AIBC 2022 Research
An Introduction to Asset Management
By Michelle Tian:
Aimed at those interested in a summarised and broad overview of the asset management industry, this article briefly introduces what asset managers are, the strategies they use, and the key trends and developments that have shaped the industry over the past few years.
What are asset managers?
Also known as the “buy-side” of capital markets, asset managers are firms, divisions within banks, or individuals that invest money on behalf of their investor clients with the aim of increasing the total value of the invested assets over time. To do so, asset managers acquire, maintain, and trade investments with the potential to grow in value. The asset management industry today comprises a large number of funds with a diverse range of investment strategies – private equity funds, hedge funds, and mutual funds, just to name a few.
Types of Investment Strategies
Broadly speaking, there are two main classes of investment strategies: active, and passive.
Active strategies give portfolio managers the discretion to select individual securities, with the investment objective of outperforming a previously identified benchmark. Passive strategies, on the other hand, simply mimic the returns generated by benchmark stock and bond indexes by buying or selling based on their constituents. Without the need to pay investment managers hefty fees to actively decide on the capital allocation, fees for passive funds can be as low as 0.1% of assets, in contrast with more than 1% for the average active mutual fund.
Over the past decade, there has been a shift from active to passive strategies in the public markets (Figure 1), partially driven by the underperformance of actively managed funds relative to benchmarks like the S&P 500. Over a 15-year period, almost 90% of active funds failed to beat the market, with hedge fund performance in particular weakening significantly in the past 10 years. Alongside this, a shift has thus been underway – in 2019, passive strategies accounted for more than 50% of publicly traded assets in US equity funds. This has prompted active managers to develop hybrid approaches, such as active ETFs, that keep the advantages of passive strategies while attempting to outperform benchmarks.
Figure 1: Total assets in active and passive mutual funds and ETFs and passive share of the total. Source: Federal Reserve Bank of Boston
Types of passive investment vehicles
The main types of passive investment vehicles are exchange-traded funds (ETFs) and index mutual funds.
An ETF is a security that is tradable on a stock exchange, and it closely tracks the performance of a basket of securities. These baskets include stocks within the S&P 500, emerging market bonds, sector-specific equities, and even ESG-focused equities. The ETF industry has witnessed explosive growth over the past decade – in 2021, assets invested in ETFs were approximately USD $9.1T, compared to USD $1.6T in 2008. Compared to actively managed funds that charge an average of 0.66%, ETFs typically charge only 0.00% to 0.05% of assets under management (AUM).
2. Index Mutual Funds
Like ETFs, index mutual funds also track an underlying basket of securities. However, while ETFs trade throughout the day, index mutual funds orders are executed once per day and are therefore less liquid. Furthermore, index mutual funds tend to be less tax-efficient than similar ETFs. This relative tax-inefficiency arises due to the fact that there are more “taxable” events in a conventional mutual fund structure than ETFs: while the sale of securities within the mutual fund portfolio creates capital gains for the shareholders, the sale of ETFs do not expose investors to capital gains on any individual security in the underlying structure. One example of an index mutual fund is Vanguard’s 500 Index Fund Admiral Shares (VFIAX), which offers exposure to 500 of the largest U.S. companies and accounts for about three-fourths of the U.S. stock market’s value.
Types of active investment vehicles
While an ETF tries to match the performance of an index or market benchmark, actively managed funds aim to outperform the market, using strategies that take advantage of the portfolio manager’s research and expertise to hand-pick assets. Some of the main types of actively managed funds include hedge funds, private equity funds, and funds managed by other institutional investors.
1. Hedge Funds
Although there is no simple and all-encompassing definition, hedge funds, broadly speaking, are actively managed, pooled investment funds that are open only to a limited group of investors. Due to their ability to facilitate a range of strategies invested across various asset classes, investors often use them as a way to reduce their beta exposure to equity and other markets. As of June 2021, hedge funds AUM totaled US$3.96T, which, alongside private equity, form the two main largest types of alternative investments. Ranked by AUM, some of the largest hedge fund managers in 2021 include Bridgewater Associates, Man Group, Renaissance Technologies, and Millennium Management.
As its name suggests, hedge funds have historically been differentiated by their use of “hedging” – that is, the reduction of overall risk by taking on positions that offset their existing source of risk. They are further characterised by their flexibility, opaqueness, and highly speculative, information-driven approach to trading, which explains why hedge funds employ less common tools, like short selling, and invest in complex and illiquid assets, such as illiquid securities, high yield bonds, etc. Today, the diverse range of strategies used by hedge funds encompass those that have historically been considered private debt, private real estate, and private equity, although the most common buckets of strategies employed by hedge funds continue to be historically popular strategies such as long-short equity, event-driven, global macro, and relative value.
Table 1: Hedge Fund Strategies and Descriptions. Source: CAIA.
2. Private Equity (PE)
Private equity funds are pools of capital usually used to buy and restructure private companies. Businesses invested in by PE funds range from venture capital investments to businesses requiring growth capital, to the purchase of an established business. The goal of a fund, ultimately, is to invest in a portfolio of private companies that are identified by PE fund managers.
Generally, private equity funds have 5 principal roles: to raise funds, source investments, negotiate and structure deals, build and actively manage a portfolio of investments and lastly, realize value from investments. Furthermore, as of 2018, the dominant sub-investment strategies used by PE funds are buyout (42%), growth (12%), others (24%), and venture capital (13%), ranked by the amount of aggregate capital raised. We will delve further into the private equity sector and these strategies in our upcoming introductory article focused on Private Equity.
