As the Australian funds management industry continues to evolve, it is important to demand the highest standards from the firms that are entrusted with managing other people's savings. Australia's compulsory superannuation regime has provided a fertile environment for funds management businesses. Barriers to entry are relatively low for what is a capital-light and highly scalable business model. This backdrop has seen numerous business structures emerge, from more-traditional diversified financial institutions to ultrafocused single-strategy boutiques. The landscape is continuing to change, with mega mergers among both publicly listed firms and industry superannuation funds, and there appears no shortage of boutique startups readily backed by specialist 'incubator' firms. Faced with such a broad and changing range of options, investors should consider which funds management model is going to provide the best structure for long-term alpha generation. At Morningstar, we ponder this question in our assessment of the Parent Pillar, which is a key input into our overall ratings framework. This article outlines the key attributes that we believe investors should look for in a fund manager and examines the differing funds management models in Australia.

What makes a good fund manager?

The key attributes we look for in a parent is strong stewardship and the ability to deliver positive net alpha to investors over the long term. There are many factors that drive this, including:

• An enduring business model that will be around for investors over the long term
• A culture of putting investors first
• Well-considered and executed capacity management
• A focus on creating centres of investing excellence
• The ability to attract and retain investment talent

Let's explore each factor in more detail.

An enduring business model

To be successful, investors need to take a long-term view. It is therefore critical that any fund manager under consideration will be around for the long term. With low barriers to entry, many individuals will try their hands at funds management, but to build an enduring and sustainable business, a certain level of scale and profitability must be reached. Larger and more established firms have an advantage here, but to address the business risk of new ventures, many startups will seek the backing of a well-funded equity partner that can provide a guarantee of working capital over a period of time. Indeed, Australia has seen the rise of the 'boutique incubator' model to solve this problem. For more-established firms, investors should consider customer concentration risk. Large redemptions (such as from institutional investors) can jeopardize the financial sustainability of the firm. It is important for investors to examine and understand the financial backing and risks associated with the fund manager itself, to ensure they will be around for the long term, and not close their doors prematurely because of a lack of profitability.

A culture of putting investors first

To be a good steward of investor capital, funds management firms must have a strong culture of putting investors first. Unfortunately, conflicts of interest exist in any business, but investors should have a clear understanding of how these are managed. One of the biggest conflicts is a firm's desire for profit maximisation, which will come at the expense of investor returns. Fund managers derive their revenue from investment management fees, which are deducted from investment returns. As mentioned above, firm profitability is important to ensure long-term sustainability, but above a certain level, fund managers should look to share the benefits of scale with investors through lower fees. Funds management businesses may also seek to maximise profits through asset growth and new product development. This must be managed carefully to not distract or detract from existing offerings (see capacity management below). While all super fund trustees and responsible entity board members have a fiduciary duty to act in unitholders' best interests, public company boards also have a duty to maximise shareholder returns. This doesn't make them any more conflicted than private companies, which have their own shareholders to consider, but profit drivers for listed companies are more visible because of reporting requirements. Indeed, this public company transparency can be helpful, allowing investors to assess whether the right balance has been struck. Industry funds are the best placed to maximise unitholder interests, as profits are reinvested for the benefit of members. Nevertheless, it remains important to ensure that costs are managed appropriately and strong governance practices are in place.

Well-considered capacity management

A key component of good stewardship is well considered and executed capacity management. There is a limit to the level of assets under management a firm can effectively manage before market impact costs have a detrimental impact on investor returns. If a fund manager is less conservative with regard to capacity, this may be a sign that it is seeking to gather assets to maximise profits, rather than protect the interests of existing investors. Given that successful firms tend to attract the highest levels of flows, it can be a difficult decision to soft-close or hard-close a strategy to new money in order to preserve capacity, but it is an important discipline to maintain. The other major driver of asset growth in recent years has been consolidation, particularly in the industry superannuation fund segment. The merger of Sunsuper and QSuper has seen the assets of Australian Retirement Trust exceed AUD 200 billion, joining AustralianSuper in what has been termed the 'mega fund' category. This is a double-edged sword as the potential cost savings from scale are countered by capacity management challenges, particularly when combined with the internalisation of the investment management function. Unfortunately, there is no standard measure of a firm’s capacity, and it is often treated as more of an art than science. The least useful measure that is most often touted by fund managers is looking at strategy size as a percentage of total market capitalisation. This figure has little relevance for active managers that seek to concentrate their investments in specific areas of the market, rather than simply replicate the total market. Much more useful are the two measures we focus on: days to trade and substantial shareholdings. Days to trade is an objective measure of the time it would take to liquidate an individual position or total portfolio based on the average trading volume of that security. As a rule of thumb, we believe a fund can trade 25% of average daily volume without having an undue impact on the price. The less time it takes to liquidate a position, the better, as it enables the fund to be nimble in the face of market shifts. Fewer than 10 days to trade represents a highly liquid portfolio, but beyond 30, 60, and 90 days begins to raise questions around capacity management. For equities, we also monitor the number and weight of substantial shareholdings (greater than 5% of issued capital). A large number of substantial shareholdings or individual holdings in securities that account for greater than 10% of issued capital are a signs that capacity management should be closely scrutinised.

