Size is not everything for talented portfolio managers
The industry is full of bloated, mediocre businesses with too many funds, says Jon Little
Fund management is a people business”; “our assets go up and down every day”. These are two of the most glib, overused phrases in the fund management business. What offends me is less their ubiquity than that those who use them have spent little, if any, time thinking what they mean.
Fund management has many peculiar characteristics but it is by no means unique. We no longer live in a society where most people earn a living making or building things.
For many of today’s workers, knowledge and skill are their crafts. Amid the four factors of production, labour is the most rewarded and prized. Yet many fund managers are wedded to outdated notions of what constitutes success and how businesses should develop and grow.
After the industrial revolution, scale and size were the goals of business. Growing bigger, producing and selling more, was the recipe for success. Greater scale means lower unit cost, leading to higher revenues and profits. However, this formula does not work for most people businesses, especially fund management operations.
Unfortunately, too many have been infected by the belief that growing in size and complexity somehow makes them better.
First, think about what it means to manage money actively. Done properly, it consumes every working hour of those rare souls who do it well. Managing a research-driven portfolio requires delving into multiple industries and understanding the dynamics of pricing, competition and strategy. It is hard, intellectually challenging and stimulating.
But stimulation is only part of it. Fund management is unusual in that success and failure are easily measurable. For those who care little about short-term results (the only decent managers as far as I am concerned), there is the excitement of unearthing something the market has missed, testing the theory, then taking a contrarian position that may, for months, seem to be a losing bet. Then the slow glow of being proved right and, more importantly, visible results in terms of published performance and higher profits for clients.
The satisfaction talented managers get is not, however, directly scaled to the size of their portfolio. Managing $5bn in large-cap equities is probably just as satisfying as managing $10bn or even $25bn. What is in the portfolio is what matters. Its size — within reason — is largely irrelevant.
Investment management businesses do not need to grow beyond a certain critical mass to be profitable. In fact, the optimum business would comprise an investment team, the largest group within the company, some support staff and just enough marketing and service staff to look after clients. Any functions would be just large enough to be effective. Unfortunately, this is rarely the case. The industry is full of bloated, mediocre businesses with too many funds and products and too many competing priorities.
In these companies I find the investment team has ceased to be the largest group of employees. Herein lies the issue. Sales people want to sell more product, marketing people want to expand client channels, product development people want to launch more product. These desires indirectly feed more expansion.
More product leads to more systems support; geographical expansion leads to greater compliance and IT support; more sales channels require more finance people. All of this leads to business complexity and a bigger HR team.
The business loses focus because suddenly there are employees whose success is judged by criteria that have little or nothing to do with investment performance or client outcomes. If the business is not growing constantly, they quickly become expensive and demotivated. At that point, even if it is sensible to restrict growth or close to new business, those responsible for running the company find it impossible to take these decisions.
The tragedy is that these bloated businesses are normally less profitable per employee and per dollar of revenue and find it harder to retain clients and investment staff. Put simply, every investment business should ask itself: “Would we be better off if we focused on managing money in one key asset class where we have a competitive advantage and ditched everything else?” The answer is yes.