To do this, we need to understand the business of asset management. We will use the example of BlackRock. BlackRock, as an investment management firm, offers single- and multi-asset portfolios that cover a variety of asset classes such as equity, fixed income, private markets and money market instruments, where products are offered through vehicles such as ETFs and open- and closed-end mutual funds. Most of the largest asset management firms also operate similarly. Generally, the main drivers of revenue are management fees and performance fees.
As an investor intending to invest in these firms, it is important to note the difference between management fees and performance fees. Management fees are charged regardless of whether the funds make money and are usually a percentage of the assets under management (AUM). On the other hand, performance fees are charged if the funds make profits, usually above a hurdle rate. The disclaimer that “past performance does not guarantee future performance” is significant because performance fees can be erratic and volatile. However, management fees are much more stable since it is tied to the size of the fund or AUM.
Investment management firms that have a larger AUM should be able to grow their revenue much faster in absolute terms through management fees. Ideally, this should be a substantial portion of the firm’s revenue, compared to performance fees. In other words, stable and foreseeable income through management fees should make up a higher proportion compared to the more volatile performance fees, as it increases the risk of the business due to uncertainty. Charts 1 and 2 show the management fees and performance fees of BlackRock over the past 20 financial periods, quarterly, where the disparity in volatility is illustrated clearly. The smaller the ratio of performance fees to management fees, the less risky the business.
See also: CapitaLand Investment’s dynamic growth proposition
Chart 3 shows the net flow in AUM, which is a good gauge of whether the asset and investment management firms are successful in strategically using their expenses to grow their AUM. These expenses could exclude employee compensation and benefits, as they are not directly spent towards the sales and marketing of the fund. However, it could be argued that compensation is a form of incentive towards marketing to grow the investment management’s AUM. The important ratio note is the expenses to AUM or AUM net flows. In other words, does spending more on sales and marketing result in higher AUM growth? Lower expenses and higher AUM net flows would reflect better effective cost management.
See also: Is Ascott a good fit for CLI?
The rest of the metrics to consider are not specific to asset and investment management firms, including operating margins. Higher margins reflect a greater competitive advantage and better management of operating expenses. The challenge is to pick the most undervalued or relatively undervalued investment and asset management firm from the industry and peer group. To do this, we can compare the growth in fundamentals of the business versus the price growth. The fundamentals of the company can be represented by revenue, operating income, and AUM, where different weights are given for each factor. Revenue can also be further broken down into management fees and performance fees. Higher weights should be assigned to more important metrics, such as management fees, compared to performance fees, as in the case of BlackRock, given that the former is significantly higher in absolute terms and much lower in earnings risk. So long as the value growth is higher than the growth in price over multiple periods, why the firm is undervalued can be justified.
Another metric that investors can consider before investing in asset and investment management companies is the relative price ratios, both current and forward. Price ratios such as price-to-earnings and price-to-net asset value (or book) should reflect whether the company is trading at a premium or discount to its peers. If it trades at a significant discount, it could indicate that the company is cheap and undervalued; however, caution should be exercised if it has persistently traded at a discount, which could reflect fundamental problems with the business.
One key risk to consider when investing in asset management firms is the general performance of the equity market. A general market downturn would be unfavourable for most stocks if investors invest in funds and asset management companies that cover equity. This will likely affect the AUM of these companies negatively, as most of the largest funds invest in all sectors of the economy, which reflects general market movements. Also, higher competition and increasing regulation may lead to lower management fees and active fees, with one example being lower-fee ETFs.
Table 2 shows the valuation overview of the top 15 largest listed asset management firms globally.
