Asset Management and Research

Asset Management
Asset Management refers to the professional

management of investment funds for individuals,

families and institutions
Investments include stocks, bonds, convertibles,
alternative assets (such as hedge funds, private
equity funds and real estate), commodities, indexes of
each of these asset classes and money market
investments
Asset managers specialize in different asset classes
and management fees are paid based on the asset
class
For alternative assets, additional fees are paid based
on investment performance as well

Alternative Assets
Management fees can range from 1% to 2% of assets

under management (AUM) and additional fees are charged

based on the fund managers performance
Some alternative asset managers receive performance
fees of 10% to 20% on the annual increase in value of
assets. This means that if a high net worth investor
entrusted $10 million to an alternative asset manager, and
the value of this investment increased to $11.5 million in
one year (a 15% increase), the asset manager would be
paid as much as 2% x $10 million = $200,000
management fee, plus 20% x ($11.5 million - $10 million) =
$300,000 performance fee. So total fees paid would be
$500,000, which is, in effect, a 5% fee on the original $10
million investment
Although this may seem high, the investors net return is
still 10% after fees. Therefore, despite the high fee
percentage, this may be a suitable fee arrangement for an
investor if the net return is better than net returns from
other investment choices

Investment Banks Have Large Asset

Management Businesses
Global Investment Bank Asset Management Divisions
Firm
Bank of America
Morgan Stanley
UBS
Wells Fargo
Credit Suisse
Deutsche Bank
J.P. Morgan
Goldman Sachs
Barclays

AUM ($bln)
$1,945
$1,628
$1,559
$1,398
$865
$368
$284
$229
$185

Source: Scorpi o Partnershi p's Annual Pri vate Banki ng

Benchmark for 2011

Performance Measurement
Fund performance is a key metric when evaluating

Asset Management capabilities

Investors measure this by relying on different
performance measurement firms, such as
Morningstar and Lipper, who compile aggregate
industry data that demonstrate how individual mutual
funds perform against both indices and peer groups
over time
For alternative asset classes such as hedge funds
and private equity, there are specialized industry
research firms that track fund performance
Many funds are ranked into quartiles based on their
relative performance each quarter and each year
Inevitably, top quartile funds draw disproportionately
more investable funds whenever rankings are
announced

Performance Measurement
For alternative assets such as hedge funds, it is common

to measure performance not only on a relative basis, but

also on an absolute return basis
These funds attempt to achieve a positive (non-negative)
return (and not just beat a certain benchmark) through the
use of derivatives and by creating short positions in
different asset classes
Performance measurement is often not just focused on
returns, but on risk-adjusted returns as well
Modern portfolio theory has established the qualitative link
that exists between portfolio risk and return: the Capital
Asset Pricing Model (CAPM) developed by Sharpe in 1964
highlighted the concept of rewarding risk
This led to the creation of risk-adjusted ratios including the
Sharpe ratio, which measures the return of a portfolio in
excess of the risk-free rate, compared to the total risk of
the portfolio

Hedge Fund Investments

Most major investment banks have large hedge funds

housed within their Asset Management Division

These funds are managed principally for the benefit of
investing clients (although the bank and employees of
the bank may also invest in the fund) and are
separate from the proprietary investing activities
conducted within the Trading Division (which invests
solely for the account of the firm, without any outside
client investments)
J.P. Morgans total hedge fund AUM at the end of
2011 was over $47 billion, making the bank one of the
worlds largest hedge fund managers
Goldman Sachss total hedge fund AUM at the end of
2011 was over $20 billion

Private Equity Fund Investments

Most large investment banks participate in private

equity as an investor for their own account

The Dodd-Frank Act has reduced the amount of
private equity investments
Banks also provide private equity funds for
investors to invest in as part of their Asset
Management Division
Direct investments in and funds offered by many
investment banks are in the following areas:
leveraged buyouts, mezzanine (subordinated
debt with attached equity warrants), real estate
and infrastructure transactions

