, nor on their commitment to future performance, but they could compete on environmental, social and governance factors. It also coincided with a parallel trend – that passive asset management also benefits from – to quantify everything. Each of the factors underlying ESG could in theory be measured and packaged into a single rating to reflect the fund’s ESG credentials. The fact that there was little method to the measures didn’t deflect from their marketing potential.
In the past few years, the number of asset management firms that have signed up to the United Nations’ Principles for Responsible Investment has increased significantly. More than 4,300 firms were signed up at the end of 2021, up from 3,000 in 2000; collectively they manage over $120 trillion of assets.
On his full year 2021 investor call, Larry Fink, Chairman and CEO of BlackRock, remarked on the trend: “We have already seen $4 trillion of capital move from traditional investments to sustainability ones in the last two years alone and this is just the beginning.” The firm itself manages $509 billion in “sustainable” assets, double what it managed a year before.
The trend is particularly strong in Europe. “In Europe, if you do not have a sustainability lens, you will not be awarded any mandates today,” said Fink. As at the end of 2021, sustainable funds in Europe accounted for a third of the open ended fund and ETF market and half of the flows.
Very quickly, though, it looks like marketers may have pushed too hard. Last week, German police raided the offices of DWS in Germany as part of a probe into allegations it overstated the ESG credentials of its funds. The whistleblower was the firm’s own sustainability officer. “I still believe in sustainable investing, but the bureaucrats and marketers took over ESG and now it’s been diluted to a state of meaninglessness,” she says.
She’s not alone. Last year, Tariq Fancy, former global head of sustainable investing at BlackRock was equally critical. “The marketing and sales people at BlackRock were all about ESG – they couldn’t get enough of it.” He thinks the marketing efforts are detrimental to values Zevin and Schwartz tried to instil, in that they create a “giant societal placebo” that is lowering the likelihood of concrete reform.
In Europe, regulations have already been put in place to ensure ESG funds are appropriately labelled. Late last month, the SEC proposed a new rule to do likewise in the US. In the meantime, the war in Ukraine has raised questions about what “responsible investing” means and has led to a slowdown in ESG-related flows.
As intermediaries, a lot of what financial services companies do is manage the waves of supply and demand. But because they are incentivised by volume, they are sometimes prone to create artificial demand or artificial supply. Many of the biggest crises in finance have emerged from this weakness and it is apparent again in fund management businesses. Unlike other crises, it doesn’t have balance sheet implications, but it does have earnings implications. Marketers will have to find something else to do.
Putnam Research Fund is still going, with $445 million assets under management, although its performance has lagged the S&P 500 Index over 1,3,5 and 10 years.