North American asset management: A year of shocks but few surprises

In a year of historic challenges to human health and the economy, the North American asset management industry has been a picture of relative calm and stability. Even in the most volatile days in the financial markets—a weeklong bout of liquidity concerns in fixed income—swift central bank intervention restored market confidence in days, and since then the capital markets have functioned without major disruption. There have been no major publicly reported breakdowns in technology or back offices at large asset managers, even with as much as a reported 98 percent of employees working from home.

With industry revenues that track the financial economy rather than the real economy, the rapid rebound in equities markets and the surge in bond prices have pulled managers back from a reckoning on their income statements. And publicly traded asset managers have fallen in the middle of the pack of all other sectors, recording flat to slightly positive returns for 2020 thus far.

Given the uncertainty in the economic outlook, the capital markets have given asset managers a valuable resource: time. Forward-looking firms will put that resource to good use by taking stock of what has changed and what has not in a new operating environment. They will recalibrate their strategic postures and accelerate the modernization of their operating models. But the breathing space is limited, as the events of 2020 have accelerated a number of trends that have been playing out in the industry over the past decade.

During the crisis

For the financial markets, 2020 started on a strong footing. But with the emergence of COVID-19 the markets entered an intense period of stress towards the end of March, and the industry experienced a year’s worth of asset allocation shifts in just several weeks. This initial period of volatility and uncertainty was marked by a dramatic flight to safety.

But while prior flights disproportionately pulled assets out of equities and other risk assets, this time the traditional safe haven of fixed income experienced the largest net outflows, as concerns over liquidity hit market participants and the long ends of yield curves flattened beyond what most investors believed was possible. In the month of March alone, long-term outflows from fixed-income funds totaled almost $300 billion. Despite a massive round of central bank interventions, which stabilized the markets, investors pulled far back to the sidelines. In just two months, money market instruments in North America accumulated an additional roughly $1.8 trillion in net inflows, including nearly $1 trillion in money market mutual funds alone.

To be sure, long-term flows have recovered significantly since March, as confidence in the market’s stability returned (Exhibit 1). A mix of central bank actions and massive fiscal stimuli catalyzed a rapid surge in asset prices to pre-crisis levels. And investors did return to the market, with close to $200 billion of net flows in North America in the second and third quarters. Yet somewhat paradoxically, despite the surge in risk-asset valuations, investors have returned primarily to the safest part of the public markets (fixed income). Equities remain in aggregate outflow for the year to the tune of $280 billion as of the third quarter. The flight to safety has proved to be an extended one for a meaningful pool of assets. We estimate that an additional $1.3 trillion in assets previously invested in third-party investment portfolios (and $780 billion in money market mutual funds) remain on the sidelines as of September 2020.

While long-term flows have recovered somewhat from massive net outflows in March, significant money remains on the sidelines.

Winners and losers amidst volatility

Passive strategies have been beneficiaries of the recovery since late March. Passive strategies and ETFs (particularly those featuring fixed income) have captured a meaningful share of the recovery in positive flows—roughly $205 billion through the third quarter. On the face of it, active flows appear to have kept pace, with $209 billion in positive flows through the third quarter. But below the surface, the active story is almost entirely driven by a resurgence in active fixed-income net flows after April.

The biggest winner of 2020 sat at the intersection of fixed-income and passive-oriented vehicles. Fixed-income ETFs have been on a roll since March—globally, they have grown to $1.4 trillion in AUM as of September 2020.

The current year posed a new set of challenges for the already beleaguered active equities sector. Active equities came into the crisis on the back of a decade of consistent outflows ($3.5 trillion since 2010) and persistent poor performance. Large-cap growth was a marked exception—both in absolute performance and in relative terms—benefiting from the massive widening of sectoral dispersions, particularly large-cap technology and health-care growth stocks, which have surged ahead of other sectors. Whether the relative outperformance of active managers in this space can be sustained remains to be seen, with results already appearing to be reverting to the mean as of the third quarter.

