An Uncertain Future for Asset Managers
While asset managers have enjoyed strong returns of late, fees and regulations have put future gains in doubt.
Countless companies have benefited from the stock market's eight-year bull run, but one sector that has seen especially strong gains is the one that invests in the market: asset managers. Since the market trough in 2009, the Dow Jones U.S. Asset Managers Index has climbed by 261%, compared with 256% for the S&P 500, while BlackRock (BLK), one of the world's largest investment operations, has soared by nearly 340% over that same time period.
These businesses have been good ones to own during the bull market, and it's not hard to see why: They do well when the market rises. The higher stocks climb, the more people invest in the market, and the more those investments grow, leading to more assets under management. Between 2008 and 2015, global AUM climbed by more than 56%, according to Statista.
"One of the key drivers is that asset values are up and that results in higher revenues," says Adam Krenn, an equity analyst with American Century, who contributes ideas to American Century Mid Cap Value (ACMVX), which earns a Silver rating from Morningstar. "These are very profitable businesses."
Now, though, many investors are wondering if the good times are nearing an end. While the sector continues outperform--the asset managers index is up 8.4% year to date, slightly more than the S&P 500 as of this writing--a push toward lower fees, growing concerns of a too-hot stock market, and the implementation of the Department of Labor's Fiduciary Rule are creating headwinds that will put enormous pressures on these operations.
"The business is not as lucrative as it was even 10 years ago," says Greggory Warren, an sector strategist with Morningstar. He and others suggest that investors tread cautiously with traditional asset managers today.
The single biggest determinant of performance for asset managers is fees. Asset managers make money from the fees they charge clients for money management. When AUM expands, whether from more people investing in the market or from rising stock prices, those management fees get applied to a larger pool of dollars, generating more revenue. It's a simple business.
"These are low capital intensive companies that generate a lot of free cash flow," says Krenn.
Naturally, when their largest source of revenue comes under pressure--investment fees have fallen by steadily over the last decade--so too do revenues, profits and, ultimately, the stock prices of asset managers, says Warren. Fees are likely to drop even more. Why? Because many active managers can't beat their benchmarks. As a result, cheaper indexed products, including ETFs and mutual funds, have been taking more market share away from actively managed funds, which tend to charge higher fees.
Even within the ultracompetitive ETF space, fees are dropping. In December, BlackRock announced a 20-basis point fee cut on some of its ETF products; in March, Vanguard followed suit, slashing costs on 124 of its funds. Others have cut their fees, too. Chris Davis, manager of Davis Financial (RPFGX), which earns a Bronze analyst rating from Morningstar, expects costs to continue to fall.
"Active-passive fee pressure, among other things like consolidation, are secular rather than cyclical forces," he says. "Add in regulations, and there are a lot of asset managers I wouldn’t be comfortable betting on."
Fiduciary Rule Impact
The U.S. Department of Labor's Fiduciary Rule, which came into force on June 9, is also having an impact on asset managers, says Warren. While the rule only applies to retirement accounts, its message is resonating with investments of all types. Essentially, advisors must put their clients' best interests first, and they can't buy products that come with compensation structures that benefit the advisor over the customer. That's supposed to stop advisors from buying underperforming, and often costlier, securities.
In a February Morningstar report, Warren wrote that the new rule "has put fees and performance under greater scrutiny. Broker-dealer and advisory networks are already culling platforms of poorer-performing (and higher-costing) products, and fees have come under pressure. The industry will also need to spend more to produce better investment results to stay relevant."
There is a chance the Trump administration will do away with the rule, but even if it does, the industry won't go back to the way things used to be.
"The power has shifted to the investor and that's not going to change if DOL rule goes away tomorrow," says Warren. "Now, asset managers have to figure out how to they're going to live in an industry where fees and margins are under pressure."
Still Some Opportunity?
As difficult as things may get for some asset managers, there's still good reason to keep some of these stocks on your radar. Thanks to the industry's headwinds, valuations have come down. Historically, asset managers trade at around 18 times price/earnings, but they're now trading in the 15 times range, says Warren. Many are also still producing strong cash flows that are being used on dividends and share buybacks. T. Rowe Price (TROW) pays a 3% yield, for instance.
Depending on your view of where stocks are headed, that cheaper valuation could be an entry point now, adds Krenn. If you think equities will keep rising, then these companies may continue to climb, too. However, if you think the market may be poised to head south, then it may be a good idea to wait, as these companies tend to fall about 1.5 times to 2 times more than overall market.
"There’s a risk and potentially opportunity," says Krenn.
For Warren, two companies are best positioned to weather the storm: T. Rowe Price and BlackRock. Both have wide economic moats and are leaders in their field, with BlackRock also staking claim to being the largest ETF provider in the world. BlackRock is currently trading in 3-star range, suggesting it’s fairly valued today. Yet with diverse revenue streams and size on its side, Warren still thinks it's the best pick of the bunch.
"It's been a much more stable player historically, and it will continue to be more stable than a lot of its peers," he says.
T. Rowe Price is a more traditional asset manager, and will have to deal with the industry's headwinds--but, in T. Rowe's case, "it's not as dire as some are saying it's going to be," says Warren. The firm has a strong target-date fund business, and while active management may be changing, it's not going to disappear.
In a March report, Warren wrote that the "biggest differentiators for T. Rowe Price are its scale, the stickiness of its asset base, strong brand identity, consistently solid long-term investment performance, and reasonable fees. While the firm will face headwinds in the near to medium term … we think T. Rowe Price has a compelling cost and service argument to make to pending retirees." He also thinks the company can pick up more advisor business, an area it hasn't focused heavily on in the past.
Overall, though, Warren suggests staying on the sidelines until the sector figures out where it's headed.
"Everyone's just waiting,” he says. "Managers can't figure out what to do with their business and platforms and there could be consolidation. It's going to be a much more active space over the next three to five years."
Bryan Borzykowski is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.
Bryan Borzykowski does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.