Boyd Erman wrote an article before Christmas titled " Squeeze Is On For Smaller Investment Firms." When I saw the headline, I shuddered a little. Was he going to talk about firms that don't have billions of dollars under management? Was he going to burst my bubble?
Well, after a couple of sentences I realized the article was about the "sell" side of the Street in these treacherous markets – the investment dealers that research, sell, trade and underwrite securities. Phew.
But what about the asset managers? How does the size challenge reveal itself on the buy side?
Let me say off the top that it's not nearly as scary. Certainly, the smaller independent firms would like to have more scale in areas such as sales and marketing, compliance, processing and administration. But there are some significant differences that make the buy side a friendlier place for the small fry.
First and foremost, asset management is not a capital-intensive business. Investment firms that manage money for clients need enough capital to fund operations and satisfy regulatory requirements, but a large capital base is nothing more than a drag on profit margins.
As for what drives money management – investment research – the playing field was levelled in 2000 when Regulation FD came into effect in the U.S. Reg FD prevents the selective disclosure of nonpublic information. In other words, an analyst from a mega-firm can't (or shouldn't) hear something from a CFO that hasn't already been disclosed to the public. Today, when corporations do their quarterly conference calls, small managers can listen in just like the big players.
But more importantly, the buy side is less threatened by large firm domination because it's an anti-scale business – the bigger a manager gets, the more difficult it is perform. While this adage has generally proven out, each area of the business is affected differently.
In general, our relatively illiquid Canadian market is a challenge for large firms. Equity managers with a few billion dollars to invest are forced to concentrate on the largest 80 to 100 stocks.
Size is less of a constraint outside of Canada. The U.S. and overseas markets offer a broad array of companies to invest in. Indeed, it's possible to be too small for international investing, as a minimum commitment is necessary to deal with the number of offerings, longer travel distances and different regulatory regimes. It can be done with a small, experienced team, but a global footprint helps overcome these hurdles.
A manager also needs critical mass for bonds. Canada's corporate market is still relatively illiquid, but if managers are too small, they won't see bond offerings until all the big guys have been filled (or have passed). Also, the market is getting more complex, which requires a serious research effort. Early in my career, small investment counsellors were stock pickers. If bonds were needed to balance out a client's portfolio, the admin assistant phoned a broker and bought some Government of Canada bonds. Not so today.
Clearly, in some asset categories, having horsepower is an advantage, but there are tradeoffs. More people in more locations means the decision-making process is prone to slippage and compromise. Bigger engine, but clunkier transmission.
I can't finish this comparison without mentioning fees. This is an area where the buy side has a greater ability to differentiate. On the sell side, trading commissions and underwriting fees are pretty standard across all dealers, but asset management fees can range from a few basis points for indexing to a 2-and-20 arrangement (2 per cent base plus 20 per cent of the return) for more specialized categories such as hedge funds. Small buy side firms that deliver a unique product can charge more and, as a result, be profitable on fewer assets.
Now don't get me wrong, it's no treat operating in the shadows of the big players. The banks and insurers are marketing machines and have plenty of advertising dollars to throw around. The large foreign firms have seemingly unlimited resources. But in the asset management business, their challenges are just as tough as the small firms' – they have to manage their anti-scale.