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Like banks, asset managers and insurance companies make profits from other people's money. Asset managers charge a fee for investing clients' money in stocks or bonds, and insurance firms invest the money they receive from customers' insurance premiums to generate additional earnings on top of their core underwriting businesses. However, the basic economics, and hence the economic moats, of these two groups of firms couldn't be more different. Asset management is incredibly lucrative, and even a poorly managed asset manager is likely to post stellar financial results. Historically, asset managers have been excellent investments, and they're well worth getting to know. By contrast, the insurance industry is extremely competitive, making it tough to build a lasting economic moat. In this chapter, we'll dig into the nuts and bolts of how these firms make money and highlight what you should look for when examining asset managers and insurers.

Asset Management

With huge margins and constant streams of fee income, asset managers are perennial profit machines. However, these companies are so tied to the markets that their stock prices often reflect oversized doses of the current optimism or pessimism prevailing in the economy, which means it pays off to take a contrarian approach when you're thinking about when to invest. The best asset managers can present truly outstanding investment opportunities "when they are selling at the right price.

What Makes Asset Managers Tick

Most people are familiar with mutual funds, but what about the companies that manage them? Asset management firms run money for their customers and demand a small chunk of the assets as a fee in return. This is lucrative work and requires very little capital investment. The real assets of the firm are ks investment managers, so typically compensation is the firm's main expense. Even better, it doesn't take twice as many people to run twice as much money, so economies of scale are excellent. This means that increases in assets under management—and, therefore, in advisory fees—will drop almost completely to the bottom line. All this adds up to stellar operating margins, which are usually in the 30 percent to 40 percent range—something you won't see in many industries.

The majority of asset managers we cover have economic moats, especially if money management is the company's main business segment. Attaining scale in this industry is evidence of a solid moat. Beyond the favorable economics mentioned previously, asset managers also benefit from reaching a level of maturity and scale that is almost impossible for upstart firms to duplicate. Gathering assets takes time, and gaining significant scale (at least $10 billion in assets under management) takes a track record. Most funds toil in obscurity until their third birthday, and even then, it takes years to build up an asset base. This puts large, established asset managers at a huge advantage.

Asset managers create wide economic moats by establishing a dominant presence in a profitable segment of the industry. The most important compet­itive advantages we look for are diversification (both in products and customers) and stickiness of assets (money that stays with the firm even when times are tough).

Diversification: Because of their close ties to the market itself, asset management stocks tend to move in tandem with the broader equity indexes.

Many investors think that selling investment products in a bear market is like selling popsicles at the North Pole. But in truth, the correlation to any particular market is more difficult to pin down because many asset managers now sell a broad array of products, from money markets to bonds to equities to hedge funds, all of "which thrive under different conditions.

Diversity of products is one way asset managers overcome market fluctuations. Bonds and money markets, which may look as dull as ditch water in a great equity market, can be an oasis in a bear market. Even better, having a large stable of diverse funds can ensure that assets stay with the company.

Asset Stickiness: If customers bailed out at the first sign of trouble, fund firms "would have a volatile time of it. But the most desirable assets tend to be sticky. Institutions and pension funds, in particular, like to stick with a manager once they have a relationship. Wealthy investors often enjoy the red- carpet treatment too much to dump their wealth management firm, even when their investments haven't performed "well. Assets that are held in tax- deferred portfolios, such as 4Oi(k)s and IRAs, also tend to move around less than assets in taxable accounts. Government regulations discourage cashing out early, and a long-term horizon helps to keep many retirement customers invested for long periods.

Direct-sold retail funds can be great for investors, but sometimes they can work against the fund companies that market them. Throughout the recent bear market, advisor-sold funds did a better job in retaining their assets because financial advisors were able to prevent clients from selling in a panic. A little handholding goes a long way in convincing clients to ride out the turbulent markets.

Asset Management Accounting

The single biggest metric to watch for any company in this industry is assets under management (AUM), the sum of all the money that customers have entrusted to the firm. Because an asset manager derives its revenue as a percentage of assets under management, AUM is a good indication of how well—or how badly—a firm is doing.

Unlike a bank or insurer, where big losses can cause the firm to become insolvent, big losses in asset management portfolios are borne by customers.

Big losses will affect fee income by reducing AUM, but an asset manager could lose "well over half the value of its assets under management and still remain in business. In a worst-case scenario, customers could withdraw their remaining dollars and the firm could fold if its fee income became inadequate to support Its operations. But because asset management requires al­most no capital investment, these companies can pare back to the bone to remain in business.

Key Drivers of Asset Management Companies

The level of assets under management is the biggest driver of revenue for an asset manager, but not all assets are created equal. Money managers typically charge higher fees to manage stock portfolios than to manage bonds or money market funds. More specialized funds, such as foreign-stock funds, real estate, or high-yield bond funds, often carry the highest fees. Institutions and large investors can count on volume discounts if they place multiple millions or billions with one firm, whereas retail investors pay steeper fees for small accounts. This means that an asset manager may see a IO percent increase in overall AUM, but only an S percent increase in revenue if, for example, sales of bond funds outpaced sales of equity funds.

