Although most of the traditional U.S. asset managers we cover continue to hit record levels of assets under management, driven by the bull market in U.S. equities, the past decade has been difficult for the industry. Between the 2008-09 financial crisis and the increased scrutiny of investment management conflicts of interest, the balance of power in the retail channel has shifted more heavily toward the distributors.
This has led to not only increased fee compression, with investors (put off by the poor relative performance of actively managed funds) increasingly seeking lower-cost index-based options, but also product rationalization on the major retail distribution platforms, with broker/dealer and advisory networks culling funds with poor performance records, high expense ratios and/or low inclusion rates. The recently announced merger of Charles Schwab (SCHW) and TD Ameritrade (AMTD), two of the largest U.S. discount brokers, will only add to the woes of the U.S.-based asset managers.
Much of this has already been baked into our economic moat and moat trend ratings for the publicly traded U.S.-based asset managers we cover, but it is instructive, in our view, to look at the traits that we think are more likely to lead to above-average levels of organic growth, as well as lower amounts of fee and margin compression, than we forecast for the industry overall. We continue to believe that asset managers will be better served in the long run if they are capable of differentiating themselves from the competition, through offering cost-competitive funds with repeatable investment strategies, and by having enough diversification and/or specialization in their product mix to cater to a wider array of investors, so they can adapt their cultures and processes to a more competitive landscape.
As the industry works to narrow the spread between the fees being charged for actively managed funds and those attached to index-based products, while also improving active investment performance and enhancing product capabilities and distribution, we expect the largest passive managers--with Vanguard, BlackRock (BLK), and Schwab standing out from the pack--and active managers that have scale, established brands, solid long-term performance, and reasonable fees--with Dodge & Cox, American Funds, and T. Rowe Price (TROW) standing out--will be likely to face fewer hard decisions.
Four traits for long-term success
Asset managers need four traits to thrive longer term, in our view. We believe that asset managers with a level of differentiation in their operations, a stable of cost-competitive funds, repeatable investment processes that generate consistent returns, and adaptable business models are more likely to survive the disruption that has affected the industry the past several years as well as thrive over the next decade.
Differentiation can be achieved four ways. With products expected to face a greater degree of scrutiny, active managers can differentiate their approach through: (1) diversification by product, asset class, channel, or geography; (2) specialized expertise in a product, asset class, channel, or geography; (3) scaled-up business or product offerings; and (4) vertical integration.
Active funds need to be more cost-competitive. We believe that by gradually lowering management fees and expense ratios, active asset managers can give their products a leg up over higher-cost offerings in the same category, as well as eventually make themselves more cost-competitive with passive products (as long as investors believe they are receiving value for the fees they are being asked to pay).
Investment performance must be more consistent and repeatable. With investors having become far less willing to pay up for products or solutions when they believe that the performance and investment outcomes do not justify the fees that managers are charging, the impetus is on active managers to improve the disparity that exists between their performance and their benchmarks.
Asset managers need to have adaptable business models. We tend to look more positively on companies with cultures and strategies designed to protect their economic moats and with a willingness and ability to adapt to competitive changes. We look skeptically on companies that are working to repair serious deficiencies in their operations or that have struggled to adjust to changing conditions.
New era for asset management
The past decade has been difficult for the industry, and the next decade looks to be much harder, especially for active large-cap equity managers. The balance of power in the retail channel has shifted more heavily toward the fund distributors the past 10 years, leading not only to increased fee compression, with investors increasingly seeking out lower-cost index-based options, but also product rationalization on the major retail distribution platforms, with broker/dealer and advisory networks culling funds with poor performance records, high expense ratios and/or low inclusion rates.
This has played to the advantage of the major providers of passive products, index funds, and exchange-traded funds, which have garnered most of the industry’s flows the past decade and remain on pace to grow organically at a high-single-digit rate annually during the next decade (compared with our expectations for flat to slightly negative organic growth for active funds). We believe that the performance disparity that exists between active and passive strategies in most categories continues to serve as a major impediment for a return to positive flows for many active funds.
