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Beware the health of your managers

Funds management is largely a fixed-cost business and with assets declining sharply due to both markets and redemptions, many managers are under financial pressure. Investors beware.

Russell Investments has come up with a 10-point checklist for institutional investors to look for warning signs that their managers may be in difficulty.
The consulting firm says that in the current environment many money managers will not only strive to protect their reputations but also the profitability and viability of their businesses.

“Russell is recommending investors now consider their exposure to investment managers as an important risk factor.”

The warnings signs are:

1.       What is the impact of falling assets under management on a manager’s revenue and profitability?

The profitability of money managers is largely driven by their level of their assets under management. Fund managers tend to charge fees based on the size of the assets under management.
With the market down more than 40 per cent and investors withdrawing assets, some firms have seen their profitability sharply decreased or possibly even evaporated.  This can also lead to questions around whether your manager still has the capacity to retain their key investment talent, or to keep investing in talented juniors.

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2.       Has the manager suffered any large client departures?

Some large institutional clients that are more sensitive to short-term performance can aggressively react to poor market conditions.  The loss of sizeable investment mandates (for example, $500 million-plus) will significantly impact revenues and could also lead to a contagion effect, whereby other clients follow suit.  In addition, firms who are reliant on niche products which have now become unpopular may be especially vulnerable if clients decide to de-emphasise those strategies in their portfolios.

3.       Is the current environment impacting the focus of key investment professionals?

An important consideration for firms during a crisis is to keep clients well informed and to address their anxiety. Some money managers are also spending time fending off questions from the media.  This can be a major source of distraction for managers as the time spent on these types of activities blows out – taking time and focus away from stock selection decisions and managing your assets.  You need to consider the depth of the client relationship team and the ability of the organisation to support its key investment professionals.

4.       Do the skills and personal characteristics of your money manager leave you confident they are equipped to navigate the turmoil?    

Generally speaking, in a bull market most managers should be returning good absolute returns. However the current environment is displaying unprecedented levels of volatility driven by extraordinary market factors ^ meaning no-one has true experience managing money in this sort of crisis.  An experienced investment team may not be particularly skilled in navigating the current volatility, while a particularly skilled manager may lack experience making investment decisions in a massively complex environment. Investors need to be confident that the investment professionals have a suitable combination of the necessary skill, experience and attributes to manage through the current turmoil.

5.       Is the manager’s business model reliant on performance fees?

Many managers have adopted performance fee-based models over the last few years. The idea is that they will incentivise managers to achieve better returns. Performance fees are widely used by the investment managers of hedge funds, which typically charge a performance fee of 20 per cent of the increase in the NAV of the fund. These models may however be severely impacted by the recent market slump.  This could be particularly painful for firms promoting absolute return products, where high watermarks could mean little prospect for performance fees in the coming years, creating a disincentive for managers to focus on the ongoing performance of the strategy.

6.       Does the firm carry substantial balance sheet risk?

In recent years a number of fund managers have developed structured products whereby the firm provides an implicit or explicit guarantee of return, which may result in a material contingent liability on their balance sheet. Given the extreme market conditions, it is more likely that a manager would be required to make good on such a guarantee, or the size of the payment could be much larger than has been anticipated.

7.       Are there risks around the manager’s ownership structure?

Some managers may be at risk due to the financial health of their parent companies or joint venture partners.  Managers whose parents are global financial services firms that are experiencing distress are particularly susceptible. It is important that investors understand the ownership structure of their investment manager, and the financial strength of the parent company.

8.       Have there been any signs of capitulation in the manager’s investment decisions?

A highly volatile environment has replaced the previous bull market and commodities rally.  It is important to understand whether your manager has capitulated on key portfolio positions or changed its investment processes in response to the current climate. This can mean that the investor is not getting the type of portfolio they expected and also increases the risk that the manager could be whipsawed if the market rebounds suddenly. Even though few investors are able to observe a manager’s actions as closely as Russell, careful examination and comparison of manager communications over time can give important clues to changes in a manager’s investment approach.

9.       Has your manager started cutting staff?

The bull market led to significant expansion of some fund managers on expectation of future growth. Many money managers are coping with lower asset bases by cutting costs and firing workers. The likelihood of a global recession and the market slump may result in downsizing, which can be destabilising to teams which are new and still fragile. Check to see which staff are being let go, and consider how involved they were in producing the investment performance to date.

10.   What is your manager’s product strategy?

Whilst it is fair to say new products in isolation are not a clear warning signal, when suffering poor performance or lower profitability, a fund manager may try to expand its range of products in order to diversify revenue sources.  Investors should consider whether new products are a revenue-seeking exercise or actual innovation that is properly resourced and positioned to add value for investors.  The launch of new products requires a large amount of time and can divert resources from existing products.  Investors should also be on the look-out for products that have had a large withdrawal of support or have simply become too small due to poor performance.  This can leave the manager with a product that isn’t really viable but may not be readily shut down.  The consequence may be that the product becomes a ‘legacy’ fund and isn’t given proper attention by the manager.

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