Value-oriented active managers continued to face their own set of challenges, as the second-order effects of COVID-19 accelerated a decade-long trend of underperformance relative to growth managers. The work-from-home environment further fueled this trend, boosting traditional growth sectors (e.g., technology, pharmaceuticals) while unleashing massive disruptions across traditional value sectors (e.g., travel, energy, financials). A small number of active firms did manage to take advantage of these shifts: the top 10 active equity funds in North America gathered about $48 billion of flows.

Contrary to the naysayers, private markets demand has stayed strong through the course of 2020. Although deal volume initially slowed early in the pandemic, it has shown signs of acceleration in the third quarter, as investors appear to be putting dry powder to work, particularly in sectors sheltered from the brunt of COVID-19-related shutdowns. Most importantly, investor demand has remained highly resilient. In fact, it has accelerated in many parts of the market, particularly for yield-oriented strategies lower down the risk-return spectrum, as investors contemplate alternatives to their fixed-income allocations in this “lower for longer” environment.

While private equity deal volume for the first half of 2020 was about half the level it was at the same time in prior years, overall fundraising levels have remained stable. Globally, private equity funds raised $237 billion in the first half of the year, similar to the same period in 2018 and 2019.

A flight to strength (and familiarity)

The pressures of the first half of 2020 led to the opening of a great divide between best and the rest as clients and investors gravitated towards a relatively small group of managers. Exhibit 2 characterizes how North American asset management fund families fared in the downturn of markets in the first quarter and in the second-quarter rebound. One group, consistent high performers, excelled through two wildly different market and operating environments, with $183 billion in net inflows through the first two quarters of 2020. Notably, 80 percent of the flows to this group went to just 10 firms.

Incumbency has benefits in a period of extreme volatility.

Incumbency has benefits in a period of extreme volatility.

Impact of COVID-19 crisis on asset-manager flows in 2020

Quarter Q2 net outflows Q2 net inflows
Q1 net inflows Mixed performers: Smaller focused firms, flows $6 billion and 11% of firms Consistent high performers: Large, diversified, consistent outperformance, flows $183 billion and 25% of firms
Q1 net outflows Challenged: Active equities, investment performance challenges, flows $290 billion and 45% of firms Rebounders: Midsize firms with performance in right asset class, flows $0 and 17% of firms

Source: Morningstar; McKinsey analysis

McKinsey & Company

The converse of these dynamics were experienced by the mixed performers—a set of smaller firms that entered the crisis with significant growth momentum. For these firms, representing some 11 percent of North American asset managers, the crisis presented new obstacles. For example, the remote environment made it difficult for them to win new business, and their limited product shelves made it harder to pivot to meet new client needs. Yet, the momentum of this group did not lapse completely, as they netted $6 billion of new money across both quarters.

Rebounders—firms that were in outflows before the crisis, but managed to turn the crisis into an inflection point and rally in the second quarter—eked out flat organic growth in the first half of the year. This segment consisted largely of mid-sized firms with good investment performance and well-positioned products with strong client demand, as well as agile smaller firms that leaned into their strengths.

Finally, challenged firms saw outflows intensify with the onset of the crisis. Some 45 percent of the industry fell into this group. Active equities-focused firms with challenged investment performance and other internal disruptions were heavily represented here. In the first half of the year, this group of managers suffered $290 billion in net outflows, exceeding the inflows taken in by all other segments by over 50 percent and further widening the great divide of industry performance.

This divide has been reflected in the capital markets’ view of the overall asset management sector—the gap between the industry’s forward P/E multiples and the S&P 500 has widened from 6.9x at the start of the year to 12x as of the end of the third quarter. Within the industry, the valuation spread between top- and bottom-quartile asset managers has also widened—from 8.9x in 2018 to 14.1x as of the second quarter in 2020. So while market-leading managers are valued at multiples in line with the broader market, those in the bottom quartile of valuations are trading at significant discounts to historical levels.

