As the bull market ebbs, asset managers across the globe—particularly in Europe—will need to innovate using data and technology to protect profit margins.
Rising equity markets around the globe bolstered the coffers of asset management firms by an average of 10% a year over the last five years. Yet, even against this favorable backdrop, firms fell surprisingly short in delivering positive operating leverage last year.
In a business where more assets should translate to higher margins, costs per dollar of assets under management (AUM) have not budged. Meanwhile, absolute costs increased by 8% in 2017.
Naturally, this dynamic may not be sustainable given the mounting pressure on firms to cut their management fees. In fact, for many firms, the lion’s share of AUM growth came from market gains rather than new flows. When the winds turn the other direction, the reality of these fee pressures could come to light.
Median Operating Margin Time Series (%)
While our 2020 base case calls for 4% revenue growth for this group, we at Morgan Stanley Research recently lowered our bear case estimates by 19% for our U.S. coverage, and by 31% for our coverage in Europe, where management fees tend to be higher.
In our recent Bluepaper, “Winning Under Pressure,” we teamed up with management consulting firm Oliver Wyman to get a clear look at how fee pressures are impacting asset managers and identify crucial steps that firms should be taking to stay competitive.
The bad news: Cost challenges could reach a critical level since the industry missed an opportunity to use the bull market to get more efficient and restructure the cost base. Several forces are at play, but the root problem is pressure on high management fees and perception of value for money—evidenced by the flow of assets out of actively-managed funds and into passive portfolios.
Fixed Income and Multi-Asset Funds Drove Increases in Active AUM
(Flows as a proportion of AUM, 2017, %)
Moving forward, though, asset managers do need to get serious about reducing their cost structures and pass on some of that savings to investors in form of lower fees.
In our bear case, we expect fees for actively-managed funds to fall closer to those of industry giant Vanguard—which charges roughly 27 basis points for its actively-managed equity funds, on an asset-weighted basis. There is also the potential for nearly all fees to shift to performance based.
The good news: Our research suggests there is ample room to reduce costs through automation and outsourcing—as much as 30% of the current cost structure—which could protect margins in our base case. This, however, will require a fundamental rethinking of the operating model.
For firms that can adapt, there are opportunities, including:
Automation: Roughly 55% of asset management costs are tied to staff, with employees at many firms still performing functions that could be automated or improved by applying data science. Our recent work found that the industry could cut costs 20% by automating some employee functions.
Outsourcing: Although firms have moved to outsource back-office offices, they have kept most distribution and investment-related functions in house. While much of this work is proprietary, there is room to reduce the current cost structure by an additional 10%.
Affiliation: While asset flows have traditionally followed performance, changes in distribution coupled with the growing importance of brands, particularly for retail products, has created a “winner take all” phenomenon. Active outflows for asset managers with less than $100 billion in AUM have been increasing at twice the industry average, while outflows for small active asset managers have been three times higher than for their large peers. This reality could lead smaller firms to affiliate and sub-advisory models, although multi-managers will also need to address high cost structures.
Consolidation: Scale matters, and not just for firms overall but also for individual funds. A significant portion of the funds in our coverage group are small, older than five years, and suffering from steady outflows. Firms should look to close or merge funds small funds that have failed to thrive, freeing up resources for products that have achieved traction.
The bottom line: Now, more than ever, the industry must tackle the cost challenge.
Insights on the latest trends and outlook for the financial sector are based on the recent Bluepaper, “Wholesale Banks & Asset Managers: Winning Under Pressure” (Mar 14, 2018), a collaborative report between Morgan Stanley Research and Oliver Wyman.
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