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Investment management is the business of investing other people’s money. It is the “buy side” of the broader financial industry. Investment managers, sometimes called asset managers or money managers, put their clients’ money to work in common stocks (equities), bonds and other fixed-income securities, commodities, or a combination of any of these. Their clients may be companies, government agencies, non-profit organizations, and individuals—in short, anyone who has money to invest.
The investment management industry (IM) manages hedge funds, mutual funds, private equity, venture capital, and other financial investments for third parties, which include companies, pension funds, endowments, insurance companies, private banks, nonprofits, and individuals. The IM industry is also known as the asset management industry. The competent management of hedge funds, mutual funds, and other financial investments provides financial security to Americans, allows companies to grow and prosper, and fuels the U.S. and world economies. The recent European financial crisis and the U.S. financial crisis of 2008–2009, underscore how important strong investment management is to the health of the U.S. and world economies.
Hedge funds are privately offered, professionally managed investment vehicles that seek, like all financial investments, a positive annual return, limited variations in value, and the preservation of capital. HedgeFundFacts.org reports that “hedge funds play a critical role in the financial markets, broadening the use of investment strategies, increasing the number of participating investors, and enlarging the pools of capital available.” As of April 2014, hedge funds managed more than $2.7 trillion in assets, according to Hedge Fund Research, Inc.
Mutual funds are a group of financial assets (such as stocks) that are managed by a portfolio manager. The Investment Company Institute reports that, in 2013, these funds managed $17.1 trillion in assets for nearly 98 million U.S. investors. Worldwide mutual fund assets were $15 trillion at the end of 2013, according to the ICI.
Private equity consists of funds obtained from investors that are then invested in mature, private companies. Over time, private equity firms build up an equity stake in the company with the goal of eventually taking over the company and turning a profit on their investment. Private-equity firms invested more than $144 billion in 1,702 U.S.-based companies in 2011, according to the Private Equity Growth Capital Council (PEGCC). The top 10 states in terms of investment were Texas, New York, California, North Carolina, Oklahoma, Florida, Massachusetts, Illinois, Colorado, and Georgia. Critics of private-equity firms believe these firms are bad for companies and employees in the long run because they often focus on streamlining or liquidating inefficient or outdated businesses, which often results in people losing their jobs. The PEGCC counters that “the direct investments made by private equity firms have a multiplier effect as the companies in which they invest hire workers, invest in research and development, and pursue new innovations and products. In short, private equity investment drives significant economic activity and growth.”
Venture capital consists of funds obtained from investors that are invested in young, innovative companies in exchange for an equity stake that hopefully can be translated into a profit when the company goes public or is merged with or sold to another company. The National Venture Capital Association (NVCA) reports that “venture capital is a catalyst for job creation, innovation, technology advancement, international competitiveness, and increased tax revenues.” Some of America’s greatest business success stories were founded with the help of venture capital, including Apple, Amazon, Google, FedEx, Starbucks, Staples, and Intel. In 2013, venture capital firms invested about $29 billion into nearly 3,382 companies, according to the NVCA. The largest area of venture capital investment was in software, where companies received 37 percent of the total funding.
Over the course of the last 100 years or so an entire industry came into existence, built on the idea that professional money managers have the skills to invest their clients’ money safely and with a certain level of confidence. However, investing is still risky business. Money managers are careful to point out in their marketing literature that “past results are not indicative of future performance.” But for investors who don’t have the time or the expertise to manage their investments, investment managers offer some assurances that they have the skill to deliver the goods consistently and reliably over time.
For much of the past century, investors’ choices were limited to traditional investments: stocks, bonds, or cash (or investment pools owning stocks or bonds, such as mutual funds). All were regarded as prudent choices for the average investor. About 20 years ago, the universe of investment options began expanding exponentially. Wealthy individuals and big pension plans wanted to own securities that cushioned their holdings when the markets whipsawed. They began putting more of their money into nontraditional investments: hedge funds, private equity, venture capital, and other alternative investments. Successfully investing with these new options requires additional expertise, making investment management all the more helpful for investors.
Although they have some discretion about how to handle investments, investment managers follow guidelines given by their clients. These might be the investment policy for a pension plan or the prospectus of a mutual fund. These guidelines describe the types of permitted investments, the investment manager’s compensation, and other details of the portfolio. The actual “assets under management” are owned by clients, and investment managers have no physical control or direct access to clients’ assets. Generally third-party custodians, such as trust companies, chosen by clients are contracted to hold the assets. That’s one reason investment managers have small balance sheets and little debt when compared to other financial services firms.
Investment managers play a unique role in the financial services industry. Their business model is fundamentally different than commercial banks, investment banks, or insurance companies. Investment banks act as principal in proprietary trading, securities underwriting, and prime brokerage; commercial banks access their depositor base or the capital markets to make consumer and business loans; finance companies tap the capital markets and essentially re-lend these funds; and insurance companies provide long-term financing for real estate.
On the other hand, investment managers are paid on a schedule based on the amount of assets under their management. The revenue sources for managing investments are the fees for the advisory services provided—selecting securities and managing the portfolio according to the client’s guidelines. The fee structure generates a more stable income stream than that of an investment bank or any other transaction-oriented financial institution.
Another important difference between a commercial bank and an investment manager is the absence of government backing such as deposit insurance. Banks accept deposits that, in the United States, are insured by the Federal Deposit Insurance Corporation. Investment managers have no such safety net. They clearly disclose to clients that investment performance is not guaranteed by the manager, the government, or any other party.
Investment managers represent their clients in making buy or sell decisions, acting as trusted agents. Their income is typically a percentage of the funds managed, which means a manager’s earnings can vary widely from one year to the next. A major sell-off in the stock exchanges can sharply reduce earnings.
Investment managers do not invest with their own funds (other than seed capital or small co-investments) or make promises about expected investment performance.
Taking a top-down view, about 7.6 million Americans work in financial services in one capacity or another. Many are involved every day in the world of investing in four different classes of investments: mutual funds, hedge funds, private equity, and venture capital. They advise clients, analyze securities, make investment and trading recommendations, run investment portfolios, or perform other essential duties.
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