Durable industry shifts

For the asset management industry, the shock to the real economy, the volatility of markets, and an intensified focus on social issues have set off a cascade of second- and third-order effects which are amplifying industry trends that have been in motion for several years. Asset managers will need to position themselves against these five shifts.

1. New paradigms of investing. Disruptions triggered by the impact of COVID-19 have accelerated an ongoing evolution of the craft of investing, characterized by the adoption of risk-factor-oriented approaches in portfolio construction, a focus on total portfolio outcomes over relative returns, liability-sensitive investment approaches, and a greater appetite for harvesting illiquidity premia. Going forward, they will generate new fast-flowing rivers of growth in areas including non-traditional sources of yield, multi-asset strategies, return-oriented private markets strategies, strategies that navigate volatility, “whole portfolio” solutions, and tax-efficient solutions for retail investors.

2. Reshuffling sources of capital. The combination of macroeconomic conditions and real economy shocks has impeded some investors’ ability to generate surpluses (i.e., the source of net flows), led to changes in the profile of their liabilities, and shifted mindsets around liquidity and appetites for risk. As a result, we expect to see a number of trends play out across client demand in North America in the next few years, including: the continuation of the trend of retail investors as the most important driver of organic growth; the emergence of targeted opportunities in defined benefits; near-term deceleration in defined contribution; a pull-back in endowments and foundations; and growth in insurance general accounts.

3. Renewed pressure on operating models. Asset management leaders have long spoken about the need for a “next-generation operating model”—supported by advances in data, analytics, and technology—that better responds to client needs and generates greater scalability. But the rhetoric has not been matched by action, with most in the industry making tweaks around the edges.

The current environment, however, has been a catalyst for innovation. For example, the sudden shift to working from home forced a new reality of remote and digital sales models and opened up new possibilities for distribution powered by geographically dispersed teams. Since the onset of the pandemic, clients have signaled that they are more than receptive to remote sales and service models and expect their best elements to remain in place once the pandemic ends.

Asset managers with the strongest digital and remote capabilities saw sales and service satisfaction climb by four percentage points relative to their performance a year earlier. Conversely, those that had strong field capabilities but struggled to adapt to a digital-led operating model, saw satisfaction drop by similar amounts. Most importantly, these differences had a tangible sales impact, with digital leaders achieving a 14-percentage-point gross sales lead relative to their more traditional counterparts.

4. A new catalyst for industry consolidation? The widening gap between the best and the rest that has opened up in the asset management industry has become a catalyst for new deals, as publicly listed industry leaders have a currency (their high valuations) to pursue high-quality acquisitions.

We see industry consolidation proceeding in three major areas: 1. capability-driven M&A, whereby an asset manager acquires a more specialized counterpart to rapidly reposition itself in some of the fast-flowing rivers of product and client demand (we expect this to be the most important driver of consolidation); 2. expansions into the ecosystem, whereby asset managers adapt their business models by acquiring toeholds into adjacent industries (e.g., wealth management, insurance, technology); 3. cross-border growth will continue to be an attractive theme as new market access is difficult to create organically and at scale. Scale and cost-oriented consolidation, which was an active theme prior to the pandemic, could abate somewhat as the number of natural pairings in the market diminishes.

5. Rethinking asset management’s social purpose. In the past few years, there has been an intensifying conversation on the role of business in society, in particular on the question of how traditional models of shareholder capitalism might need to be adapted to the realities of a new age. The events of 2020 have only sharpened the tone and profile of these debates. We believe that three sets of issues will be central to defining the broader role of the asset management industry: financial security, socially responsible investing, and diversity and inclusion.

Financial security. COVID-19 has engendered a near-term healthcare and economic crisis, but in the longer-term it will deepen a crisis in retirement security that has been many years in the making. With severe unemployment numbers, Americans are not just taking a near-term hit to their livelihoods, but also facing a longer-term impact on their retirement savings—a loss of 401(k) matches and an uptick in plan withdrawals to meet critical liquidity needs.

