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Challenges in Asset Management

To survive and thrive, asset managers will need these key traits

Morningstar Staff

 

The past decade has been a disruptive one for asset managers and their fundholder clients. Investors have not only been put off by the poor performance of actively managed funds, but they have also increasingly sought out lower-cost options, with passively managed index-based products becoming the default choice for many.

But these aren’t the only challenges in the asset management industry.

The rollout of the U.S. Department of Labor’s fiduciary rule has only heightened the scrutiny that active asset managers will face as they look to secure access to retail-advised platforms. Funds with poor performance track records, high expense ratios, or low inclusion rates on platforms are less likely to make the cut with gatekeepers of the broker/dealer and advisory platforms in the long term.

As we’ve explored in recent research, the shift in the balance of power from fund manufacturers to distributors is expected to lead to greater fee and margin compression. Active asset managers will likely need to narrow the spread between the management fees charged for their funds and the fees being charged by index-based products. They also need to improve active investment performance and enhance distribution to remain competitive.

For active asset managers to survive and thrive during the next decade, it is likely they’ll need a combination of these characteristics:

 4 traits to help address challenges in the asset management industry

  1. Differentiation. In an era when investments are expected to face a greater degree of scrutiny, active managers must be able to differentiate their approach and offerings from the pack. One way is by scaling up their level of assets under management, which should allow them to better absorb lower fees on their product offerings. Others may do so with a deep, well-known expertise in a single asset class or investment type. Another approach would be to diversify—offering a variety of well-supported investment capabilities and services that will appeal to a much broader set of clients. Differentiation is likely to take many forms, but we expect it to be a key theme among active managers as they look to navigate the industry disruption we see occurring over the next decade.
  2. Low-cost funds. Good partners for the next decade are likely to offer inexpensive funds. By lowering expense ratios, asset managers will help give their investment products a leg up and increase the odds that they’ll outperform passive competitors. Lower expenses and better performance are more likely to improve scale, but we still see asset-manager profit margins declining over time, as more capital is expended to improve investment performance and enhance product distribution. Asset managers who historically have been mindful of costs are under less pressure to dramatically lower fees in the near future, giving them a competitive advantage and resulting in steadier profit margins and healthier earnings over the long run.
  3. Repeatable investment processes. Active asset managers will need to have reliable, repeatable investment processes that can yield strong performance overall to be successful. These processes must be backed up by an experienced, stable investment staff that’s well-resourced in terms of personnel and tools, including risk management analysis. The resulting investments should have predictable return patterns, making them better tools in a diversified portfolio. Firms that have such investment processes in place are also likely to avoid key-person risk through thoughtful succession planning.
  4. Adaptable business models. When growth is harder to come by, firms are likely to take a variety of actions. They may overhaul their leadership or the investment process, buy a competitor, or branch out into passive or strategic-beta strategies. We expect these responses to become commonplace in the coming years, and the impact of each shift requires careful evaluation. In general, we tend to look positively on firms whose actions are designed to protect their economic moat, or competitive advantage, and we look skeptically on firms that are working to repair a serious deficiency (as such repairs have traditionally been difficult to execute well).

This blog post is adapted from an article that originally appeared in the June/July 2017 issue of Morningstar magazine.  Read the full article.

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