Wealth Management
Wealth Management refers to advisors who provide

investment advice to individual, family and institutional

investing clients
Wealth Management advisors identify investors who have
a significant amount of funds to invest and then help these
investors make investments in different asset classes
based on risk tolerance and diversification preferences
Wealth Management advisors are not directly involved in
the management of asset classes (which is the role of
Asset Managers)
They either assist investors in self-directed investments, or
if preferred by clients, make investments on the investors
behalf
They also help clients obtain retail banking services, estate
planning advice, legal resources, and taxation advice
Wealth Management advisors must exercise good
judgment in allocating funds to achieve high investment
returns and appropriate diversification relative to client risk

Wealth Management
Wealth Management advisors typically limit their

services to clients that have more than $5 million in

investable funds
Some banks require an even higher amount of funds
in order to focus attention and limited resources on
investing clients
For example, subject to a number of considerations,
Goldman Sachs largely limits its Wealth Management
efforts to clients that have more than $25 million in
investable funds
Some banks have created a private client services
business that brings many, but not all Wealth
Management services to investors who do not meet
the investable fund threshold amount required to be

Retail Brokerage
Individual investors that have an even lower amount

of investable funds are covered by retail advisors

and brokers who help them invest cash in both the
Asset Management products offered by the bank and
products offered from external sources
All of the largest investment banks, with the exception
of Goldman Sachs, have a retail team
Citigroups Smith Barney division established a joint
venture with Morgan Stanley during early 2009
(majority owned by Morgan Stanley, with the right by
Morgan Stanley to acquire 100% ownership in the
future over a five-year period)
The new Morgan Stanley Smith Barney joint venture
is now the largest retail brokerage

U.S. Brokerage Ranking

U.S. Brokerage Force Ranking, as of December 2010
Firm
Morgan Stanley
Bank of America/Merrill Lynch
Wells Fargo/Wachovia
UBS (U.S. division)
Source: Respective 10-K filings

Number of
Brokers
18,043
16,722
15,200
6,783

Revenue
($ in billions)
$12.6
$11.6
$6.9
$5.3

Revenue per Client Assets

Broker ($ in billions)
$742,000
$694,000
$454,000
$782,000

$1,700
$1,480
$1,200
$715

Potential Conflicts of Interest

Since wealth management advisors at investment banks

have a duty to help clients achieve the best possible

returns in the context of their risk tolerance, in some cases,
investing clients may be directed to investment products
not provided by the investment bank
For example, if an investment banks Asset Management
fund offerings do not include a type of investment that a
client wants to invest in, or the performance of an internal
fund (from a risk/return perspective) is less than a
competing fund at another firm, the wealth management
advisor may choose to direct part of a clients investment
portfolio to an Asset Management product provided by a
competitor
However, at many banks, incentive systems are designed
to keep all client investments within the bank rather than
see funds go to a competing firm, which creates a potential
conflict of interest

Avoiding Conflict of Interest

During 2005 and 2006, both Merrill Lynch and Citigroup decided

to give up control over their asset management business

because, among other reasons, they wanted to avoid a potential
conflict of interest between the wealth management advisory
function and the asset management function
In 2005, Citigroup entered into an arrangement with Legg
Mason, Inc whereby the brokerage portion of Legg Mason was
bought by Citigroup, while the asset management business of
Citigroup was bought by Legg Mason
In 2006, two months after the Citigroup-Legg Mason deal closed,
Merrill Lynch entered into an arrangement with BlackRock
whereby Merrill Lynchs asset management business merged
with BlackRock, creating a new independent company with
nearly $1 trillion in assets under management
Merrill Lynchs ownership of the combined asset management

company was 49.8%, and it came with a 45% voting interest in a

firm that had a majority of independent directors

Research
Research is provided by all large investment banking firms

to selected institutional and individual investing clients on a

global basis
This research usually covers equity, fixed income, currency
and commodity markets
Equity research focuses on public company specific
analysis as well as on industries and attempts to project
future cash flows and share prices
Fixed income research focuses on corporate debt in the
context of the issuers industry and is critically dependent
on understanding credit risks
Commodities research is a globally focused effort that
principally analyzes energy and precious metals
Research professionals also focus on economics, portfolio
strategy, derivatives and credit issues, offering insights and
ideas based on fundamental research