A focus on centres of investing excellence

When it comes to managing money, it is better to be good at one thing than average at many. This is one of the main benefits of the boutique asset-management model—a singular focus on an area of excellence rather than suffering from the distractions of a diversified product offering. Larger diversified firms can overcome this issue by developing individual centres of excellence under a single firm umbrella, but it is not easy. The rise of the boutique asset-manager model has seen increased competition for talent. Larger diversified firms must continue to evolve to create an environment that nurtures and retains investing excellence. Industry funds have increasingly moved toward the internalisation of investment teams. This is a significant shift in approach and brings a substantial challenge of maintaining a strong investment culture across each individual asset class.

The ability to attract and retain talent

Funds management is an industry reliant on human capital and individual talent. The boutique model's emergence was due to star fund managers wanting to own their own businesses and be masters of their own destinies. The list of portfolio managers who have left large, diversified asset managers to start their own shops is a long one. While boutiques have had an edge, diversified financial-services firms and industry funds are evolving their business models to address the issue of talent retention. Revenue share models and shadow equity arrangements have become more common as large firms seek to replicate the economic benefits of the boutique structure. There are other benefits that a larger diversified firm can bring, such as greater distribution, compliance, and administrative support. But this is where the boutique incubator models have stepped in to simplify the business ownership experience and allow fund managers to focus on alpha generation. The main drawback of the industry's reliance on individual talent is key-person risk. Recent history shows that despite all the incentives of equity ownership and profit-sharing, portfolio managers may choose to leave for unexpected and personal reasons. All fund managers should have a clear succession plan in place. The onus is on the board and management to ensure that contingencies are well-thought-out and implemented

An overview of the funds management structures in Australia

When it comes to providing the best platform for investor success, the various funds management models in Australia have a number of advantages and disadvantages to consider. We broadly categorise the market in Australia into three distinct funds management models:

• The diversified financial firm
• The boutique
• Member-owned and profit-for-member industry funds

The diversified financial firm

Diversified financial firms are those that provide investment management services across a range of asset classes, as well as internally managing their own compliance, marketing, and distribution. They are full-service firms, with many historically going so far as to vertically integrate into advice. These firms once dominated the Australian funds management landscape. Perpetual and AMP were stalwarts of the industry, followed by Pendal (formerly Bankers Trust). The major offshore players have also entered the Australian market, either directly (Vanguard, Fidelity, BlackRock, and T. Rowe Price) or via acquisition (Nikko). The benefits of diversified financial firms are scale, diversification across asset classes and products, and financial strength. These businesses should have longevity when managed well, although this is not assured, as we have seen in Australia, particularly if a firm's culture strays off course. The key strengths of the business model have the potential to become weaknesses. Size and scale bring complexity and a lack of focus, and success can evolve into hubris. As with any firm, leadership is key. Diversified financial firms are able to deploy significant resources into not only investment capability, but product development, client services, and environmental, social, and governance investing. The drawback is the lack of focus on a single area of investing excellence. Retention of talent has historically been difficult, with talented individuals drawn to the potential of the more lucrative equity ownership structure of boutiques. Diversified financial firms can address this in a number of ways. They can make the firm greater than the individual, as has been the case with Fidelity and Perpetual, or increasingly they have sought to give talented individuals equity-equivalent packages like revenue share arrangements.

The boutique

Boutiques have flourished in Australia over the past 30 years. The attraction for talented managers to strike out on their own and be in control of their own destinies is strong. Boutiques have made a number of individuals extremely wealthy. Platinum Asset Management and Magellan Asset Management are two of Australia's most successful boutique investment managers that have grown into large firms. The challenge of setting up a new firm has been made easier by the emergence of boutique incubators such as Fidante and Pinnacle. These businesses take a minority stake in the new boutique in exchange for providing startup working capital as well as distribution, marketing, and administrative support. While a singular focus is a key strength of the boutique model, it can also expose weaknesses. The success or failure of a boutique can be dependent on one or two key individuals, resulting in substantial key-person risk. Business sustainability can also be endangered by a concentration in assets among a few key clients. Numerous boutiques have closed in Australia because of personal or commercial reasons, even when a boutique incubator has been involved.

Member-owned and profit-for-member industry funds

Member-owned and profit-for-member firms reinvest profits back into the business to benefit all members. Vanguard has been the poster child for the member-owned model over the past half century, with scale benefits reinvested back into lower fees. In Australia, industry superannuation funds are set up as profit-for-member and have a similar ethos of passing on the full benefit of scale to investors. The success of industry super funds in Australia has introduced its own challenges, given they have become behemoths in themselves. Capacity management is a key challenge, particularly after many funds have internalised the investment function. One solution has been increased investment in alternative asset classes and unlisted investments, which carries additional liquidity risk. Industry funds are having to undergo a cultural change as they shift from being administrators and asset allocators to being fully fledged investment managers.

Conclusion

While funds management firms come in a variety of shapes and sizes, the features that make them effective stewards of investor capital are not exclusive. There is no single model that has all the answers. Rather, investors must analyse businesses on their own merits, identifying where they have maximised their strengths and minimised their weaknesses. Culture and effective stewardship cannot be taken for granted, and it requires the constant efforts from a firm's management and board to ensure that interests are aligned and there is the greatest chance of long-term net alpha generation. Morningstar is committed to helping investors make an educated assessment of their fund managers through our Parent Pillar ratings.