Beyond the Rubicon: Asset management in an era of unrelenting change

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Any question as to whether North American asset management has undergone a fundamental phase shift should have been put to rest in 2018 (and 2019 thus far). The period served up a heady mix of macroeconomic shocks to the financial markets as well as changes in the industry, spurring revenue and profit pressure for firms across the sector (Exhibit 1). While average assets under management (AUM) in North America edged up nearly 7 percent for 2018 to $43 trillion, the industry’s aggregate revenue pool gained just 1 percent and, facing a rising cost bill, industry profits fell nearly 4 percent. Net flows for the year were anemic, and the drop in both equity and bond markets late in the year made for a weak fourth quarter and a challenging start to 2019.

Industry profitability was challenged in North America and Europe.

The macroenvironment of 2018 was a source of both opportunity and outsize challenge to asset managers. Volatility established itself as an apparently permanent fixture of the new environment, with the markets increasingly feeling the effects of central-bank policy, geopolitical tensions, and frictions in global trade.

An industry in structural transition

A set of now-familiar industry forces continued to redraw the asset-management landscape, and their impact was accelerated and intensified by the stresses of the macroeconomic environment. Six major themes played out in North America over the course of 2018:

  • An intensifying search for yield and diversification, as institutional and retail clients alike faced the realities of a “lower for longer” environment in global economic growth and interest rates. These developments have in turn encouraged meaningful growth in demand for yield-generating assets such as credit, as well as for private-market investments such as infrastructure and real estate (Exhibit 2).
 Shifts in client demand continued in favor of lower-fee products, with the exception of private markets.
  • A continued challenge to active management in the public markets, particularly in domestic equities. The overwhelming influence of interest-rate policy led not only to heightened volatility but also to continued high correlation among stocks as well, further eroding the foundations of fundamentals-based security selection. In 2018 some 70 percent of assets in domestic equities underperformed their passive equivalents after fees—adding to the pressures on this already-beleaguered sector and accelerating the shakeout of underperforming active equities managers.
  • A power shift in favor of distributors and intermediaries. Market reactions to macroeconomic shocks have elevated the importance of portfolio construction as a source of returns and resilience. Accordingly, investors have turned to specialists—advisors who deliver model portfolios in the retail market, outsourced chief investment officer (CIO) services among institutions, or expanded in-house asset-allocation teams—expanding the role of professional gatekeepers.
  • Emergence of a new paradigm for pricing. Pressure on fees reached a record high in 2018, bringing average declines in management fee rates over the last five years in the 6 to 9 percent range. Moreover, a few managers launched experiments with zero fees on a handful of retail products in a bold attempt to draw flows. Fee levels have become a more important factor in client purchase decisions, as the familiar winning formula of “good performance at a fair price” shifted to a new value equation of “good performance at the best price.” Exhibit 3 demonstrates that in 2018 only the top-performing funds captured new assets, and even among those, customers gravitated to the low-priced options.
Performance still counts but at the right price.
  • An untethering of costs from revenues, as the complexities of legacy operating models, the proliferation of products, the increasing demands of serving clients, and a growing legal and regulatory burden added to the fixed costs of doing business (Exhibit 4). In the current environment of low growth in revenues and clients’ sensitivity to fees, operating costs are an increasingly important item on the industry’s strategic agenda, as asset managers contemplate retooling and simplifying their operating models for a new era.
Despite 2018's more challenging growth environment, North American asset managers increased spending in virtually every function.
  • Continued importance of scale and scope. Across multiple product and vehicle categories, net flows continued to drift in favor of managers benefiting from scale (able to deliver products at low cost) and scope (able to serve a broad range of their clients’ needs). Moreover, industry consolidation gathered steam as managers sought high-growth areas like alternatives and exchange-traded funds (ETFs) via acquisitions, and more efficient and scaled operating platforms. But size alone—as measured by AUM—was no guarantor of success in the increasingly competitive arena of North America. In fact, during 2018 even some of the industry’s “trillionaires” faced outflows.

