Investment Management

When you look at the investment business, you can see there are two camps or industry groupings: there are the “big ticket” big institutional firms that work mainly with pension funds, endowments, foundations, and government agencies; a second grouping comprises the retail investment firms that work mainly with individual investors. Some will straddle both camps, but these are a minority.

Investment management companies compete in their market niche in one of several ways, broken out roughly as follows:

• Retail Experts: Companies such as Aviva and Dreman cater to individual investors with a wide array of investment products.
• Financial Supermarkets: Fidelity, Vanguard, and Charles Schwab service individual investors and investment advisers with a broad product mix.
• Institutional Pure Plays: Specialist companies such as Research Affiliates and Wellington Management work with big institutional investors, family offices, and wealthy investors.
• Off-the-Shelf Shops: Boutique firms like Federated Hermes and Abrdn service retail and institutional clients with in-house products and investment advice.
• Smart Customizers: Firms like Black Rock and Dimensional Fund Advisors (DFA) have a full menu of customized products to offer their clients. Black Rock services wealthy individuals; DFA’s niche is investment advisers who work with individual investors.

The investment management industry is much like the broader financial services marketplace: very concentrated at the top. Think of the industry as an inverted pyramid. The very largest firms, while small in number, play a dominating role and have the biggest market share. The largest firms, by virtue of their size, are active players in nearly every corner of the investment universe—mutual funds, exchange traded funds, hedge funds, and private equity. Companies like J.P. Morgan Chase (a commercial bank), Goldman Sachs (an investment bank) and Black Rock (hedge funds, private equity, and mutual funds) are examples of deep pocket companies with plenty of clout in a broad range of investment products and services.

The consolidation trend—more money managed by fewer firms—is backed by industry data. In 2022, the 10 largest firms managed 66 percent of mutual fund and exchange-traded fund assets (up from 46 percent in 2005), according to the Investment Company Institute, a trade group. The top 25 companies held 83 percent of assets (up from 67 percent in 2005). Recent high-profile mutual fund industry mergers include Janus Capital and Henderson, as well as Standard Life and Aberdeen Asset Management. Consolidation is also occurring in the hedge fund sector. Hedge funds with more than $1 billion in assets under management control roughly 90 percent of hedge fund assets. The largest hedge funds may, or may not, produce the best results every year, but they have enough marketing clout to pull in an outsized share of client money.

More concentration at the top reveals only part of the picture. Beyond the 25 largest firms, there are many specialist managers, each focusing on a different niche or market sector (large cap stocks, small cap stocks, investment grade bonds, etc.) The largest investment firms are, in fact, incubators for newer, start-up, advisory firms created whenever a star manager leaves the big company to start up his or her own, independently managed advisory firm.

Investment management is a complex, competitive business with many different companies working together to deliver financial services to their clients. The complexity of the business is due in part to the way mutual funds or hedge funds are structured. A mutual fund (or a hedge fund) is a company set up solely for the purpose of managing investments. It has no employees. Its only asset is the investment portfolio. All client services are contracted out to a management company.

The management company hires the people—the securities analysts, traders, and portfolio managers—who actually manage the investment portfolio and process fund purchases or redemption orders. The management company also files the fund’s registration documents with the Securities and Exchange Commission. It computes daily portfolio valuations and performs other administrative duties. Fund marketing may be handled by the management company or by an independent distributor.

Hedge funds work with another servicer, the prime broker. The prime broker, a company usually affiliated with an investment bank, is a counterpart on the other side of a hedge fund’s day-to-day trading activities, providing short-term financing and structuring derivative transactions for hedge fund managers.

The complexity of the investment industry also can be seen in the distribution channels. The big mutual fund complexes sell directly to individual investors through an in-house sales force (Fidelity Investments, T. Rowe Price), through securities broker-dealers and financial planners (Capital Group for instance) or through mutual fund supermarkets (Charles Schwab, Fidelity, T.D. Ameritrade). Smaller fund companies sell their funds directly to the public or through their connections with financial planners or broker-dealer firms such as Merrill Lynch (now a division of Bank of America) and Edward Jones. Financial planners and broker-dealer firms receive a sales commission for their efforts.

The mutual fund supermarket (or fund marketplace) is a kind of “one-stop shopping” center for commission-free (no sales charge or “no load”) mutual funds and exchange traded funds. The fund marketplace, pioneered in the 1990s by Charles Schwab, has since been copied by several other leading firms, including mutual fund giant Fidelity Investments. Individual investors have access at the press of a mouse click to hundreds of no-load mutual funds (funds purchased with no sales charge or commission), and can sell or exchange funds at any time.

