What Is Fund Management?

Fund management is the business of managing and allocating capital for a group of investors that have pooled their money together. By pooling their money they are able to gain increased risk diversification for lower overall transaction costs and obtain professional management - all things that would be very difficult for most investors to do themselves.

Typically a fund manager will actually do the day-to-day work of looking after the money, as opposed to wealth management which is generally the service that a financial planner provides directly to a client. A wealth manager will often help a client select funds and sectors. At this higher end of the private wealth sector, financial advisers will be helping clients with asset allocation decisions (which funds to choose) and then the individual fund managers will make their own asset management decisions within the fund.

There are a number of types of investment vehicle that can be used to pool money. They are generally known as collective investments and are usually open ended (meaning that they can accept an unlimited amount of new clients and money). In the United States these are mostly known as mutual funds.

For the purposes of this article and site, the decisions discussed will normally involve an equity market fund, however, there are many ways in which it is possible to use a collective investment for real estate, commodities, bonds and money market. In short, there are more options for capital investment than any of us can possibly imagine!

Fund management careers

As we all know, any sort of work that involves investment banking, a hedge fund or portfolio management more generally is relatively well paid when compared to much of the rest of the economy. For this reason, fund management jobs are very competitive and recruits are normally very intelligent, well educated and logical people. The world of capital management is not normally for wild-eyed mavericks and is instead populated by accountant and MBA types who are sensible.

While the "traditional" route into a fund management career is considered to be a degree and Masters in subjects like business, economics and accounting, there does not seem to be a proven background that provides the instincts required for outperformance. For example, George Soros studied economics and philosophy and has become one of the wealthiest men alive. The most notable exception would be Warren Buffett who did actually study investment under Ben Graham (information here). The big investment banks generally focus on recruiting MBA students, though there appears to be little proof that an MBA is a more appropriate qualification than pure or applied mathematics, econometrics, economics or anything else.

Since the results of every mutual fund and unit trust are published publicly it is quite clear who has done a good job in the preceding weeks, months and years. Some element of annual fund performance relates to the asset class, sector or market in which the money is invested, but beyond the benchmark is the world of alpha, or outperformance of that benchmark. Those with alpha earn very well indeed. The best will have opportunities to open their own hedge fund and earn astounding amounts of money. 

In contrast, behind the scenes are the more normal banking jobs that keep the wheels turning. These are known as back office jobs and will involve fund administration, accounting, reporting and marketing. In some investment banks these will be very well paid positions, but in many firms they will be much more normal salaries.

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The boutiques

For the truly super rich, the services of a Swiss private bank or an investment bank might not be personalised enough. For these billionaires, oil sheiks and oligarchs the answer to their investing problems is to simply recruit their own team.

These small teams are known either as a family office (where the firm manages the wealth of just one family) or a boutique (where the firm manages the wealth of a few families). Needless to say, when you have a team of ten plus people looking after your finances you can have all the personal service you wish for.

Since they offer financial management services for just one or a few families, these offices do not need to report their annual results in the same way that a mutual fund would. In this regard they are very similar to the private hedge funds, the most successful and famous of which is Soros Fund Management that works the money of George Soros, a hedge fund billionaire.

Other super rich individuals choose private equity funds and investment banks such as Goldman Sachs to help keep their money working hard. It is this ability of the very rich to hire the best financial team that helps them to grow and expand their wealth in ways that the rest of us cannot.

Follow the leader

Back in the real world, some of the most powerful people in the developed world are in fact asset managers. There are many pension funds and mutual funds with over US$1 billion under management. Such money provides real financial clout in the world's boardrooms.

In contrast, there are many index funds and exchange traded funds (ETFs) that are essentially managed by computer and mathematical formula. For those funds, the aim is to follow an index (such as the DJIA or NASDAQ) as closely as possible for as little money (low transaction fees) as possible. These are discussed in more detail below in the passive fund management section of this page.

The low fees charged has helped to make these very popular means of investing on the stock market for the average family. By reducing the human input and selling the funds online and through magazine advertisements, much of the fear of dealing with Wall Street has been removed.

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Another reason for the popularity of this style of investing is the often reported failure of a very large percentage of mutual funds to match or beat the Dow Jones. There are a great many people that wonder why the investment industry earns so much money for not delivering at least the same as the market. It is a good question.

No free lunch

There are a number of different ways in which mutual funds earn money. The most obvious is via an annual management fee. This will be between 1% and 2% per year depending upon the company involved. Notice that it is a percentage of money under management which for large funds turns out to be a lot of money. When the economy is growing and the financial markets of the world are prospering, money floods into funds and the funds will grow in value just by the nature of a growing market. In these good days, companies that manage funds are often a good investment!

Any mutual fund company worthy of the name will also charge a fee (also a percentage) when new money is invested into the fund. Depending upon the country you are reading this from and the type of fund you are investing in, this fee might be as low as 2% or sometimes (especially in the offshore world) as high as 7%. This fee is taken upfront meaning that on day two in the fund your capital has shrunk in value already. This is a clever means of keeping investors in a fund for the long-term - it is simply too expensive to switch frequently.

