Asset Management Companies for Beginners
A Basic Introduction to Asset Management Firms and How They Work
By Joshua Kennon
I want to talk about asset management including what it is, why it is important, how investors should think about it, and what makes some asset management companies different from others. It's a topic that has been on my mind lately because, I'm in the process of launching a global asset management group that will not only serve as what is effectively my own family's office in the coming decades but, simultaneously, offer private accounts to affluent and high net worth investors with at least $500,000 in investable assets who share our conviction in highly passive tax efficient value investing; who want to invest alongside us as we search the world for wonderful businesses to own.
That first-hand experience, including working daily on the necessary regulatory preparation, developing the pricing models, finalizing service offerings, and more, has taught me a lot about what people do and do not know about not only the asset management business but the investment industry as a whole.
There is frequently an enormous divide in knowledge, net worth, and experience between the type of person that will be invested alongside my family as a client of Kennon-Green & Co. and the average investor, who often doesn't even realize he or she is speaking a different language. As I sit at home in a reading chair writing to you late this evening, let me pull back the curtain a moment and give you a better understanding of how money management works. My hope is that it can better arm you to make more informed decisions as you embark on your investing journey; help you understand the role asset management companies play compared to financial planners and other advisors from a perspective that is somewhat unique being in the trenches myself as we embark on this new venture that very well could turn out to be the central enterprise for the remainder of my career as we transform it into the firm we envision.
This is a bit "inside baseball" as I'm in a unique position of not only undertaking this venture but, having been the ?Investing for Beginners Expert since 2001, have a platform to share with you a side of things you may not get the chance to see.
What Is Asset Management and What Do Asset Management Companies Do?
Asset management is the process of taking investor capital and putting it to work in different investments including stocks, bonds, real estate, master limited partnerships, private equity, and more.
Investments are handled according to an investment mandate. A lot of asset management companies, such as the one I am launching, Kennon-Green & Co., restrict their services to wealthy individuals, families, and institutions because it can be extremely difficult to offer meaningful and useful services at a price that is worth the effort to service smaller investors. These wealthy investors have what are known as private accounts. They deposit cash into the account, in some cases at a third-party custodian, and the portfolio manager(s) run the portfolio for the client using a limited power of attorney based on a number of variables including the client's unique circumstances, risks, and preferences. Positions can be selected or modified for income needs, tax circumstances, liquidity expectations, moral and ethical values, personal psychological profiles... it is truly a bespoke experience at the better firms. For this reason, it isn't unusual for the wealthy to have a relationship with an asset management firm of which you have never heard, relationships frequently lasting for generations as assets are transferred to heirs. There are a number of firms that the typical American has never heard of but that is immediately recognizable to those in the top 1%.
Investment fees typically range anywhere from a few basis points up to a substantial cut of the shared profits on performance-agreement accounts and will depend on upon the specifics of the portfolio. In many cases, there is a minimum annual fee, such as $5,000 or $10,000 per year, to help make sure smaller investors don't try to waste the firm's time. A few companies have minimum annual fees of $100,000 or $1,000,000.
That doesn't mean that asset management firms don't want to make money by serving smaller investors. Many frequently do. To achieve that objective and get around the limitations of scale that would make smaller clients prohibitively expensive to service if taken on a one-on-one basis, many asset management companies create pooled structures such as mutual funds, index funds, or exchange traded funds, which they can manage in a single centralized portfolio.
Smaller investors can then invest directly or through an intermediary such as another investment advisor or financial planner; e.g., their financial planner might say, "I think we should buy these three ETFs, this index fund, and this bond fund". Online Robo-Advisors such as Wealthfront and Betterment, to provide two illustrations, are effectively shoving money into these pooled structures run by third-party asset management companies by recommending asset allocation models made up of their funds.
A perfect example of this is Vanguard. The firm has become the largest asset management company in the world by focusing on the poor and middle class who would be all but non-serviceable at many other institutions. Though it is somewhat tight-lipped on its overall client base, it releases information about the median balances of participating retirement accounts. (Remember that median refers to the dividing point at which half of a given population falls above and half falls below.) Vanguard's median participating balance for a retirement account was only $29,603, so half of folks with a retirement account there had more than that and half had less. From an asset management perspective, these are very, very small amounts. They're doing a tremendous service for these people who otherwise could barely cover the minimum fee at most private asset management groups or even regional bank trust departments. They don't have sophisticated needs, they don't have enough wealth to worry about the practical consequences of things like asset placement or exploiting tax equivalent yield differentials on municipal bonds and corporate bonds by putting one in a certain type of account and the other elsewhere. Instead, they buy $3,000 worth of a Vanguard S&P 500 index fund and it goes out and follows the rules set by the S&P 500 committee, picking up shares of individual stocks like Apple, Microsoft, General Electric, and Chevron for the fund to hold indirectly. There's no real flexibility but it gets the job done in a lot of cases since they don't have many alternatives. Once you get to a decent net worth, though, should you still wish to index, you'd probably consider going to a firm like the one we are launching or Goldman Sachs and try to get it to agree to construct and maintain a directly held, passive portfolio built and run for you for fees ranging from 0.25% to 0.50%. This is a first world problem, though, that most investors will never need to worry about because they'll never have that kind of money.
Some firms combine both service offerings. J.P. Morgan has a private client division for its rich clients, who enjoy private accounts, and sponsors mutual funds and other pooled investments for regular investors, who often invest through their financial planner or retirement plan at work. Northern Trust has a large asset management business but also owns a bank, trust company, and wealth management practice so it can be hard to tell them apart if you aren't familiar with the actual setup; something that is by design so it appears to be a comprehensive, all-in-one solution.