Hedge fund (also private equity funds) marketing is a little less formal. Fund managers recruit investors through their own network of personal connections or from client referrals, investment consultants and other hedge fund managers. Hedge funds sell directly to qualified (or “accredited”) investors, who are individuals with at least $1 million in investable assets (excluding real estate owned), through a hedge “fund of funds” or through third party sales networks. A fund-of-funds is a basket of similar hedge funds that are currently open to accredited investors. Venture capital firms usually sell to interested investors through client referrals or through their own industry contacts.

Investment consultants, who are professionals who advise pension funds and other big investors on investment options, also play an important role in fund distribution. Investment consultants evaluate an investment manager’s “style,” or their method of picking stocks, bonds, and other securities and try to determine what their investment performance looks like when compared to similar managers (large capitalization stocks, small capitalization stocks, etc.) and the market itself. By making these comparisons, the consultant can recommend the investment managers best matching their client’s needs.

Another sales channel targeting wealthy hedge fund investors is the “family office” network. These are basically service firms created to advise groups of wealthy families on investment planning as well as tax and estate planning. The family office business dates to around 1990 when Northern Trust organized the Family Office Forum. Following the success of the Family Office Forum, the Family Office Exchange and the Institute for Private Investors were started up within a few years.

Mutual Funds and Hedge Funds: The Key Differences

Both mutual funds and hedge funds are pooled investments holding a mix of stocks, bonds, financial derivatives, etc., and both are managed by a professional money manager, but there are important differences. Almost anyone can buy a mutual fund, as long as they put up the minimum investment needed to open an account. This can be as little as $250 to $500. Hedge funds are generally limited to wealthy individuals, people with $1 million or more in liquid, investable assets (excluding real estate). These are known as “accredited investors.”

A mutual fund is a publicly traded company that invests in a group of financial assets (stocks, bonds, etc.). The company is really a “shell company.” It has no employees and makes arrangements with third parties—the investment adviser, board of directors, fund distributor, and others—for all of its functional services. Mutual fund companies are tightly regulated by the government—far more than hedge funds—and must be registered with the Securities and Exchange Commission (SEC) as an “investment company,” as directed by the Investment Company Act of 1940. There were 9,345 mutual funds in the United States in 2022, according to the Investment Company Fact Book. This was a significant increase from the 8,003 mutual funds that existed in 1999. Some of the largest mutual fund companies in the United States are BlackRock Funds, Vanguard, Charles Schwab, State Street Global Advisors, and Fidelity Investments.

Investors who put money in a mutual fund are buying shares of stock in the investment company, which in turn buys the stocks, bonds, or other tradable assets described in its fund prospectus. The fund prospectus, part of the fund’s SEC registration, outlines its list of permissible investments and the management fees paid by fund shareholders. The fund raises money by continuously selling shares to the public. Shareholders are free to sell their shares at any time. They can also exchange their ownership interest for shares in another fund sponsored by the same fund distributor.

Careers in the mutual fund sector include financial analysts, buy-side analysts, investment advisers, fund managers and administrators, underwriters, transfer agents, fund custodians, research analysts, and public accountants. Companies in Massachusetts, New York, California, Pennsylvania, Illinois, Wisconsin, Colorado, Kentucky, North Carolina, Florida, and Texas employ large numbers of mutual fund workers.

Comparing hedge funds and mutual funds side by side is a little like comparing apples and oranges. True, both are investment products. But they are fundamentally different in the way they are structured, the way they operate, and in the way managers are compensated. Hedge funds, unlike mutual funds, are private investment pools with a “go anywhere” investment strategy. They have the flexibility to invest in a much broader universe of assets. Hedge funds buy stocks and bonds, as mutual funds do. They have the flexibility to buy currencies (including cryptocurrencies such as Bitcoin), derivatives, and futures. Hedge funds can also “go short” on a stock, anticipating falling prices. Hedge fund firms use leverage and other speculative investment practices to earn increased returns on their investment (although these practices may also increase the risk of investment loss). Interests in hedge funds are sold to institutional investors and high-net-worth individuals via private offerings.

Although the term “hedge fund” is popular, “pooled investment vehicle” and “private investment company” are more accurate ways to describe the sector. The Hedge Fund Association reports that “hedge funds are flexible in their investment options (can use short selling, leverage, derivatives such as puts, calls, options, futures, etc.).” (Funds that invest in real estate, private equity, and venture capital are not considered hedge funds, although some hedge funds have these investments in their portfolios.)

That said, hedge funds usually follow a defined investment strategy most of the time. Some examples are long-short equity, convertible arbitrage, fixed-income arbitrage, and merger arbitrage. Some of the largest hedge funds, such as Bridgewater Associates pursue a more aggressive “macro,” strategy. They buy anything they believe will “add value” to the portfolio.

Investment objectives are also different. Hedge funds pursue an “absolute return” investment strategy. Their objective is a positive investment return in every quarter. Mutual funds, on the other hand, try to match or exceed an investment benchmark, the S&P 500 for example.