The hedge fund sector also charges a percentage fee for outperformance of their benchmark. When they deliver the goods, they want to earn a part of it. This is generally 20% of the outperformance which means that a good hedge fund manager has the opportunity to become seriously wealthy in a matter of five to ten years. This has meant that there are now thousands of such funds all trying to do similar things with very large amounts of money - thus performance suffers. There are now calls for their fees to be restructured.

The following explanation of two major styles of fun management (written for my newsletter subscribers in 2006) will hopefully help further.

What Are The Two Main Fund Management Approaches? Which Should You Choose?

Welcome to this part of my overview of how a fund manager manages funds. I'd like to reiterate that for anyone to help their money management abilities, studying the work of the professionals is likely to help. Even if only a little.

Otherwise, understanding the options available ought to help people that do not want to actively invest themselves (information here) and save lots of time and effort as well as reducing the fees paid (information here).

There is a group of investors who are of the opinion that stock picking is pretty pointless within an asset class. The argument goes that the market is efficient but that mispricing is likely between markets. This means that the big additional returns can be made by the asset allocation decision.

I'm not saying that these thoughts are right or wrong. However, Warren Buffett has laughed at any idea of an Efficient Market Theory for years. His compelling response, is that if markets are efficient, why does he do so well by picking individual stocks? You can see his point...

This leads to an obvious decision. Do you choose an 'active' or a 'passive' fund manager?

Active Fund Management

These managers spend their time looking for over or under priced assets and then altering their portfolios to take advantage of the situations. In other words, they are looking for 'mispricing' opportunities.

This obviously increases potential risks. The manager may move the fund heavily into or out of one security or sector. The risk is then increased by taking on more mispriced assets. This can lead to larger gains or losses and greater levels of volatility.

Managers may also be trying to 'time' their trades to maximise profits. We have all heard of the maxim to 'buy low and sell high', which in theory is easy to do. Fund managers on the other hand, are trying to do this for six selections at a time and taking into account all available information (including company, market or macro economic news). It really can't be easy.

To put it into perspective, as easy as we may think all this is (or should be), only about 20 percent of managed unit trusts (in the UK) outperform the market each year.

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Passive Fund Management

This route to returns has been championed over the last decade by the 'index tracker'. They are designed to mimic a financial market index. This includes the risk and return profile.

To achieve this, a fund will choose a group of securities (usually a little less than the number in the index) and buy enough to weight the holdings closely to the levels in the actual index. By holding less securities than the index, some of the less influential holdings can be avoided and thus costs held down.

A big factor in favour of index tracking is the low level of transactions (and therefore transaction costs) that are required. For example, if you were tracking the NASDAQ, you would need to hold a lot of Microsoft shares. But being such a big part of the index, you would not be trading into and out of Microsoft stock. Once the holding is in the fund, it is pretty much going to stay that way for a long time to come. There will be some obvious occassional adjustments, but nothing big.

Oddly, an index fund manager is considered to be successful according to two main criteria.

Firstly, the costs involved in managing the fund, the lower the better. This must be one of the few areas in high finance where low fees are considered to be a good thing!

The second area relates to performance and is called 'tracking error'. This relates to the difference between the returns of the index and the returns of the fund. As you might imagine, the closer the index comes to matching the returns of the fund, the better.

Since, much of the passive fund management process is 'hands off' it makes some sense to limit human intervention. For this reason, many major fund managers pass their decision making over to complex computer modelling systems. I'm not sure whether this actually reassures me or not. I imagine that we have all heard about the active sell programs that made the 1987 crash far worse than it needed to be.

Whilst an investor may like the sound of this approach, the risk profile of the index in question should be assessed. If the market is too risky for you, using an index tracker will not make it any safer!

As constituent companies change over time, the bias and risk profile of the market will change. This will also have an impact on the investment risk to an investor. Should the risk profile change too much, it would be wise for an investor to find new holdings with a profile to match. One problem is that many, if not all, private investors will not think about this, meaning that over time they may find themselves with unsuitable holdings and not realise.

In investment, the risks always come home to roost sooner or later.

This leads to an obvious downside to passive management. This is in a falling market. As nice as it might seem to be in a passive fund on the way up, who would want to stay in a fund that will track down? At least with an active fund manager, you know he (or she) is trying to do their best.

I have no doubt that many investors will be holding at the wrong times and then find themselves tracking an index down. This always seems to be the situation.

There is (of course) a 'third way'. Until a few months ago, the very words, 'portfolio tiliting' were a mystery to me. I discussed this subject in some depth a few months ago in my monthly letter, so won't do so again here (this link).

* This article was first sent to my newsletter subscribers in September 2006 *

For more articles on related topics, please visit:

How To Copy A Fund Manager's Asset Allocation Techniques

Asset Allocation And Portfolio Management For Individuals

Strategic Asset Allocation For Beginners

How Do You Assess Fund Performance?

The Concentrated Portfolio

The Competitive Advantage / Business Franchise