Size more a myth than a hit

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The Independent Online

Size in the asset management industry is a good thing, we have been told. Five years ago, a report by Goldman Sachs, the US investment bank, said asset management firms would become more polarised between massive global giants and smaller specialist niche firms with well-defined regional and product strengths. That report has been followed by a spate of mergers and acquisitions which lend apparent support to that view.

Size in the asset management industry is a good thing, we have been told. Five years ago, a report by Goldman Sachs, the US investment bank, said asset management firms would become more polarised between massive global giants and smaller specialist niche firms with well-defined regional and product strengths. That report has been followed by a spate of mergers and acquisitions which lend apparent support to that view.

The Government-appointed Myners Inquiry reviewing the UK's pensions industry and focusing on fund management demonstrates that the size argument deserves more rigorous scrutiny. Passive asset management - the use of portfolios which mirror a stock market index - is characterised by high fixed costs and low profit margins. So large volumes are required to generate profitable returns.

Unsurprisingly, as barriers to entry have risen, large global players have established dominance in passive management. From an investor's perspective, this has two potential dangers. One is that the cost differential between active and passive management may fall, should these huge firms raise prices. The second is that executing trades will become more difficult when such a large volume of funds is controlled by such a small number of decision centres.

In active asset management, there are five size myths worth rebutting. The first is that size is needed for research, because an asset management company needs financial resources to develop a broad, deep research capability. No asset manager, they say, can claim to have a genuinely global research operation unless that can cover 3,000 to 5,000 companies across the major financial markets.

But the competitive advantage of asset managers has inexorably shifted from gathering information to interpreting it. Thanks to technology, information is available globally. The added value lies in interpreting that information to discover fresh investment ideas.

This does not require gargantuan resources. A small experienced group of individuals working together is likely to be just as effective. A firm can operate successfully and globally with a team of 100 to 150 investment professionals. The second size argument in the investment process. No asset management house can deliver consistently superior risk-adjusted returns for investors without a robust investment process and methodology underpinned by quantitative analysis.

But an equally important requirement is to have a decision-making structure that eliminates unwanted bureaucracy. If you have multiple committees of 10 or more people layered on each other in pyramid, the outcome will inevitably be consensus decisions - which by, definition, have no hope of producing superior risk-adjusted returns. The largest asset management firms have difficulty avoiding this trap.

A third issue is how flexible firms can be in implementing investment decisions. The more assets a manager has to invest, the more difficult it is to implement investment ideas. A $300bn "gorilla" will be hard-pressed to execute its decisions, particularly in less liquid sectors and asset classes, such as smaller companies and emerging markets. There is added risk for a firm with large holdings in an individual stock of being caught by time-consuming intervention in the management of the company.

A fourth myth is that scale is required for effective distribution of products and services to clients. This model, on which much of the Goldman Sachs report was based, appears outdated. The most effective distributors are increasingly unwilling or unable to market just one asset manager's products. They prefer "open architecture"giving them and their retail investors access to a broader range of investment products. As a result, distribution is becoming not only the art of reaching consumers but being successful in the quest for new products.

Intellectual capital is the real differentiator. As investors become more sophisticated, and consumers smarter, financial advisers will need to offer more choice, which will be hard to achieve if they are tied to the products of a single-asset management company. Asset managers will find rental of third-party distribution increasingly possible.

A fifth myth is that scale is needed if you want a firm which can offer a wide range of balanced and specialist mandates. As institutions lean more towards the US practice of splitting portfolios into a broad range of specialist mandates, some say smaller asset management firms will be at a competitive disadvantage unless they can offer a wider product range. The evidence from the UK suggests otherwise. The most recent data indicates that for the past 18 months, amongst the biggest losers of business have been three of the largest asset management houses. Amongst the biggest gainers of new mandates have been mid- and small-sized ones.

The mergers and acquisition trend in the asset management industry is sure to continue. Insurance companies, investment banks and other financial institutions continue to pay generous premiums to acquire the more secure earnings streams asset management firms offer. What is less clear is how investor-clients of the firms in these mergers and acquisitions will benefit. Anecdotal evidence suggests strongly that the key stakeholders in asset management firms - clients and employees - show signs of acute volatility when subjected to the stresses of a change of ownership.

Since the case for scale is flawed in many important respects, there is a lot to be said for firms large enough to deliver global competency, yet still small and nimble enough to be able to render a top-quality service to the client, big enough to deliver, small enough to care.

If size demonstrably delivered superior performance and service, there would be few independent asset management firms left. That there are so many still around and flourishing suggests this is not so. Investors should start to worry if the trend is not reversed soon.

David Brennan is chief executive, Investment Management Group, Baring Asset Management

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