The market’s response

The capital markets have been tracking these developments closely and casting their votes through valuations. In 2018 stock prices of publicly listed asset managers hit historical lows—both in absolute and relative terms—trading in a range of ten to 12 times earnings. This modest valuation was a sharp reversal from the baseline of the past ten years, when asset managers earned historical valuations of 14 to 18 times—a meaningful premium relative to the broader financial services sector and even to the market as a whole (Exhibit 5).

The asset-management sector has been repriced, with multiples recently hitting 20-year lows.

In our conversations with market participants and investors, the single most pressing issue clouding the industry is a perception that growth has hit a wall. Some have gone so far as to characterize the new world of asset management in starkly Darwinian terms—as a zero-sum game where growth will come only from the strong taking share from the weak.

Whither growth?

While industry flows have indeed slowed across the board and economic pressures are real, it would be a mistake to assume a complete drought of new growth opportunities for individual asset managers. Indeed, 2018 illustrated the power of the macroeconomic environment to put significant amounts of money into motion, including healthy demand for fixed income as a foil against volatility; private markets as a source of idiosyncratic returns; portfolio-level solutions (for example, outsourced CIO and liability-driven investment mandates) to help manage complex liabilities in the face of uncertain markets; and innovative vehicles such as ETFs as tools for intraday risk exposures.

Looking further into the future, we see longer-term fundamentals in place to restore the industry to steady growth. Asset management thrives where three conditions are present: sustained wealth creation, a set of growing retirement needs, and room for the deepening of financial systems.

All of these conditions currently hold in North America. A robust economy and ecosystem of innovation continue to be sources of wealth. A 75 million-strong cohort of baby boomers is beginning to exit the workforce, bringing a new pool of retirement assets and seeking a means to manage them. Furthermore, other societal challenges like climate risk and the infrastructure gap are crying out for financing solutions. And as professional management has penetrated just 25 percent of global financial assets, there remains tremendous room for growth in both developed and emerging markets. Overlaid across all these factors is the reality that investing has become far more complex in the current macroenvironment, making it more challenging for investors to “do it themselves.” Put simply, the conditions are in place for a new narrative of growth. However, the industry has yet to write it.

A tragedy of horizons?

The fundamental challenge for the North American asset-management industry is therefore not simply where to find growth, but perhaps more importantly how to manage growth in the context of a multispeed portfolio of businesses, both old and new.

McKinsey’s research in the field of corporate strategy suggests that up to 80 percent of a company’s growth typically comes from its decisions about “where to play,” with the remainder coming from its decisions on “how to compete.” In the midst of a rapidly transforming industry, asset managers that succeed in pivoting toward areas poised for secular growth will benefit from meaningful tailwinds. Yet even among managers aggressively pursuing these new growth opportunities, most are saddled with a large base of legacy assets for which there is anemic new demand, but nonetheless sustains their franchises.

As an example, the challenges facing actively managed equities over the past few years are well documented, as are the secular factors encouraging outflows. Yet the asset class remains an outsize part of the industry—representing 31 percent of revenues in 2018. And it is not going away anytime soon: Active equities are still expected to account for over 25 percent of revenues in 2023. Sustaining a near-term competitive position amid these shrinking but sizable revenue pools, while investing in new capabilities and pursuing new sources of growth, is a challenge in management dexterity.

These conditions create a classic tension between defending the old and investing in the new. The risk at hand is a self-inflicted “tragedy of horizons,”1 where near-term pressures to defend profitable legacy businesses create organizational stasis, which inhibits investments in new capabilities, and a structural pivot in business mix and practices in favor of longer-term growth.

Remaining in a defensive crouch trying to weather the storm of structural change is rarely a winning formula. In our view, then, current depressed industry valuations are not signaling a sector with fundamentals that are in inexorable decline. Instead, they reveal a broken connection between old business models and the realities of a new world.

But today’s valuations are by no means destiny. While the industry as a whole may have been slow to respond to secular trends, forward-looking firms have laid out decisive plans on where to compete and how to win. The gap between the winners and losers is wide, but the capital markets still recognize and reward growth and profitability.

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Four models for capturing growth

The investment-management competitive ecosystem continues to evolve with great pace, and asset managers increasingly face the existential questions of who they want to be in the market and how to create value.