3. Institutional investors
Institutional investors, usually in contrast to retail investors, are financial institutions that accept funds from clients for investment on these parties’ behalf. Examples of institutional investors include pension funds, sovereign wealth funds, and insurance companies.
In many capital markets, institutional investors are a major driver in the asset management industry and invest with the goal of optimizing returns for the targeted level of risk (depending on who their clients are) and for prudential regulation. As such, they usually diversify into large portfolios and might by law have to be both prudent and diversified in a way that is meant to protect them from significant losses. Furthermore, while the traditional strategy for institutional investors like pension funds is to split assets among bonds, stocks, and real assets, many have in recent years shifted from active management to passive strategies, like index funds.
Types of Hybrid Vehicles
Driven by an industry shift towards passive strategies and with US asset managers receiving regulatory support in 2019 to run stock-picking ETFs, with them no longer needing to declare their daily holdings, active managers have been adopting hybrid styles that blur the line.
(i) Active ETFs
One such example would be active ETFs. Although an active ETF follows a benchmark index, the underlying portfolio allocation is decided upon by a team and does not adhere to a strictly passive investment strategy. Compared to traditional active strategies, structuring it as an ETF gives it liquidity, ease of trading, and tax advantages, giving the fund additional flexibility.
Apart from the famous active ETFs by Cathie Wood, other popular ones include PIMCO’s Enhanced Short Maturity Active ETF (MINT) and JP Morgan’s Ultra-Short Income ETF (JPST). Pending approval, JP Morgan plans to convert another 4 of its active mutual funds – amounting in total to US$10B in assets – to active ETFs. Today, these active ETFs occupy a small, but growing share of the global ETF market, carrying about US$282.8B AUM.
(ii) Smart-beta ETFs
Beta is a measure of market volatility represented by an index. When the allocation of an index is tweaked to achieve a better risk-reward ratio, it becomes a ‘smart’ beta. Built on traditional ETFs and the multi-factor asset pricing model, smart beta ETFs can either use a single-factor approach or a multi-factor approach.
With historical data pointing towards the cyclicality and underperformance of single-factor-based index strategies, most smart-beta ETFs today revolve around more than one factor, the main ones being low volatility (low variation in prices), value (low price), quality (growth despite business cycles), and momentum (trend-following). By combining both characteristics of passive and active investing, investors retain many benefits of passive strategies while also attempting to improve returns.
Key Trends in Asset Management
1. Large asset managers take a tougher stance on ESG issues
A growing number of large, traditional active investors are taking a tougher approach – involving shareholder activism and divestments - on ESG issues as the industry comes under pressure to prove it is taking climate change seriously. For example, Aviva, ABP, and Norway’s oil fund (the world’s largest wealth fund) have all recently announced divestment plans, marking a possible shift in the stance of investors globally. The New York State Common Retirement Fund, one of the US’ biggest public pension plans, as well as the Church of England have also been selling stocks over climate concerns.
Traditionally, these large active asset managers have favored softer approaches, staying away from divestment, and preferring to alter companies’ strategies through conversation rather than walking away. In response to this more lax approach, companies have responded with lackluster and actionless commitment. Research from Edhec Business School, for example, has shown that despite institutional investors claiming to be actively engaging with companies on ESG issues, they have been ineffective in leading to an actual decrease in the carbon footprint of those businesses.
Pressure from clients, regulators, and the public, however, has been growing. Apart from the threat of legal action (such as with ABP), asset managers could also be left behind by investors. Foundation groups, university endowments, and religious groups in the UK, for example, have established standards around climate change that they require to be met by asset managers. For asset managers, several levers are at their disposal, including backing greener companies and projects, divestment, and shareholder activism, such as pushing for resolutions at annual meetings.
There are complications, however. Some posit that divestitures have limited influence on corporate strategy – even if they divest, other less diligent companies could whip up the shares, even those who care less about climate change. Shareholder activism is also complex and requires substantial effort, money, and time. Nevertheless, for investors, the success of US hedge fund Engine No 1’s recent campaign in Exxon is encouraging and suggests that more asset managers could leverage their influence on the board to push effective shareholder climate campaigns. As asset managers rethink their engagement with ESG, a tougher stance involving activism and divestment is thus expected to become increasingly mainstream, especially as the narrative around ESG and climate change grows more urgent.
2. Greenwashing and lack of clarity around ESG disclosures cloud green investing
In 2021, investors have been pouring hundreds of billions of dollars into green investments, with inflows into sustainable funds surging in 2021 compared to 2020. However, there are rising concerns over “greenwashing” and skepticism over the real impact of sustainable investments, which focus on environmental, social, and governance (ESG) goals. Greenwashing – which refers to investment funds or products that are labeled as sustainable or green, but do not necessarily have the substance to support it – not only damages the credibility of the green finance movement, but it also risks misleading capital from being used for legitimate green purposes.
In response to this, global regulators and investment managers have been taking action to ensure more clarity for investors on ESG performance and investment impact. The US SEC, in March 2021, assembled a task force to target climate and ESG misconduct, and Hong Kong, Singapore, the EU, Switzerland, and UK regulators have also issued or are in the process of discussing similar disclosure agreements aimed at protecting fund investors from greenwashing.
Earlier this year, German and US regulators opened investigations into asset manager DWS following allegations about greenwashing made by its former global head of sustainability, and Tariq Fancy, former CIO of sustainable investing at BlackRock, decried ESG as a “marketing gimmick”. For global asset managers, this threat of enforcement by regulators is a clear signal for them to implement policies, practices, and processes to prevent greenwashing.