The past decade has been difficult for the industry—and the next one looks to be much harder, especially for active large-cap equity managers. 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 mutual fund distributors.
This, along with investors (put off by the poor relative performance of actively managed funds) increasingly seeking lower-cost, index-based options, has led to increased fee compression on actively managed funds. 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—has also added to asset-manager woes.
In light of these industry trends, we’ve dug deeper into 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, for U.S.-based asset managers. Here’s our perspective on firms that might stand out in each area.
Trait #1: Differentiation in operations
With their products expected to face a greater degree of scrutiny, fund managers must differentiate their approach and product offerings. We see four strategies they can follow to achieve this goal:
- diversification by product, asset class, channel, or geography
- specialized expertise in a product, asset class, channel, or geography
- scaled-up business or product offerings
- vertical integration
BlackRock, with a wide Morningstar® Economic Moat™ Rating, is an example of a company using more than one of these traits. The company’s biggest differentiators, in our view, are its scale, ability to offer both passive and active products, greater focus on institutional investors, strong brands, and reasonable fees.
The company’s iShares ETF platform maintains a leading market share both domestically (39%) and globally (37%), despite intense pressure from Vanguard and Schwab. The company also offers risk management and product/portfolio-construction tools directly to end users via its Aladdin platform, making them stickier in the long run. These traits should allow the company to generate higher and more-stable levels of organic growth than its publicly traded peers over the next five years.
Unlike many of its competitors, BlackRock is currently generating solid organic growth with its operations, with the iShares platform riding the secular trend toward passively managed products. This has helped the company maintain above-average levels of annual organic growth despite the increased size and scale of its operations. Although we expect several secular and cyclical headwinds to make AUM growth difficult for the U.S.-based asset managers over the next five to 10 years, we still envision BlackRock generating 3-5% average annual organic AUM growth, with slightly lower revenue growth but steadily improving margins during 2019-23.
Trait #2: A stable of cost-competitive funds
We believe that by gradually lowering management fees and expense ratios, active fund managers can give their products a leg up over higher-cost offerings in the same product category. They can also eventually make themselves more cost-competitive with passive products—that is, as long as investors believe they are receiving value for the fees they are being asked to pay.
A good example of a platform with a stable of cost-competitive funds is Charles Schwab Investment Management, or CSIM, the asset-management arm of wide-moat Charles Schwab. That company’s disciplined focus on low-cost core strategies has fueled considerable growth over the past few years, particularly among the index-based strategies that account for the bulk of its assets.
CSIM’s product mix is not overly diverse—Morningstar Direct℠ was tracking $241 billion in long-term, open-end and exchange-traded funds at the end of September 2019, and 86% of that sum was dedicated to equity strategies. However, these are predominantly low-cost passive products (which actually accounted for 97% of the company’s long-term AUM we were tracking at the end of the third quarter).
CSIM had more than 80% of its offerings in low- to below-average fee arrangements relative to comparable funds, with fees (currently sitting at an adjusted expense ratio of 12 basis points) likely to continue to fall as many of Schwab’s index-based products scale up further. Fund scores relative to category peers are also solid, with 92% of funds in the high range and just 1% in the low category.
Trait #3: Repeatable investment processes that generate consistent returns
With investors having become far less willing to pay up for products or solutions when they believe the performance and investment outcomes do not justify the fees that managers are charging, the impetus is on asset managers to improve the disparity that exists between their performance and their benchmarks. We continue to believe that managers who have committed themselves to reliable, repeatable investment processes have historically been able to—and are more likely to continue to—produce strong and consistent performance for their fund shareholders.
For example, wide-moat T. Rowe Price has never really tried to be, nor has it needed to be, anything other than an active manager. Factors that have contributed to the firm’s success include:
- The level and consistency of its investment performance. With most broker/dealer and advisory platforms tending to give deferential treatment to 4- and 5-star funds, T. Rowe Price is well-positioned with more than 40% of its fund AUM rated 5 stars, and another 35% rated 4 stars, on a five-year basis. Additionally, with 68%, 75%, and 81% of the company's sponsored U.S. mutual funds beating their peers on a three-, five-, and 10-year basis, respectively, at the end of September 2019, we expect the firm to generate better organic growth from its active fund platform than the industry as a whole.
- A single corporate culture dedicated to a common purpose. This is reflected in the level and consistency of its investment performance, rate of organic growth, and a relatively small level of employee turnover. Morningstar’s manager research group views the management at T. Rowe Price as highly insular and protective of its culture: It has cultivated a disciplined, risk-conscious investment process that consistently produces successful results across its fund lineup, often with less volatility than peers.
- Management that is willing to evolve. The company has, for several years now, been focused on: building additional scale through new investment products (like its target-date retirement funds); expanding the reach of its investment-advisory business by further penetrating domestic distribution channels (like the retail-advised channel) and moving into non-U.S. markets (especially emerging and developing economies in the Asia-Pacific region); and bolstering technology (in an effort to improve performance outcomes, drive down incremental costs, and improve product distribution).
These factors, along with the stickiness of the company’s asset base (which leans more heavily toward retirement-based assets) have allowed it to consistently generate operating margins in excess of 40%, the highest among the U.S.-based asset managers that we cover. The company’s ability to generate more stable revenue, profitability, and cash flows than its peers has, in our view, provided it with more than enough excess capital to continue building on the competitive advantages that it already possesses.
Trait #4: Adaptable business models
When growth is difficult to come by, as has been the case for most traditional active asset managers, we expect firms to take a variety of actions, including:
- overhauling their leadership or investment processes
- buying a competitor with better performance or greater product, asset class, channel, or geographic diversity
- branching out more aggressively into strategies that are far less exposed to the fee and margin pressures created by extremely low-cost, index-based products
Essentially, active asset managers will need adaptable business models to remain competitive in a continually evolving market. In general, we tend to look more positively on asset-management companies with: cultures and strategies designed to protect their economic moats; a willingness and ability to adapt to competitive changes; and a skeptical view on firms that are working to repair serious deficiencies in their operations or that have struggled to adjust to changing conditions.
We view this as another area where CSIM has excelled—resisting the temptation to launch trendy strategies and demonstrating a willingness to shutter some of its older, higher-cost funds in order to provide more cost-competitive funds to investors.
And T. Rowe Price—which is expected to continue to face headwinds in the near to medium term as the baby boomer-rollover phenomenon affects the organic growth it derives from the defined-contribution channel—deserves credit for shifting gears and actively pursuing business in the retail-advised channel.
For more about how we evaluate asset managers’ competitive positioning, join our webinar on Feb. 27.