With the looming long-term gap in retirement readiness, asset managers have a critical role to play in retirement security: working with pension funds to close funding gaps and shore up their resilience in delivering benefits; delivering innovative, customized retirement savings and income products; and continuing to democratize affordable access to a broader range of returns engines across the public and private markets.

Diversity and inclusion. The events of 2020 have added particular urgency to conversations on racial injustice and gender diversity. Senior executives across the industry have redoubled their firms’ commitments on each of these fronts. But the asset management industry’s internal record on diversity and inclusion is mixed at best. Minorities and women both are significantly underrepresented in senior roles. According to McKinsey research, women represent just 19 percent of C-level and president roles at North American asset managers. In the same survey, we found 59 percent of North American asset managers do not set diversity and inclusion-specific targets for their leadership positions.

Firms are making progress—63 percent of North American managers have implemented policies and practices to reduce gender bias in their evaluation systems—but the industry as a whole needs a more fundamental shift for reasons both principled and pragmatic: McKinsey research has shown that companies that lead in racial, ethnic, and gender diversity are more likely to be profitable than their peers. The challenge for asset managers is to embrace diversity and inclusion as more than just a corporate and social responsibility initiative, and as a core ingredient of a sustainable business model.

Socially responsible investing. Environmental, social, and governance (ESG) considerations have long been a feature of asset management. But the broader focus on ensuring that asset managers deploy capital in socially responsible ways has been sharpened in 2020, as a slew of natural disasters in North America, from wildfires to hurricanes, coincided with growing consensus among investors that climate risk and financial risk are inextricably linked.

Client demand for responsible investment products has been ratcheting upwards, with a growing desire for portfolios that not only optimize risk and return, but also align with the values of a given institution or individual. In the United States, flows to sustainability, impact, and ESG-oriented funds reached record levels of $26 billion in 2019 and accelerated to hit $30 billion through the third quarter of 2020. And according to our annual survey, North American asset managers believe 30 percent of their AUM will integrate ESG in the next five years.

Navigating the Great Divide

In the near term, we propose a five-point strategic agenda for North American asset managers seeking to navigate the extreme uncertainty that lies ahead:

  1. Keeping the client at the center. If this is an uncomfortable moment for asset managers, it is even more so for clients. Both institutional and retail clients are seeking out partners (rather than product providers) to help them manage the volatility of the markets and changes in their industries. This is a moment for asset managers to invest deeply and strategically in the “platinum” clients that anchor their franchises.
  2. Finding growth that is hidden in plain sight. While current uncertainties have put a damper on net flow growth, they have created an unprecedented set of money-in-motion opportunities, whether through big shifts in asset allocation, the emergence of new sets of client needs, or in delivering products that turn disruptions into investible themes.
  3. Managing uncertainty by leaning into “known knowns.” Amidst the current uncertainty, there is much that can be known; for example, the realities of volatile markets, lower-for-longer interest rates, and the realignment of industry sectors that has been accelerated by the pandemic. Asset managers need to be nimble in adapting their investment strategies and portfolio construction approaches to help clients create value amidst these major shifts.
  4. Launching bold moves. Asset managers should be asking “If not now, then when?” with regard to bold M&A moves, significant talent liftouts, operating model re-engineering, radical reallocation of resources towards growth priorities, or structural shifts in the cost base to create a currency for growth.
  5. Planning to win the recovery. Even in the most pessimistic scenarios, markets ultimately bounce back. And across all of the narratives, demand for high-quality investments remains. Asset managers need to be thinking today about how to win the recovery of tomorrow. Who are the emerging leaders within their organizations who will push the envelope on growth? Where do investment engines need to be retooled? Where do distribution capabilities need to be strengthened to build “relationship alpha”? How do business models need to be repositioned within a changing investment ecosystem?

The full report, available for download here, provides more comprehensive detail, examines what each of three macroeconomic scenarios set out by McKinsey could mean for client and competitive dynamics, and looks at how individual managers used the catalyst of the financial crisis to put themselves on new trajectories, with implications for today’s environment.

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