chapter 6-asset management

8/10/2019 Chapter 6-Asset Management

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Asset Management and Research


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Asset Management Asset Management refers to the professional

management of investment funds for individuals,families and institutions

Investments include stocks, bonds, convertibles,

alternative assets (such as hedge funds, privateequity funds and real estate), commodities, indexes ofeach of these asset classes and money marketinvestments

Asset managers specialize in different asset classesand management fees are paid based on the assetclass

For alternative assets, additional fees are paid based

on investment performance as well


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Alternative Assets Management fees can range from 1% to 2% of assets

under management (AUM) and additional fees are chargedbased on the fund managers performance

Some alternative asset managers receive performancefees of 10% to 20% on the annual increase in value ofassets. This means that if a high net worth investorentrusted $10 million to an alternative asset manager, andthe value of this investment increased to $11.5 million inone year (a 15% increase), the asset manager would bepaid as much as 2% x $10 million = $200,000management fee, plus 20% x ($11.5 million - $10 million) =$300,000 performance fee. So total fees paid would be$500,000, which is, in effect, a 5% fee on the original $10million investment

Although this may seem high, the investors net return isstill 10% after fees. Therefore, despite the high feepercentage, this may be a suitable fee arrangement for an

investor if the net return is better than net returns fromother investment choices


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Investment Banks Have Large AssetManagement Businesses

Global Investment Bank Asset Management DivisionsFirm AUM ($bln)

Bank of America $1,945

Morgan Stanley $1,628

UBS $1,559Wells Fargo $1,398

Credit Suisse $865

Deutsche Bank $368

J.P. Morgan $284

Goldman Sachs $229Barclays $185

Source: Scorpio Partnership's Annual Private Banking

Benchmark for 2011


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Performance Measurement Fund performance is a key metric when evaluating

Asset Management capabilities Investors measure this by relying on different

performance measurement firms, such asMorningstar and Lipper, who compile aggregate

industry data that demonstrate how individual mutualfunds perform against both indices and peer groupsover time

For alternative asset classes such as hedge fundsand private equity, there are specialized industry

research firms that track fund performance Many funds are ranked into quartiles based on theirrelative performance each quarter and each year

Inevitably, top quartile funds draw disproportionatelymore investable funds whenever rankings are

announced


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Performance Measurement For alternative assets such as hedge funds, it is commonto measure performance not only on a relative basis, but

also on an absolute return basis These funds attempt to achieve a positive (non-negative)

return (and not just beat a certain benchmark) through theuse of derivatives and by creating short positions indifferent asset classes

Performance measurement is often not just focused onreturns, but on risk-adjusted returns as well

Modern portfolio theory has established the qualitative linkthat exists between portfolio risk and return: the Capital

Asset Pricing Model (CAPM) developed by Sharpe in 1964highlighted the concept of rewarding risk This led to the creation of risk-adjusted ratios including the

Sharpe ratio, which measures the return of a portfolio inexcess of the risk-free rate, compared to the total risk ofthe portfolio


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Hedge Fund Investments Most major investment banks have large hedge funds

housed within their Asset Management Division

These funds are managed principally for the benefit ofinvesting clients (although the bank and employees ofthe bank may also invest in the fund) and areseparate from the proprietary investing activitiesconducted within the Trading Division (which investssolely for the account of the firm, without any outsideclient investments)

J.P. Morgans total hedge fund AUM at the end of2011 was over $47 billion, making the bank one of the

worlds largest hedge fund managers

Goldman Sachss total hedge fund AUM at the end of2011 was over $20 billion


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Private Equity Fund Investments Most large investment banks participate in private

equity as an investor for their own account

The Dodd-Frank Act has reduced the amount ofprivate equity investments

Banks also provide private equity funds forinvestors to invest in as part of their AssetManagement Division

Direct investments in and funds offered by manyinvestment banks are in the following areas:leveraged buyouts, mezzanine (subordinateddebt with attached equity warrants), real estate

and infrastructure transactions


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Wealth Management Wealth Management refers to advisors who provideinvestment advice to individual, family and institutional

investing clients Wealth Management advisors identify investors who have

a significant amount of funds to invest and then help theseinvestors make investments in different asset classesbased on risk tolerance and diversification preferences

Wealth Management advisors are not directly involved inthe management of asset classes (which is the role ofAsset Managers)

They either assist investors in self-directed investments, or

if preferred by clients, make investments on the investorsbehalf

They also help clients obtain retail banking services, estateplanning advice, legal resources, and taxation advice

Wealth Management advisors must exercise goodjudgment in allocating funds to achieve high investmentreturns and appropriate diversification relative to client risk


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Wealth Management Wealth Management advisors typically limit their

services to clients that have more than $5 million ininvestable funds

Some banks require an even higher amount of funds

in order to focus attention and limited resources oninvesting clients

For example, subject to a number of considerations,Goldman Sachs largely limits its Wealth Management

efforts to clients that have more than $25 million ininvestable funds

Some banks have created a private client servicesbusiness that brings many, but not all Wealth

Management services to investors who do not meetthe investable fund threshold amount required to be


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Retail Brokerage Individual investors that have an even lower amount

of investable funds are covered by retailadvisorsand brokers who help them invest cash in both the

Asset Management products offered by the bank andproducts offered from external sources

All of the largest investment banks, with the exceptionof Goldman Sachs, have a retail team

Citigroups Smith Barney division established a jointventure with Morgan Stanley during early 2009

(majority owned by Morgan Stanley, with the right byMorgan Stanley to acquire 100% ownership in thefuture over a five-year period)

The new Morgan Stanley Smith Barney joint ventureis now the largest retail brokerage


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U.S. Brokerage Ranking

U.S. Brokerage Force Ranking, as of December 2010

Firm

Number of

Brokers

Revenue

($ in billions)

