Asset managers face an existential crisis as they confront the end of a six-year rise in asset prices. What does the future hold for the industry? Christopher O’Dea investigates
The main trends affecting the asset management industry today include existential challenges to the business model and core investment theory. Rising asset prices since the financial crisis have helped asset managers to maintain margins despite the shift to low-cost investment strategies and product solutions. But that tailwind has subsided, leaving asset management firms in the doldrums as storm clouds gather – increasing client demand for lower fees, new regulation, and closer scrutiny of the social value of the investment management industry itself.
At a glance
• Asset management firms face more risks to their business.
• Downward pressure on fees is becoming relentless.
• Americans are asking why there are so many pension funding shortfalls at defined benefit plans and such small balances among defined contribution plans.
• Digital capabilities are becoming more prevalent but the human touch will remain essential.
In short, risks are rising – not just risks to the value of securities in portfolios of investment management firms, but risks to the firms themselves. Today, asset managers are grappling with those risks, which promise to bring lower revenues, reduced employment, new technology, and a heightened focus on delivering sustainable returns instead of the historic chase for above-market performance.
“The six-year tailwind to asset managers from asset inflation appears to be over,” according to a report on European asset managers by Goldman Sachs International published in April. Assets under management (AUM) at European investment managers doubled over the six years to the end of the first half of 2015, according to Goldman. “More than 70% of this was driven by asset inflation, rather than flows,” Goldman says. “This tailwind is at an end, replaced by a more volatile, less directional market backdrop.” In fact, the global investment-management industry is entering a period of consolidation and reorganisation, setting the stage for what Tim Hodgson, head of the Willis Towers Watson Thinking Ahead Institute calls “necessary re-invention”.
Business model under duress
The starting point for a re-invention is that downward fee pressure – already a regular feature of the industry – is becoming relentless. That will lead to a shrinking revenue pool, as clients act on the belief, however well-grounded, that active managers provide no net value. Signs of that can already be seen, as recent growth in industry revenue and profits has resulted primarily from asset-price inflation rather than net new AUM. That situation highlights the crux of the problem – the industry is set up to benefit asset managers and related intermediaries, not pension plan members and asset owners.
“We are interested in the behaviour of the investment system,” says Hodgson. “Asset managers are part of the system, and there are problems out there that are bigger than the asset managers.” Over the past few years, the Thinking Ahead team has developed the notion that the best way to discern what is ahead for asset managers is to “follow the money”. Following that trail leads to the conclusion that the investment management industry has a fundamental problem – it is set up mainly to benefit industry service providers. In a 2014 survey, Thinking Ahead found that only 42% of industry participants agreed that the industry is primarily designed to help the members rather than the agents working within it. In a report on the study, Hodgson wrote: “For a properly configured, customer-focused industry, 90+% of participants would be able to agree with such a statement.”
The result is that too much of the $100trn (€87trn) in capital invested globally in bonds and fixed-income securities is regularly transferred to asset managers and intermediaries in the form of fees based on the value of those assets. Asset management pays high wages to employees and high margins to shareholders, Hodgson says, in contrast to other industries such as food retailing that pay low wages and low margins. The asset management industry is extracting “excessive rents”, he says.
Hodgson argues that oversight of the world’s securities portfolio could be accomplished in a manner that would dramatically reduce the fees paid to asset managers. Willis Towers Watson highlights active management as the primary source of improving investor returns. “We have singled out the excessive shuffling of ownership rights, that is, pursuit of ‘alpha’, as value destructive.” Investors already own the securities in portfolios, they say, so the main service needed is to register ownership and collect and disburse dividend and coupon payments.
But asset managers expend enormous effort moving securities among themselves in an effort to have the highest-priced securities in the funds they manage. The exercise does not increase the aggregate value of the global portfolio – but asset managers charge hefty fees for trying to beat their peers.
The value thus transferred from portfolios to asset manager accounts is significant. According to the latest Global Asset Management report from the Boston Consulting Group (BCG), the industry’s profit pool rose 7% to $102bn in 2014, matching the pre-crisis peak, while operating margin – profit as a percentage of net revenue – stood at 39%, just below the pre-crisis high of 41%. But most of the increase resulted from asset price increases as equity markets rallied; net new flows in 2014 overall were just 1.7% of 2013 industry AUM, and institutional managers saw inflows of only 0.1% in 2014. And BCG says net revenue growth slowed from 9% in 2013 to 7% in 2014 owing to fee pressure and the shift from traditional actively managed products to passive strategies, solutions such as liability-driven investment and target-date funds, and speciality strategies.
All in all, net revenues measured in basis points continued to decline. Traditional active products are already on the ropes, representing just 39% of industry AUM at the end of 2014 compared with 59% in 2003. “This structural shift will continue in the medium term,” BCG predicts, “squeezing the share of active core products and managers.”
Engine needs repair
In short, active management has not paid off for investors and they have been putting Hodgson’s thought experiment into practice at an increasing pace. While the shift to indexing was well underway before the crisis, the low interest rates that followed quantitative easing have served to further disrupt long-standing portfolio management standards. The search for techniques to manage risk and capture available risk premiums has accelerated.
