Fund Management The Perfect Business

Win Win

There is nothing complicated about the reasons for the existence of the Fund Management profession: it is really very simple. The more money an individual or a firm have under management, the more money they will make. And best of all, it is not their money. If things go wrong, the customer – normally the general public – takes the loss. It is a perfect risk free business for so-called fund management professionals.

How Institutions Profit From Fund Management.

As one simple example, consider a fund of £100 million (small by stock market standards) where the fund manager is tasked only with “beating the returns” of, or outperforming, one of the leading UK Stock Market Indices – for example the FTSE 100: in this simple example, the fund would not be allowed to invest in any financial derivatives or other instruments, international currency variations would not be an issue, and the only permitted trading would be in the blue chip Company Shares that make up the Index.

The first decision would be as to how much liquidity (univested cash) should be in the fund: after all, if the fund is 100% invested, and no buying or selling takes place, then the result should be identical to the FTSE annual growth – or fall – and so how can a management fee of 0.75 per cent or £750,000 be justified? Of course, the actual trading that takes place in any fund is a closely guarded secret, but the reality is that the “experienced” Fund Manager if he is to outperform the Index will need to “take a view” and alter the liquidity in the fund over a period, maybe for example through profit taking, or possibly for the avoidance of further losses on certain stocks.

Here is where it gets interesting. Every time stocks are traded, this involves a commission – the difference between the buy price and the sell price – also known as the “spread”. This commission – which can be anything from 0.25% and upwards – will be debited to the Fund, and of course the more active the Fund Manager, the greater the commissions generated to the advantage of the market makers concerned, who are aften linked with or associated with the Fund Manager. And it is not uncommon for such a fund to generate far more in dealing commission “earnings” than the basic management fee, which in this example is £750,000 annually.

Of course, if the Fund Manager gets the investment strategy right (or guesses correctly, however you may view the process) then everybody is “happy” – meaning that there are no apparent victims. 

Churning If however, the fund performs below expectations, the fund manager may be accused of “churning”  or “over trading” with the purpose of generating extra commission. This really is difficult to prove one way or another, as the Fund Manager may argue with some justification that he is “only doing his job” and each trade was a judgement call at the time.

Scratching the Surface But this example of how one simple fund can provide far higher returns than the “management fee” is only scratching the surface. In reality, funds under management are massive – hundreds of billions of pounds or dollars: think of mutual funds, insurance and pension funds. And all the “sophisticated” trading and financial instruments available in use – with  hedge funds for example.