Even as the structural shifts in the industry are clear, there is no one-size-fits-all path to success. But there are distinct recipes. We have defined four that we believe will find resonance in the new industry landscape:

Sustained alpha generators set themselves apart through a unique edge in investing and consistent outperformance. These firms build an effective “flywheel” of a strong investment culture and a disciplined investment process, which in turn generates outstanding results, attracting clients who understand their philosophy deeply (and thus are willing to stick with them through cycles), as well as top investment talent drawn to opportunities for learning and growth.

However, alpha has been in short supply in recent years and is likely to remain so against a market background of lower expected returns across traditional asset classes. Clients will continue to seek out and reward firms that consistently beat the market: top-quartile firms in this archetype have historically achieved outsize growth in AUM and revenues.

Broad-based scale manufacturers meet a full set of client needs and are well positioned in their cost base by virtue of their size. Firms that embrace this recipe seek to meet a full set of client needs and are well positioned to efficiently manufacture and distribute products across the full range of asset classes. When successfully executed, this recipe enables firms to position themselves as core partners to their clients—a major advantage when many clients are seeking out fewer but more strategic manager relationships.

The key to success in this recipe is simplicity—a client interface that seamlessly delivers the whole firm to clients in an intuitive way and an operating model that delivers capabilities at scale and increases productivity as the firm grows. Top performers in this group have achieved organic growth at approximately double the industry average and the strongest revenue and profit growth. However, the costs of mediocrity in this recipe are high: average performers—those who achieve breadth without scale—struggle to grow and to deliver their offerings at attractive unit costs.

Vertically integrated distributors leverage their control of the full value chain to capture flows. Success with this recipe requires equal measures of skill in product management and industrial engineering. These firms internalize processes from manufacturing to distribution via proprietary “pipes” giving them privileged access to end investors or permanent capital—through direct-fund platforms, wealth-management arms, record-keeping platforms, or balance sheets that are owned or “rented.”

These firms make heavy use of technology—in particular, digital channels—to access clients in a highly scalable way. They also make strategic use of pricing, for example, via fee reductions on established funds and on new products to accelerate customer acquisition with high-visibility loss-leader products.

Solutions providers deliver value through bespoke services designed around clients’ long-term, complex investment needs, such as liability-driven investing, outsourced CIO services, strategic asset allocation, and pension-risk-transfer advice.

Results for this group fall in the middle of the four archetypes—average providers achieve results comparable to industry averages, although typically with a stickiness of customer relationships that does not show up in aggregate numbers. That said, top-quartile providers have managed to generate relatively strong net flows, and there seems a clear pathway for this growth to continue given the increasing complexity of client portfolios.

Concluding thoughts

The industry’s post-crisis decade of steady revenue growth through market recovery seems to be near, or even past, its peak. For firms to attain growth and high profitability for the next ten years, marketing innovation and investment excellence will be required to capture new sources of demand. Asset-management executives should consider four broad categories of actions in their strategy and competitive positioning:

  • Re-underwrite business beta. Taking a hard-nosed look at industry trends and demand shifts at a granular level and making deliberate decisions on “where to play” and “how to win” that realign resources with the areas of greatest growth.
  • Reinvigorate investment alpha. Making realistic appraisals of investment skill relative to the competitive set and market conditions and identifying opportunities to improve investment processes through technology, advanced analytics, and data.
  • Reinforce distribution efficiency. Developing a sharper knowledge of evolving client needs, defining a clear value proposition against each segment, and creating mechanisms—such as strategic partnerships—that “deliver the firm” to the most important clients.
  • Re-architect operating models for scale and speed. Simplifying overbuilt operations from front to back, to rationalize products and services and smooth the journeys of the highest-value customers. Firms should streamline legacy architecture to attack structural costs, including aggressive outsourcing and investment in next-generation technical capabilities.

If we want everything to remain as it is, everything needs to change.”2

North American asset management has entered a period of unprecedented challenges. New opportunities are available, but in order for the industry’s position to stay the same—earning premium growth, profitability, and valuation—everything will need to change.

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