Revenue per

Broker

Client Assets

($ in billions)

Morgan Stanley 18,043 $12.6 $742,000 $1,700Bank of America/Merrill Lynch 16,722 $11.6 $694,000 $1,480

Wells Fargo/Wachovia 15,200 $6.9 $454,000 $1,200

UBS (U.S. division) 6,783 $5.3 $782,000 $715

Source: Respective 10-K filings


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Avoiding Conflict of Interest During 2005 and 2006, both Merrill Lynch and Citigroup decided

to give up control over their asset management businessbecause, among other reasons, they wanted to avoid a potentialconflict of interest between the wealth management advisoryfunction and the asset management function

In 2005, Citigroup entered into an arrangement with LeggMason, Inc whereby the brokerage portion of Legg Mason wasbought by Citigroup, while the asset management business ofCitigroup was bought by Legg Mason

In 2006, two months after the Citigroup-Legg Mason deal closed,

Merrill Lynch entered into an arrangement with BlackRockwhereby Merrill Lynchs asset management business mergedwith BlackRock, creating a new independent company withnearly $1 trillion in assets under management

Merrill Lynchs ownership of the combined asset management

company was 49.8%, and it came with a 45% voting interest in afirm that had a ma orit of inde endent directors


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Research Research is provided by all large investment banking firmsto selected institutional and individual investing clients on a

global basis This research usually covers equity, fixed income, currency

and commodity markets

Equity research focuses on public company specificanalysis as well as on industries and attempts to projectfuture cash flows and share prices

Fixed income research focuses on corporate debt in thecontext of the issuers industry and is critically dependenton understanding credit risks

Commodities research is a globally focused effort thatprincipally analyzes energy and precious metals

Research professionals also focus on economics, portfoliostrategy, derivatives and credit issues, offering insights andideas based on fundamental research


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Research Research is typically (but not always) housed within

the Trading Division of an investment bank and iscomprised of two different groups

Research that is provided to investing clients of the

firm is called sell-sideresearch Research that is provided to proprietary traders who

trade for the account of the bank and to the banksasset managers, who manage money for investing

clients, is calledbuy-side

research

This is the same type of research that hedge fundsproduce for their internal traders, or that large mutualfunds such as Fidelity produce for their internal fund

managers


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Sell-Side Research Sell-side research has always been an analytically intense

area within investment banks where research analystsproduce detailed financial models that forecast earningsand the future value of assets

For example, equity research is produced by analysts who

build models that forecast a companys future revenueand earnings based on several factors, including companyguidance, economic conditions, historical trends and newcompany, product or industry information

Analysts use multiples based on enterprise value,revenue,

EBITDA, earnings, book value, and cash flow in order tohelp assess a companys future share price

Analysts also employ other valuation models such as peercomparisons, discounted cash flow analysis, orreplacement value analysis and then use this information

to formulate an investment opinion, which is thencommunicated to investors or investment advisors


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Paying for Research Research departments have historically received revenue

from investing clients through an indirect mechanism: partof the commissions paid by investors to salesprofessionals when they buy securities is redirected to theresearch department

Thissoft dollar

compensation arrangement has been a

key part of sell-side research for decades, since investorsare generally reluctant to pay direct fees for the use ofresearch

For example, an investor who values equity research

provided by a sell-side analyst at an investment bankmight be willing to pay a commission of 3 cents per sharefor common shares the investor purchases through thebank (instead of 2 cents a share the investor will pay toother investment banks who do not provide good research)

In this example, 1 cent per share will be redirected to theresearch department as soft dollar compensation


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2003 Research Settlement Because of the conflict between bankers and researchprofessionals, during April, 2003, the SEC, New Yorks

attorney general, the National Association of SecuritiesDealers (NASD), and the New York Stock Exchange(NYSE) announced enforcement actions against thefollowing 10 investment banks: Bear Stearns, Credit

Suisse, Goldman Sachs, Lehman Brothers, JPMorgan,Merrill Lynch, Morgan Stanley, Citigroup, UBS and PiperJaffray

The banks were required to pay a total of approximately$1.4 billion, comprised of $875 million in penalties anddisgorgement, $432.5 million to fund independentresearch, and $80 million to promote investor education

In addition to the monetary payments, the firms were alsorequired to comply with significant requirements thatincluded eliminating any influence by the InvestmentBanking Division over the research department, increasing

supervision and making independent research available toinvestors


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2003 Research SettlementProvisions There must be a physical separation between research andinvestment banking professionals

The firms senior management must determine the researchdepartments budget without input from the Investment BankingDivision and without regard to specific revenues derived frominvestment banking activity

Research analystscompensation may not be based, directly orindirectly, on Investment Banking Division revenues or on input

from investment banking personnel

Research management must make all company-specificdecisions to terminate coverage, and investment bankers canhave no role in company-specific coverage decisions

Research analysts are prohibited from participating in efforts tosolicit investment banking business, including pitches androadshows

In addition to providing their own research, investment banks areobligated to furnish independent research to investing clients


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Regulation FD

Regulation FD (Fair Disclosure) was implemented by the SECduring 2000

This regulation prohibits a companys executives fromselectively disclosing material information that could impact acompanys share price

This means that prior to discussing any potential stock moving

information with research analysts, the company must disclosethis information through an SEC filing

Prior to Regulation FD, some large institutional investorsreceived stock moving information before other investorsreceived it based on private discussions that a company had witha research analyst, which was passed on selectively to favored

large investors The benefit of this regulation is that it levels the playing field,

enabling all investors to receive the same information at thesame time

However, critics claim that because companies must now bemore careful in what they say to analysts and investors, and

when they say it, less information is distributed in a less timelyway, reducing the quality and depth of information

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