Another key difference is manager compensation. Hedge funds have a performance-based compensation system, collecting a management fee (around 2 percent of assets under management) and 20 percent of any profits generated. The 2/20 model remained in place for years, but that has changed recently. In 2019 (the latest year for which data is available), the industry average was a 1.50 percent management fee and 19.00 percent performance fee, according to Preqin. On the other hand, mutual fund managers are paid a management fee—a percentage of the assets under management.

In Quarter I, 2022, there were 9,628 hedge funds in the United States, according to the Securities and Exchange Commission, although this number changes constantly as new funds open and existing funds close. The top 250 hedge funds in the world managed $6.39 trillion in assets in 2022, according to HedgeLists.com, which is much higher than the $3.88 trillion that they managed in 2021. Fourteen hedge fund firms managed in excess of $100 billion in funds in 2022. Major hedge fund firms include Bridgewater Associates, AQR Capital Management, Man Group, Renaissance Technologies, Two Sigma, Millennium Management, Elliott Management, Baupost Group, BlackRock, Mariner Investment Group LLC, and Winton Group.

The largest hedge funds have only a few hundred employees. Popular careers include investment advisers, investment managers, fund administrators, traders, programmers, software engineers, artificial intelligence specialists, buy-side analysts, fund custodians, legal advisers, auditors, registrars, research analysts, transfer agents, distributors/placement agents, brokers, and prime brokers. Careers can also be found at government agencies that monitor and regulate the hedge fund sector and other sectors in the investment management industry.

Private Equity

Private equity is capital invested in direct ownership of a business. Of course, any individual who owns a single share of stock is, indeed, a private equity investor. The kind of private equity we’re talking about is much bigger; these individuals don’t just invest in stock—they buy whole companies. These companies are privately owned. Ownership shares are traded away from the public stock exchanges.

Private equity investors put their money to work in any of three ways: a limited partnership in a fund managed by a general partner; a “fund-of-funds” owning shares in a number of private equity pools (an investment structure similar to a mutual fund); or direct investment in the target company, working alone or alongside a co-investor.

Additionally, private equity firms earn revenue by collecting transaction and monitoring fees for consulting, management, and other services that are provided to the companies they acquire. Historically, these fees have provided a lucrative revenue stream that augmented the firm’s share of investment gains on deals (the key source of profits for PE firms). For example, The Carlyle Group LP, KKR, and Apollo Global Management LLC reported earning $9 billion in management fees from their private equity businesses between 2008 and the end of 2013, according to the Wall Street Journal.

When a fund is liquidated, the limited partners get a proportionate share of the fund’s capital and investment profits (if any). In most cases, funds are returned to the limited partners only if the deal has produced their preferred rate of return (the “hurdle rate”), typically set at 8-10 percent. Investment returns above the hurdle rate are split on a percentage basis, often 80/20 between the general partner (who gets the larger share of the split) and the limited partners. A general partner’s share of the fund profits is known as “carried interest.”

The managers of these private equity pools put that capital to work by “fixing” them (cutting overhead or making capital investments in plant or equipment) so they generate more revenue, cash, and earnings, and then selling (“flipping,” in industry parlance) the improved company to another buyer or taking it public on the equity markets. Another strategy is for the PE firm to expand the portfolio company’s product and/or service lines and expand into new geographic sales areas in order to earn more revenue and make the business (or some of its units) more attractive to potential buyers.

The private equity market is a sizable sector in the economy, according to data from the American Investment Council (AIC), an industry trade group. About 5,000 private equity firms are headquartered in the United States. In 2022, the number of private equity deals that closed reached 6,549, according to the AIC, significantly higher than the 2,376 deals that closed in 2010 soon after the recession but much lower than the record 9,140 deals that closed in 2021.

PE firms now have stakes in more than 35,000 companies across the world (including 18,000 in the United States), and account for a staggering 6.5 percent of the United States’ gross domestic product, according to the Institutional Limited Partners Association. These companies employ 12 million Americans. Here’s a breakdown of PE employment by type of economic activity in 2022, according to the American Investment Council:

1. Business Services: 36 percent
2. Personal Services: 26 percent
3. Manufacturing: 13 percent
4. Retail Trade: 7 percent
5. Information: 6 percent

Most private equity firms are relatively small, often with less than a dozen professionals. Careers include financial analysts and associates, portfolio managers, research analysts, accountants, and lawyers. Partners in the firm are expected to bring in investors and identify target prospects.

Like their venture capital cousins, private equity firms generally find specialties within the industry. Some firms will focus on the middle-market (mid-capitalization companies, or companies with an equity valuation anywhere between $250 million and $10 billion). Still others look at small, public companies or those within a specific industry sector such as pharmaceuticals, energy exploration, or semiconductors.