Beyond tracking the ups and downs of particular asset classes, we like to keep a close eye on just where changes in AUM come from. Market movements—appreciation or depreciation of securities prices—can have a huge effect, so much so that many asset managers can almost be considered as leveraged bets on the market. Firms with a heavy concentration In equities, such as Janus or London-based Amvescap, have seen their stocks soar during bull markets and market rallies. These market movements lift AUM without any new money moving in or out of funds, and this increases revenue from investment management fees.

But the best asset managers are not simple bets on the market. Investors should look for asset management companies that are able to consistently bring in new money and don't rely only on the market to increase their AUM. Look for net inflows (inflows higher than outflows) in a variety of market con­ditions. This is a signal that the asset manager is offering products that new in­vestors want and that existing investors are happy with the products they have.

Inside the Back Office

Custody and asset services are the lesser known sidekick of asset manage­ment. Like many sidekicks out there, this one does much of the boring work and doesn't garner much glory or recognition. (Think of Tonto feeding the horses day in and day out while the Lone Ranger gets to do the more exciting stuff.) However, custody operations are essential to many pension plans, in­surance companies, asset managers, and even wealthy individuals "who need someone to keep track of their investments and perform the back office accounting work every day.

The custody and asset servicing business works on a principle similar to the asset management business, but with lower fees and more economies of scale. Many trust banks such as State Street and Bank of New Ifork have huge cus­tody operations that manage trillions of dollars in assets. Custodians don't in­vest the money they are entrusted with; they just keep track of it. Mutual fund companies frequently outsource their back offices to custodians because they don't want the hassle of record keeping. Custodians keep track of the securities that their customers buy and sell, collect dividends, and calculate an accurate value at the end of the day. Many offer a huge array of additional services, such as performance analytics, risk management, and pension consulting.

This business requires a hefty investment in technology and a penchant for absolute accuracy. It isn't particularly profitable, however, until you collect well over a billion dollars in custodial assets. Fees for custody typically come in below .05 percent of assets under custody, making scale essential to support the necessary technology investment.

Key Drivers of Custody Companies

Revenues in this industry are primarily driven by the level of assets under custody. Because economies of scale are so significant here, higher levels of assets under custody are a sign of competitive advantage. Bigger operations can pay for leading-edge technology and make a larger profit from each additional dollar of custody fees. This bigger-ls-better model has fueled increasing consolidation, with smaller players exiting and custodial assets being concen­trated with the largest players. As a result, barriers to entry have risen, and small operations have little chance of attaining competitive scale. This gives the largest players, such as State Street and Bank of New York, wide economic moats.

Watch out for custody firms' loan portfolios, though. Most custodians also lend money to their clients as part of their overall service relationship. As "with any bank, these loans can become too concentrated in one company, one industry, or one sector. Many of these loans are not very profitable for the banks, but they can be one of the largest risk factors. Bad loans can easily eat into a profitable custody operation. For example, during the tech and telecom bubble of the 1990s, Bank of Newlfork loaned billions of dollars to cable and telecom companies, forcing it to write off the bad loans when many of these firms collapsed. This ate into the profits from its lucrative global custody business, which was then the largest in the world.

Hallmarks of Success for Asset Management Companies

Asset managers can be great investments, but it's important to buy into the right ones. We recommend seeking the following qualities:

Diversity of products and investors: Asset managers and custodians benefit
from having a diverse pool of managed assets. Swings in the markets can
take a grinding toll on one-trick ponies. Janus Capital is a good example
of an asset manager with all its eggs in one basket. Because its assets "were
mostly in growth stock funds, the firm's shares were killed when the stock
market fell in 2OOI and 2OO2. Diversified firms such as Franklin Re-
sources have enjoyed much greater stability.

Sticky assets: Firms that are revolving doors can be extremely volatile.
Asset managers who attract the buy-and-hold crowd, including institu­
tional investors and retirement savers, can count on a steadier stream of
fees in varying market conditions. With its large retirement savings busi­
ness, for example, T Rowe Price enjoys relative stability in its equity as­
sets under management.

Niche market: Asset management is an increasingly crowded field, as attractive profits have lured many firms into the industry. Those companies with unique products and capabilities have more control over pricing and less competition for investor assets. Eaton Vance is a good example of an asset management boutique. The firm specializes in tax-managed products— both stocks and bonds—and has had success in attracting and keeping tax- conscious investors.

Market leadership: High barriers to entry and economies of scale in the custody industry make size a formidable competitive advantage. With the biggest custodians overseeing trillions in assets, smaller competitors face overwhelming challenges. Established asset managers also enjoy the advantages of long-term performance records and name recognition. Privately held Fidelity Investments is the largest asset manager in the world. It is also one of the most widely known and trusted names in the industry, a virtue which helps it gather assets and manage them profitably.

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