Low yields disrupt the basic bargain of the 60/40 stock-bond portfolio; with official rates at zero, or even negative, fixed-income yields provide negligible income cushion, and bond prices have basically one way to go when rates return to normal levels. “One of the fundamental issues, structurally, is that you can’t get paid for safety anymore,” says Donald Marron, founder and chairman of New York-based Lightyear Capital, a private equity firm specialising in financial-services companies. “You used to be able to manage money in such a way that you could have some downside protection from fixed income,” he says. But institutional investors have offset low high-grade corporate bond yields by investing in lower-rated bonds, credit strategies and other alternatives that offer higher income. That has created a new problem, Marron says. “Essentially every portfolio is at higher risk now than it was a few years ago.”
Managers have responded with several alternative approaches to asset allocation and portfolio construction, including smart beta investing, factor investing and risk parity. Each has its advantages, and collectively they have helped the asset management industry move to a world of lower-cost investing that focuses on delivering specific outcomes rather than trying to assemble a bundle of securities that generate a return moderately better than a market index.
Non-traditional strategies are expected to attract most new assets in the years ahead. Several equity research firms view BlackRock as the best example of where investment management is heading. “BlackRock remains the best growth story in asset management, in our view, with numerous tailwinds supporting organic fee growth and its premium P/E ratio,” according to a Goldman Sachs report on the company earlier this year.
BlackRock, which has one of the strongest franchises in exchange-traded funds (ETFs) and indexing products, encountered headwinds during the first quarter, as net inflows dipped to $36.1bn from more than $70bn in 2015, but its iShares ETFs added $24.3bn in assets, primarily in fixed-income ETFs. The iShares business is the biggest growth driver for the medium term, according to Morningstar, posting a 12.6% organic growth rate in 2015 on the strength of $130bn net inflows – more than 80% of the company’s long-term inflows last year.
While iShares have “ridden the trend towards passively managed equities”, active equity remains a sore spot. Illustrating the zero-sum nature of active equity investing, Goldman estimated that about 60% of equity funds had negative alpha by early March, and Morningstar notes that just half of BlackRock’s actively-managed fundamental equity funds were ahead of its peers on a three- and five-year basis, as of January.
But “rising uptake of factor products and smart beta is a tailwind to BlackRock’s Scientific Equities unit”, Goldman says. And “unlike many of its peers”, says Morningstar, “BlackRock has been generating inflows with its fixed-income operations – both active and passive.” That trend is expected to continue for the medium term, as “institutional investors reassess risk in their bond portfolios.”
From supervision to transformation
While asset managers revamp themselves, regulators are changing their own mission from supervision to transforming the US investment industry from the outside in.
For instance, the long-term effects of new US Department of Labor rules requiring financial firms handling retirement investment accounts to register as fiduciaries are already taking shape. An analysis of the final rules by Morningstar predicts that index and exchanged-traded product providers will get an additional boost; the effect on active asset managers will be mixed; and some alternative asset managers will face new challenges. The final rules dropped an earlier list of permitted assets excluding some alternatives. But advisers will still be required to justify using alternatives, which typically charge relatively high fees, and Morningstar expects advisers will be “leery of using high-fee products, even if they’re technically allowed, when under a fiduciary obligation”.
That is another question mark on alternatives at a time of weak performance by hedge funds. “Any institutional investor allocating to hedge funds is studying the recent performance period carefully,” says Lightyear’s Marrron. They are looking to answer one question: “Whether the hedge fund model, in terms of the fees that are charged, is consistent with the performance that is available.”
Under pressure: five issues faced by asset managers
Business model under duress – changing the beneficiary designation
• Fee pressure is relentless and shrinking the revenue pool, probably for good.
• Managers provide no net value and growth comes from asset-price inflation not new AUM.
• The crux of the problem is that the investment industry structure is set up to benefit asset managers and intermediaries, not beneficiaries and asset owners.
The investment engine – in need of repair
• Pursuit of alpha is not paying off and clients are voting with their feet.
• Low yields disrupt the basic investment model of the 60/40 world. You cannot get paid for safety anymore, and the search for yield means all investors have more risk in their portfolios than they realise.
• Exchange-traded funds (ETFs), passive, smart beta and risk parity offer different approaches, while the poor performance of hedge funds highlights the failure to deliver results for high fees and portends a shakeout in alternatives. But hope springs eternal and alternative AUM should trend higher.
• BlackRock seems to be winning. It is the favourite pick of Goldman and Morningstar, for similar reasons – it is big, it has a solutions group, most AUM are institutional and it is leading the ETF pack.
Regulation – from supervision to transformation
• US versus Wall Street – Department of Labor fiduciary rules will fuel fee reduction and further adoption of passives/ETFs, boosting large, low-fee players.
• Regulatory energy taps into societal questions about investment managers: if the industry is so great, why are there are so many pension funding shortfalls?
Technology – friend or foe?
• Low-hanging fruit is mostly harvested and operational tech will drive incremental savings.
• Quants and computers enable new strategies and reduce the need for analyst/portfolio manager talent.