Then there are the big ones. The biggest private equity players have the fundraising clout to go after the mega-deals in a variety of sectors. Some of the biggest household names in U.S. commerce—RJR Nabisco, Burger King, Neiman Marcus, Hilton, PetSmart, Toys R Us, Dollar General, Staples, Michaels, Petco, Mattress Firm, and Claire's Stores—have all been swallowed up by private equity firms in the last several decades.

The 10 largest private equity firms in the world by amount of funds raised over a five-year rolling period ending March 31, 2023 were:

1. The Blackstone Group (headquartered in New York)
2. KKR (New York)
3. EQT (Stockholm, Sweden)
4. Thoma Bravo (Chicago)
5. The Carlyle Group (Washington, D.C.)
6. TPG (Fort Worth, TX)
7. Advent International (Boston, MA)
8. Hg (London, United Kingdom)
9. General Atlantic (New York)
10. Warburg Pincus (New York)

Venture Capital

According to the National Venture Capital Association (NVCA), venture capital firms “invest mostly in young, private companies that have great promise for innovation and growth.” Some private equity firms target startup companies. Venture capital firms invest in early stage companies needing capital for growth. Initial funding (the “seed round”) is often contributed by wealthy individuals (“angel investors”). Assuming the seed round is successful, the startup will receive several additional rounds of funding. The exit strategy is through an initial public offering (IPO) or acquisition by a larger company.

Venture capital funding is very similar to a private equity deal, although there are key differences. (To be sure, private equity firms also invest in promising startups, mostly the larger, more diversified private equity deal makers.) Venture capitalists focus their attention on cutting edge products or technologies and their impact on markets. Venture capitalists are optimistic by nature, asking “What can be done?” Private equity investors worry about worst-case scenarios and try to mitigate those downside risks through deal structures.

When individual investors entrust their money to a venture capital firm, the firm puts the money in a fund. The companies a VC firm invests in become part of the VC firm’s portfolio. The VC firm assumes financial risk in exchange for an equity stake in the company. Firms receive a return on their investment when the company they have funded goes public or is bought by or merged with another company. This fund is then invested in several companies, with the expectation that the companies receiving funding will be in a position to repay the money advanced in about three to seven years, with interest. Sometimes, the money is repaid through shares of stock in the company. Once all of the money in a particular fund is returned, the money, with the interest earned, is then sent back to the investors. Of course, the venture capital firm takes a portion of the funding as its fee.

Venture capital firms are excellent places for start-up businesses that can’t get funding from traditional sources such as banks, or lack the credentials to raise money through an equity financing or debt offering. The key is finding a venture capital firm that chooses to invest in their type of business.

Focus areas for venture capital (VC) firms include software, biotechnology, media and entertainment, medical devices, wireless communications, Internet, and networking. In the past decade, VC firms have also begun investing in the clean technology sector (which includes renewable energy, power management, and environmental and sustainability technologies). Some VC firms invest in traditional fields such as financial services, consumer goods, manufacturing, health care services, and business services and products. Many venture capital firms are beginning to fund late-stage start-ups (those about to announce an initial stock offering) to reduce their level of risk.

To form a venture fund, VC firms receive investments from pension funds, foundations, insurance companies, endowments, and wealthy individuals. (Those who invest in venture capital funds are known as “limited partners.” Venture capitalists manage the portfolio, and they are referred to as “general partners.”) Venture capital investing can be risky. The NVCA reports that “40 percent of venture-backed companies fail, 40 percent return moderate amounts of capital, and only 20 percent or less produce high returns.”

At the end of 2022, there were 4,064 venture capital firms in the United States with 11,133 funds, according to the NVCA. Major firms include:

• ABS Capital Partners
• Accel
• Andreessen Horowitz
• Austin Ventures
• Battery Ventures
• Bessemer Venture Partners
• Columbia Capital
• DST Global
• First Round Capital
• Founders Fund
• Greylock Partners
• Grotech Ventures
• IDG Capital
• Index Ventures
• Khosla Ventures
• Kleiner Perkins
• Lightspeed Venture Partners
• Mayfield Fund, Menlo Ventures
• New Enterprise Associates
• River Cities Capital Funds
• Scale Venture Partners
• Sequoia Capital
• Softbank Vision Fund
• Spark Capital
• Tiger Global Management

"Venture capital remains concentrated around a few major hot spots, with roughly 60 percent of 2022’s deals occurring in five states (California, Massachusetts, New York, Texas, and Florida),” according to the NVCA. “However, the story of the past few years has been one of increasing diffusion across the country. Since 2018, the West Coast and Northeast have seen relative decreases in investment levels, while regions such as the Intermountain West and Southeast have seen relative increases in investment levels.”

Venture capital firms typically employ anywhere from two to 50 people. Careers include general partners, junior partners, financial analysts, financial associates, research analysts, and accountants. Many funds have only partners and support staff (secretaries, receptionists, etc.).