Intelligence

Asset Managers Respond to Intense Pressures

Milton Ezrati

Chief Economist

Asset management is not the business it once was.  Margins have shrunk dramatically and seem likely to fall farther.  In part, the problems stem from an explosion in regulatory burdens, but that is far from the whole picture.  Client demands for transparency and for more and better service have contributed to the margin pressure as well, as has the business active management has lost to indexing and algorithm-driven investment schemes sometimes called “robo” investing.  The asset management business as a whole has lost to the growth of exchange-traded funds (ETFs).  While technology has at times facilitated these margins squeeze, it has also provided answers to the challenge.  The pattern in all its aspects will carry on for the foreseeable future.

The margins squeeze is well documented. Fees have dropped precipitously. In 1990, mutual funds on average charged nearly 100 basis points for both equity and hybrid mandates and about 90 basis points for fixed-income mandates.  By 2005, these had shrunk back to 85 basis points for equity funds, 80 basis points for hybrid mandates, and only 65 basis points for fixed-income efforts.  In 2017, the most recent period for which data exist, they were respectively 60, 65, and 55 basis points. Fees on client specific products have, if anything, fallen still more, though statistics in this area are spotty at best.

Part of the fee problem stems from the poor performance of active managers during this time. According to Bloomberg, global active managers have lost to their benchmark indices by more than 300 basis points a year during the last few years.  Though some studies show a less dramatic shortfall, all show active management underperforming on average. Little wonder then that clients have shifted from high-fee active management to low-fee passive management, including ETFs, with all the attendant ill effects on fees generally. At the same time, fees have also suffered as regulators have constrained the ability of financial advisers to put clients into funds that pay them best. The existing data are striking. According to calculations by PwC, low-cost passive funds have risen more than six-fold in the last 20 years, far faster than the overall asset base.  Funds in ETFs have more than doubled in just the last ten years.  Projections by PwC indicate that active management as a share of global assets under management (AUM) will fall from 74 percent in 2015 to 65 percent by 2020, while passive will see its share rise from 14 to 22 percent.

While fees have plunged, the cost of doing business has risen.  More demanding regulations have played a big role.  In the United States, the Dodd-Frank financial reform legislation has imposed considerable cost, as has the Liquidity Risk Management Rule of the Securities Exchange Commission (SEC).  Europe during the last ten years has imposed no less than nine major financial regulations.  All have imposed cost increases on asset managers.  Though meaningful cost measures remain, in the words of KPMG, “elusive,” the accountants there estimate a 20 percent increase in compliance costs alone during the last five years. Adding to this are the demands clients have made for more thorough reporting, through even mobile aps.  This combination of pressures on both fees and costs has, Boston Consulting estimates, shrunk profit margins overall in the asset management business by nearly a third from their peak of 39 percent in 2007 to the mid 20s more recently.   

The desperation among asset managers created by this margin pressure has, unsurprisingly, become a boon for consultants.  Under their direction and the insights of asset managers themselves, the industry has responded to the challenge through a combination of technology and organizational changes.

Mergers are one way of coping with the growing fixed costs of regulatory compliance, as well as of other so-called “shared services” such as operations, marketing, and sales.  Expenses in these areas are virtually the same for a two-person shop for a large organization.  By enlarging the overall effort, spreading these costs over more products and more revenue, they have become relatively more bearable.  To be sure, more products have also enlarged the burden of compliance, operations, and client service, but not proportionally.  Mergers have also enabled firms to consolidate overlapping product and reduce the usually expensive investment staff involved.  To hold those costs down still more, firms have also begun to link pay more closely to performance.  The drive for cost containment has also prompted managers to shift their client focus toward larger accounts.  The whole effect is an industry that has fewer, larger firms that focus more than ever on the super-rich.

On the technology side, the changes have been still more pervasive.  At one time, cost-saving efforts involved offshoring, mostly of operations, to lower cost venues such as India.  Now with more advanced technology, firms have begun to bring these activities home into still more cost-effective AI systems.  Technology has entered the client service realm as well, to meet client demands for timely access to their accounts and other support.  Though answering these demands has increase costs, tech solutions have kept those costs in check.  Tech has also entered marketing, which increasingly has turned to big data to better serve existing clients, to cross-sell, and to ferret out new sales opportunities.  This, too, has increased costs, but the efforts presumably pay a substantial dividend.  On the investment side, technology has long been the backbone of passive management.  Increasingly tech systems have begun to support active management, as a way to improve performance but also as a way to check rising compensation costs.  With the turn to the super rich, tech has also found a new role in robo investment management for the mass affluent.  Even in meeting compliance burdens, fintech has offered ways to keep a lid on an array of costs, from staffing and bookkeeping to reporting. 

In all these efforts, cost-sensitive firms have turned to specialized fintech providers rather than develop the capabilities themselves, and this includes some of the biggest players.  Whether in-house or outsourced, the use of systems, for cost savings and ways in improving client service, has simultaneously increased cyber risk in all these firms.  They have accordingly had to spend on cybersecurity, which has to some extent limited the overall cost savings these technological solutions have brought.  Evidently, the Gods, as usual, have decided to take with one hand even as they give with the other.

It understates to describe this as a complex transition.  It is accelerating both in the United States, where assets under management still amount to a third of the world’s investable funds, but also in Europe, Japan, and elsewhere in Asia, where asset growth is fastest.  Because all the pressures creating these trends will likely remain in place for the foreseeable future, the pattern shows every sign of continuing, indeed accelerating in coming years.

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