• State Street shines a Beacon… State Street’s digitisation plan aims to cut its cost base while also pivoting into new services based on digital insights gleaned from real-time analytics of its $27trn (€23.4trn) AUM.
• …. while Alibaba’s Ants go on the March – one of the world’s largest money-market funds is part of the Chinese e-commerce giant’s financial-services empire and shows the power of technology in investment products.
Relationship matters – winning and retaining clients
• Customer experience/understanding in the new world – it is about execution for marketing effectiveness, productivity increases and moving jobs to lower-cost locations.
• But for institutional managers the human touch is key. Persuasion and presentation skills are more critical than ever and the role of consultants will increase.
The regulator’s efforts to reshape the US individual retirement investing market tap into social questions about the value of investment managers. The conventional wisdom in the US to ask why, if the industry is so successful, there are so many pension funding shortfalls at defined benefit (DB) plans, and such small balances in the defined contribution (DC) accounts of most Americans. “Society needs the [investment management] function,” says Hodgson. But the mission of investment management is being refocused on increasing the collective return available to investors that own securities in a sustainable way.
Hodgson suggests replacing fees as a proportion of asset values with a flat fee arrangement in which investors buy a slice of a manager’s capacity. Managers might find such an arrangement attractive in light of long-term asset flows. Assets in DB plans are flowing out of the industry as plans move into net distribution status, and the contribution rates of new DC plans are too low to generate offsetting asset inflows, he explains.
And the prospect of flat equity returns and falling bond prices means managers will not be able to rely on asset price inflation to boost revenue and profits. BCG reports that in 2014, institutionally-focused managers increased assets by just 8% and revenues by only 3% – while their profits shrank 1%.
Technology – friend or foe?
These days industries look to technology as a way to reduce costs. In asset management, technology has already made significant cost savings through operational improvements and outsourcing back-office functions. Now technology is being applied in two new areas – client relationships and the investment process.
In ‘Investing in the future’, a study of megatrends affecting investment managers, KPMG predicts that client profiling and effective data analytics will increasingly act as differentiators. With transaction processing already optimised or outsourced, “client profiling, data analytics and operational flexibility will be increasingly critical to effectively target and service an increasingly diverse client base,” says KPMG.
The consultancy cautions managers against complacency. “Investors can now access significant quantities of data in real time, meaning this is no longer the exclusive domain of the professional investment manager – how will you handle a better-informed investor?”
Global asset servicer State Street plans to shine new light on the digital files related to the group’s $27trn of client assets. The goal is to use data analytics to glean new, real-time insights from the transaction data and other information in its computer systems. The manager is also implementing Beacon, a five-year digitally-driven programme to reduce its cost base through automation of business processes, which the company believes can achieve 70% to 80% of the targeted $500m cost cuts. State Street’s previous technology initiative reduced costs by $625m through a private cloud and automation of processes that resulted in 4,000 job cuts.
Analysts view the new programme with cautious optimism. State Street detailed many aspects of Beacon at its 2016 Investor Day, according to a Goldman Sachs report on the company, “emphasising the long-term revenue opportunity it could create amid rising demand for digitisation among asset managers, that is market data, portfolio analytics and liquidity solutions, aided by regulation.” Although “the revenue opportunity is vague”, and State Street faces pressure on its net interest margin, Goldman says “we see value in this type of innovation for State Street’s clients”.
Whatever their product focus, asset managers today face a future in which achieving growth will require firms to differentiate themselves by demonstrating value through marketing campaigns, sales activity and pricing. In many cases, says BCG, “winning managers will gain advantage by developing and deploying advanced capabilities in data-driven decision-making”.
While digital capabilities are becoming essential to compete in 21st-century asset management, for institutionally-driven managers the human touch will remain – and perhaps take on even more significance.
New research from Greenwich Associates shows that top-notch persuasion and presentation skills will be more critical than ever for investment managers seeking to build relationships with consultants, who are tightening their control of institutional assets.
Formal meetings with investment consultants are often make-or-break events for asset managers, Greenwich says, as 86% and 92% of institutional investor relationships are intermediated by consultants in the US and UK, respectively.
Consultants remain extraordinarily selective, and just 3% of equity managers and 8% of fixed-income managers tracked in databases are invited to formal meetings. The shift to solutions-focused investment products has increased the demand for consultant relations staff to possess investment knowledge on par with the portfolio management team, but Greenwich says consultants ultimately want to look the investment team in the eye when asking tough questions – across the US, UK and Canada, the impression of investment professionals has a 0.86 correlation with impressions of overall firm quality. So investment managers need to heed an old maxim – people will do business with people they like.
European asset managers may soon have a story to tell that would make any investment team welcome in a consultancy conference room.
A Goldman analysis of Lipper fund data suggests that 65% of European equity funds benchmarked against the Stoxx 600 outperformed in 2015, and through early April fund managers measured against the Stoxx 50 index showed a knack for generating alpha, with 76% posting above-benchmark performance.
Performance like that just might re-invigorate active management – and put the wind back in asset managers’ sails in the process.
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