Research
Research is typically (but not always) housed within

the Trading Division of an investment bank and is

comprised of two different groups
Research that is provided to investing clients of the
firm is called sell-side research
Research that is provided to proprietary traders who
trade for the account of the bank and to the banks
asset managers, who manage money for investing
clients, is called buy-side research
This is the same type of research that hedge funds
produce for their internal traders, or that large mutual
funds such as Fidelity produce for their internal fund
managers

Sell-Side Research
Sell-side research has always been an analytically intense

area within investment banks where research analysts

produce detailed financial models that forecast earnings
and the future value of assets
For example, equity research is produced by analysts who
build models that forecast a companys future revenue
and earnings based on several factors, including company
guidance, economic conditions, historical trends and new
company, product or industry information
Analysts use multiples based on enterprise value,revenue,
EBITDA, earnings, book value, and cash flow in order to
help assess a companys future share price
Analysts also employ other valuation models such as peer
comparisons, discounted cash flow analysis, or
replacement value analysis and then use this information
to formulate an investment opinion, which is then
communicated to investors or investment advisors

Paying for Research

Research departments have historically received revenue

from investing clients through an indirect mechanism: part

of the commissions paid by investors to sales
professionals when they buy securities is redirected to the
research department
This soft dollar compensation arrangement has been a
key part of sell-side research for decades, since investors
are generally reluctant to pay direct fees for the use of
research
For example, an investor who values equity research
provided by a sell-side analyst at an investment bank
might be willing to pay a commission of 3 cents per share
for common shares the investor purchases through the
bank (instead of 2 cents a share the investor will pay to
other investment banks who do not provide good research)
In this example, 1 cent per share will be redirected to the
research department as soft dollar compensation

Research Conflicts of Interest

Investment Banking Divisions have historically put

pressure on research analysts to modify negative

views on a company when bankers were soliciting a
financing or M&A transaction from a company
Negative equity or fixed income research can upset
company management, making it problematic for
bankers to obtain mandates
As a result, some bankers have asked research
departments to prioritize their research activities
based on the Investment Banking Divisions
underwriting or M&A effort, rather than on the firms
investing clients priorities for objective research
This created a conflict of interest that had far-reaching
repercussions

2003 Research Settlement

Because of the conflict between bankers and research

professionals, during April, 2003, the SEC, New Yorks

attorney general, the National Association of Securities
Dealers (NASD), and the New York Stock Exchange
(NYSE) announced enforcement actions against the
following 10 investment banks: Bear Stearns, Credit
Suisse, Goldman Sachs, Lehman Brothers, JPMorgan,
Merrill Lynch, Morgan Stanley, Citigroup, UBS and Piper
Jaffray
The banks were required to pay a total of approximately
$1.4 billion, comprised of $875 million in penalties and
disgorgement, $432.5 million to fund independent
research, and $80 million to promote investor education
In addition to the monetary payments, the firms were also
required to comply with significant requirements that
included eliminating any influence by the Investment
Banking Division over the research department, increasing
supervision and making independent research available to
investors

2003 Research Settlement

Provisions
There must be a physical separation between research and

investment banking professionals

The firms senior management must determine the research
departments budget without input from the Investment Banking
Division and without regard to specific revenues derived from
investment banking activity
Research analysts compensation may not be based, directly or
indirectly, on Investment Banking Division revenues or on input
from investment banking personnel
Research management must make all company-specific
decisions to terminate coverage, and investment bankers can
have no role in company-specific coverage decisions
Research analysts are prohibited from participating in efforts to
solicit investment banking business, including pitches and
roadshows
In addition to providing their own research, investment banks are
obligated to furnish independent research to investing clients

Regulation FD
Regulation FD (Fair Disclosure) was implemented by the SEC

during 2000
This regulation prohibits a companys executives from
selectively disclosing material information that could impact a
companys share price
This means that prior to discussing any potential stock moving
information with research analysts, the company must disclose
this information through an SEC filing
Prior to Regulation FD, some large institutional investors
received stock moving information before other investors
received it based on private discussions that a company had with
a research analyst, which was passed on selectively to favored
large investors
The benefit of this regulation is that it levels the playing field,
enabling all investors to receive the same information at the
same time
However, critics claim that because companies must now be
more careful in what they say to analysts and investors, and
when they say it, less information is distributed in a less timely
way, reducing the quality and depth of information