Published Apr 22, 2022
By Qredo Team
What's an Institutional Investor? Part 1: TradFi Asset Managers
Through our decentralized MPC tech stack and integration with MMI, Qredo is making it easy for institutional investors to gain secure, compliant, and operationally efficient exposure to digital assets.
But what exactly is an institutional investor?
This much-used label covers a wide range of very different organization types — each with their own process, performance, and risk characteristics.
In this educational series, intended as a general introduction, we'll start by exploring the main features of one of the biggest, most established institutional investors — the asset manager.
Though slower-moving and restricted in how they can invest, these established players are waking up to crypto and finding new ways to meet the growing customer demand for digital asset exposure.
Examples of TradFi asset managers
These big beasts of the money management world fall into two camps:
Standalone managers - eg Fidelity, Franklyn Templeton, Capital International
The investment management divisions of larger banks - eg Goldman Sachs Asset Management, JP Morgan AM, Allianz Global Investors
The size and market-moving power of an asset manager (AKA investment manager, fund manager, or money manager) is indicated by its AUM (Assets Under Management).
The largest managers control eye-watering amounts and in January, 2022, BlackRock became the first public asset manager to hit $10 trillion in assets.
How do asset managers make money?
They earn revenue by charging a percentage fee on the value of the assets they manage.
These assets sit in various products, including mutual funds (typically sold to non-professional “retail” investors), and segregated accounts (private pools of money that are invested on behalf of “institutional clients” such as pension funds, insurance companies, and sovereign wealth funds). Larger firms will also have a private bank division that manages the portfolios of high net worth (HNW) individuals and families.
Fees vary by product type. Equity mutual funds have higher management fees, with fees for bond funds, money management, and exchange traded funds (ETFs) on a sliding scale below that.
Institutional asset management is lower fee than retail but the amounts managed are much larger. Fees for private banking clients are the highest because of the high level of white glove service and portfolio tailoring these clients receive.
The profitability of each type of product will vary a little by firm. Note that some of the costs in managing an investment product (including management, administration, marketing) are passed back to the investor in the form of the fund expense ratio.
Is asset management a good business to be in?
Broadly speaking, yes. Whilst it may not offer the explosive profits seen in more racy areas like corporate finance or trading, the revenues it generates are more consistent.
Supporting this is the important role played by financial market investment in the business models of sectors like insurance and pension provision. These firms are important institutional clients for the asset management industry.
In the short term, asset management fee income does have some correlation to underlying markets; a manager’s AUM (and therefore fees earned) will rise and fall with the assets held in each fund.
Similarly, investor flows in and out of products will reflect market and economy conditions. Example: current fears around inflation and higher rates has led to an outflow of money from fixed income and money market funds.
Asset management bosses use industry fund flow data from sources like Lipper Refinitiv to keep an eye on shifting investment patterns.
Asset managers can also grow AUM by launching new products that reflect new investment opportunities or appeal to a new investing demographic.
What is relative and absolute performance?
Many investment products are benchmarked against an index. This means the manager of the fund will hope to deliver an index return that is equal to, or greater than, the performance of the index over a given period.
For example a Japanese equity fund that seeks to give investors exposure to the largest Japanese companies from a wide range of industry sectors might be benchmarked against the Nikkei 225 index.
By contrast, absolute return products seek to give investors a return that does not reference a benchmark. As we’ll see next time, absolute return is more associated with specialized, niche managers such as hedge funds.
Understanding active vs passive investment
Welcome to one of the most important distinctions in the money management world.
Active managers – running “actively managed” products – believe that, by using fundamental analysis or quantitative techniques, they can exploit market inefficiencies and beat the performance of their benchmark. They do this by underweighting or overweighting a stock versus its weighting in the benchmark index. Successful active managers — "stockpickers" — include the legendary Peter Lynch and John Templeton.
Passive, or ‘passively managed”, index products aim to give investors the same performance as a benchmark index. They achieve this by building a portfolio that uses quantitative techniques to replicate the composition or performance of the benchmark index. They charge a lower fee because they’re not paying a portfolio manager (PM) to make clever decisions.