With many broker/dealer and advisory networks having culled their platforms of funds with poor performance records, high expense ratios, and/or low inclusion rates, much of the damage has already been done, but the hurdles that have been raised for asset managers to gain and retain access to these distribution platforms have made the operating environment more difficult. We expect the announced merger between Schwab and TD Ameritrade, two of the largest discount brokers in the U.S. market, to only add to the woes of the traditional U.S.-based asset managers.
Throw in a focus on the part of regulators on increased accountability and transparency to investors, an increase in the amount and intensity of competition for investor capital (not just in the United States but globally), and the likelihood that the decadelong-plus bull market in U.S. equities will end in the near to medium term, and the future for the asset managers looks to be full of far more headwinds than tailwinds. While much of this has already been baked into our moat ratings for our coverage, it is instructive, in our view, to look at the traits that are more likely than not going to lead to positive organic growth, as well as help to stem the levels of fee and margin compression we anticipate for the industry overall.
Identifying winners and losers in a more competitive market
Our long-standing belief has been that the asset-management business is conducive to economic moats, with switching costs and intangible assets being the most durable sources of competitive advantage. While the switching costs might not be explicitly large, inertia and the uncertainty of achieving better results by moving from one asset manager to another tends to keep many investors invested with a fund for extended periods. As a result, money that flows into asset-management companies tends to stay there.
We’ve also believed that the traditional asset managers can improve upon these inherent switching costs with organizational attributes (such as product mix, distribution channel concentration, and geographic reach) and intangible assets (such as strong and respected brands and manager reputations derived from successful, sustainable records of investment performance), ultimately providing them with a degree of differentiation from their peers.
Although the barriers to entry are not all that significant for the industry, the barriers to success have tended to be extremely high. It takes time and skill to put together a long enough record of investment performance to start gathering assets, but even more time to build the scale necessary to remain competitive in the industry. This has generally provided the larger, more established asset managers with an advantage over the smaller players, especially when it comes to gaining cost-effective access to distribution platforms.
Competition for investor inflows can be stiff and has traditionally centered on investment performance, especially in the retail channel. While institutional investors have always exerted pressure on pricing, with the institutionalization of the retail channel only adding to the pressure on fees, competition based on price has generally been rare, aside from what we’ve seen in the U.S. market for exchange-traded funds. While compensation remains the single-largest expense for most asset managers, supplier power has been manageable as many companies have reduced their reliance on star managers and have tied manager and analyst pay to portfolio and overall company performance.
Asset stickiness (the degree to which assets remain with a manager over time) tends to be a bigger differentiator between wide- and narrow-moat companies, as asset managers that have demonstrated an ability to gather and retain investor assets during different market cycles have tended to produce more stable levels of profitability, with returns exceeding their cost of capital for longer periods. While the more broadly diversified asset managers are structurally set up to hold on to assets regardless of market conditions, it has been companies with solid product sets across asset classes (built on repeatable investment processes), charging reasonable fees, and with singular corporate cultures dedicated to a common purpose that have done a better job of gathering and retaining assets. Companies offering niche products with significantly higher switching costs--such as retirement accounts, funds with lockup periods, and tax-managed strategies--have also tended to hold on to assets longer.
Based on this viewpoint, we on the equity research side have traditionally focused on the following six questions when assessing the competitive positioning of the U.S.-based asset managers:
- Does the company have a more broadly diversified product set across asset classes, distribution channels, and geographies that would allow it to hold on to investor assets across market cycles?
- Does the company offer a niche product set that has significantly higher switching costs than the industry overall, providing it with the ability to hold on to investor assets for longer periods?
- Does the company’s size and scale and breadth of product offerings provide it with access to distribution platforms without having to give up too much in order to garner and retain shelf space?
- Are the company’s brands and overall reputation solid enough to allow the company to hold on to assets during periods of poor investment performance within its product lines?
- Does the company have a single corporate culture dedicated to a common purpose, which is ultimately reflected in the level and consistency of investment performance, rate of organic growth, focus and importance placed on risk management, and amount of employee turnover?
- Are the benefits of competitive advantage passed along to the holding company and its shareholders, or do they accrue to employees or other stakeholders?
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