How Are Asset Management Companies Different Than Financial Advisors?
The Financial Industry Regulatory Authority, or FINRA, allows the following investment professionals to refer to themselves as financial advisors even though they do very different things and play very different roles for a client:
- Financial Planners
- Insurance Agents
- Investment Advisors
Furthermore, that last category - investment advisors - refers to firms that are "Registered Investment Advisors" under the law. Many RIAs, as they are known, do not handle their asset management in-house but, instead, outsource it to a third-party asset management group, either through a negotiated private account or by having the client acquire the asset management company's sponsored mutual funds, ETFs, or index funds. Additionally, many asset management firms are also RIAs. (For example, before we take clients at our upcoming asset management company, Kennon-Green & Co. will have to become an RIA. Right now, as we get the business ready to launch, we're doing the pre-work to get ready for that, such as having the limited liability company formed, signing the operating agreement, choosing compliant technology vendors to help us meet what will become our regulatory obligations, comparing different insurance providers, meeting with the tax partners at our accounting firm, etc.) Hence, they are both "investment advisors", or financial advisors, as FINRA allows them to be called, but are not at all the same type of business model.
In other words, in the same way that all heart surgeons are doctors but not all doctors are heart surgeons, most asset managers are investment advisors but not all investment advisors are asset managers.
What makes this even more confusing is that many large asset management firms end up hiring their own financial advisors, who aren't managing assets directly. These advisors take on clients and steer those clients into the asset management division's products and services, perhaps picking an asset allocation model from a software package or some internal firm guideline. To go back to Vanguard, it is first and foremost an asset management company. However, recently, it has been moving aggressively into financial planning for investors without a lot of capital (the minimum is presently $50,000). The client pays these Vanguard advisors 0.30%. These advisors then invest the client's money into Vanguard funds, on which the asset management division charges its asset management fees. Vanguard also raises a lot of money for its asset management business by getting independent investment advisors to have their clients invest in the funds through their brokerage and retirement accounts. Furthermore, Vanguard's trust department will deal with setting up a $500,000 trust for what I estimate to be all-in fees of roughly 1.57% per annum, only part of which is going to the asset management business. It's easy to see how the terminology can be very confusing but you get used to it.
What Differentiates Asset Management Companies from Each Other?
Different asset management firms do different things. Some are generalists - they are enormous enterprises that design financial services or products they think investors will snap up in the marketplace. A good example of this is American Century, one of the largest asset management groups in the world, which is headquartered in Kansas City after it was started out of the founder's apartment. Some are specialists, focusing on one or a handful of areas, which is what we are doing because we're only interested in working with fellow long-term investors who believe in a value investing or passive investing approach. Some only cater to the rich through private accounts (aka individually managed accounts) or hedge funds. Some focus exclusively on launching mutual funds (to learn more about this, read How a Mutual Fund Is Structured). Some build their practice around managing money for institutions or retirement plans, such as corporate pension plans. Some asset management companies provide their services to specific firms, such as for a property and casualty insurance company.
How the asset management company, and just as importantly, how the men and women who distribute the service or product on its behalf, are paid is something I'd consider extraordinarily important. There are many different business models in the asset management world and not all of them are equally attractive to the client. For example, a mutual fund might have a 5.75% sales load, which comes right out of the investor's pocket, and which pays the mutual fund salesmen or financial advisor for placing the client in that particular fund. Meanwhile, the asset management business itself is earning its annual management fee, which is taken out of the pooled structure. In cases of integrated firms where asset management is one of the businesses under the financial conglomerate's umbrella, the asset management costs might be lower than you'd otherwise expect but the firm makes money on things like transaction charges and commissions. In another twist, they may charge no transaction charges or commissions but, instead, charge higher fees that are split between the advisor and the firm for its asset management services. Finally, there are so-called "fee-only" asset management groups that only make money from fees charged to the client. If I were selecting a firm for my own family, I'd go with a fee-only asset management group, which is the reason we decided to opt for that model for our firm. It strikes me as fairer to both parties and, at least in my mind, eliminates certain conflicts of interest I find troubling. A lot of digital and physical ink has been spilled on the topic of fee-only advisors and the reasons they might be better for clients so there's no reason for me to reiterate them here. It's worth researching if this sort of thing interests you.
I'd also be looking at asset management companies at which the portfolio managers and other decision-makers have a meaningful amount of their own money invested alongside clients in the same strategies and holding many of the same assets they select for clients. It strikes me as absurd that a person would hire an asset manager who doesn't treat the client's money the same way he or she treats his own but people do it all the time. It baffles me. Truly, it does.
What Is an Asset Management Account and How Is It Related to an Asset Management Company?
If you work with some financial institutions, including certain private banks, you may hear about something called an asset management account. It is basically designed to be an all-in-one account that combines checking, saving, and brokerage. You can deposit your money, earn interest on it, write checks when needed, buy shares of stock, invest in bonds, acquire mutual funds, and a number of other securities all from this one, centralized, magical account. In many, but not all, cases, the account is actually managed by a portfolio manager of the institution. Typically, fees might run you between 1.00% and 2.75% depending upon your account balance but, sometimes, other advantages come along with the deal that makes any underperformance relative to a benchmark potentially worth it. For example, some banks will allow you to create instantly-collateralized loans against your asset management account holdings at highly attractive rates if you want to take advantage of an opportunity that required immediate liquidity. Sometimes, they'll bundle services, such as insurance policies, so you save money by crossing a certain relationship size threshold.