The first index fund was the Vanguard 500 Index Fund, launched in 1976 by John Bogle.
Though Bogle was widely ridiculed at the time, there is now a steady shift of assets towards passive products (aided by the fact that most active stock fund managers fail to outperform their benchmarks after fees).
What’s the difference between a portfolio manager and a trader?
For simplicity, let’s compare a trader to an active, fundamentals-driven portfolio manager (PM). This is a generalized comparison but it will give you the gist 🙂
Whereas a trader will be focused on short term moves in price (and often use tools like technical analysis), a PM will generally hold a position for longer and be more interested in the medium-to-long term price outlook of any company they’ve invested in.
Rather than watching a price screen all day, they and their analysts will be talking to the management of target companies, doing industry research, and listening to quarterly results calls.
Using this information, they will build detailed P&L models for each company – applying valuation metrics to predicted earnings and cash flow numbers to arrive at a price target. They can also pay brokers for their research and investment recommendations.
Unlike traders, PMs of publicly available investment products are also restricted in their trading. The prospectus for an investment fund will typically specify portfolio turnover limits (how much trading a manager can do), concentration (the maximum weight a position can hold in a fund), and the levels of risk they can take.
This isn’t to say that a PM has no interest in short-term price action. A meaningful price drop, for example, may reveal new information about a company's situation, or be an opportunity to buy more of something they’re keen on.
There is also an investment style called “momentum". Unlike value and growth styles, momentum investors pay relatively more attention to recent price performance and market sentiment around a stock.
Are TradFi asset managers excited about crypto?
Even if they’re not yet fully on board, the mainstream are definitely warming up to it. This is for two reasons:
Investment opportunity 📈
Fund managers are constantly curious about ways to boost fund performance. Blockchain — and its impact on different economic sectors — promises the kind of exciting investment returns many senior PMs enjoyed during the first internet boom in the late 1990s. There are also parallels between crypto and the commodities investment boom of the 1990s.
Product strategy 💰
Product development teams in asset management firms know that interest in crypto investment is spreading fast, beyond the private bank customers who were early investors.
A recent Fidelity Digital Assets survey found 70% of institutional respondents (eg pension funds) expect to invest in digital assets in the future. There is also a new generation of retail investors – including the harder-to-reach younger demographic – that is looking for packaged, convenient exposure to crypto without the learning curve needed to invest directly.
The question is how to meet this demand in product form; existing funds don’t have the mandate to hold crypto directly, although some can invest in Saylor’s Microstrategy and a number of other crypto plays available on the stock market.
An alternative and more effective path is to launch new “thematic” funds and products. One of the most popular is the exchange traded fund (ETF), a type of exchange traded product (ETP).
Here, traditional managers can learn from the example of new generation of digital native asset managers. Firms like Grayscale, Valkyrie, Coinshares and 21Shares have blazed a trail in product development and offer incumbents a model for running a successful cryptoasset operation.
The rise and role of crypto ETFs
ETFs are low fee, exchange-traded products that replicate the performance of an index.
They’re popular with investors of all stripes because they’re regulated, liquid, and provide easy exposure to asset classes that can be tricky to buy and hold directly. A good example is the SPDR Gold Trust GLD – an ETF that tracks the price of gold bullion and has over $69B in assets.
We’ve recently seen recently a number of high profile cryptoasset ETF launches from TradFi managers, coinciding with a growing universe of cryptocurrency related indices:
November 2021 - The Invesco Physical Bitcoin ETP
January 2022 - The iShares (BlackRock) Blockchain and Tech ETF
April 2022 - Fidelity’s Crypto Industry & Digital Payments ETF, and Metaverse ETF
Of course, the ETF everyone is waiting for is the spot Bitcoin ETF. When the SEC will move to approve this is subject to much speculation.
One thing’s not in doubt: we can expect more such crypto-related ETFs from established managers and they will be an important gateway to people investing in digital assets for the first time.
To be continued...
Next time, we'll look at hedge funds (including crypto native HFs) and some of the adventurous ways they're embracing digital assets and DeFi.