The fund industry is on a roll compared to the banking sector. Whilst bank profits and share prices in Europe have yet to fully recover from the financial crisis, with profitability mostly struggling to reach double digits globally, listed US managers have enjoyed an average profit margin of 17.6% since 2003.
However, that’s not enough to cheer an industry in the face of significant and growing pressure on margins. A recent report by PwC highlights that while total assets under management have continued to rise in recent years, on average profit has not kept pace.
The PwC report identifies two main reasons for falling profitability. First, fees are declining as active managers face increasing competition from passive investment strategies and, especially, low-cost exchange-traded funds. So-called smart beta investments are also gaining ground, making further inroads into the primacy of human judgement at the heart of the asset management industry as they go.
The second factor is rising costs, which the industry mostly tends to blame on increased regulation. New iterations of the EU’s UCITS, MiFID and anti-money laundering directives, along with the AIFMD and other legislation, have added to firms’ reporting and compliance burdens, with environmental, social and governance reporting among more requirements on the way. Money market funds, already adapting to the constraints of major post-crisis regulatory changes, will have to cope with European Securities and Markets Authority stress tests from next year.
Strategy in business as well as investment
Every active fund manager has an investment strategy – but not all asset management firms have a sufficiently clear business strategy. With costs under pressure, businesses are forced to become more efficient, whether through outsourcing of administrative and other functions or deploying new technology. But they have to be smarter too.
It might also be a good time for a strategic rethink on the very existence of some, even many, funds. According to EFAMA, there were more than 33,000 UCITS funds alone at the end of March, roughly one for every 15,000 EU residents, and far more than the continent really needs. The result is sub-optimal fund sizes and less ability to control costs, which eats into investor returns.
Fund groups have taken some steps to simplify and consolidate their ranges. Regulators such as the Central Bank of Ireland have helped the process along with initiatives targeting so-called closet trackers that offer little more stock selection than ETFs but charge investors for active management.
Yet me-too products keep popping up. Did the market really need (and will it support) 155 new UCITS bond funds in the first three months of this year? ETF providers such as WisdomTree are buying competitors to gain scale, but also slimming down their ranges as even passive funds face competition from the zero-fee vehicles pioneered by Fidelity. That means the pressure on active managers’ fees is likely only to intensify, and the scope for further rationalisation remains vast.
Consolidation is also taking place at a higher level. In many markets, a handful of funds and brands account for the majority of sales. As the big get bigger, smaller and medium-sized firms are feeling the pinch. That said, consolidation is no panacea; even relatively big names need to manage their merger projects carefully if they hope to benefit from cost synergies.
Adding a different kind of value
In certain asset classes, rationalisation is not enough. It’s genuinely hard to beat the S&P500 on a consistent basis. Being the biggest US active manager in that area is no guarantee of success, but getting it wrong will annoy more investors.
Should active managers try to fight ETFs when the odds are stacked against them? They might do better, in terms of profitability and sustainability, to redefine what value they are capable of adding. Firms with multi-asset capabilities may find that new types of asset that are not correlated with shares and bonds, such as infrastructure or trade finance, can enhance their sales message, providing their investment teams can work together and take a holistic view, rather than operating in their traditional silos.
Developing investment strategies that cannot be replicated with a black box will also need a strong sense of purpose that is closely aligned with real investment needs. ESG may well be the example to follow – many investors now place virtuous use of their money above maximising returns at all costs. Fund managers with a refreshed sense of purpose may find that doing good can maximise their own returns, too.