In 2013, the CEO of Blackrock announced that the firm had some 70,000 share classes in the fund universe. Yet, only 185 of them (0.3 percent) attracted almost 100 percent of new inflows. We experienced a wave of asset management innovation that took the shape of product proliferation.
In the first quarter of 2019, pursuit of low-cost passive strategies sent $62 billion into Vanguard, which meant that it saw nearly half of all fund inflows in North America – more than its three biggest competitors combined. We are experiencing a wave of asset management innovation that takes the shape of a race to the bottom.
In many ways, both are symptoms of the 2008 global financial crisis as the subsequent rise of a low-yield environment has intensified the search for such blockbuster products. However, their success rests more on luck than judgement – often driven by the prevailing market sentiment, deft marketing and clients’ wish to chase the next rainbow.
Vanguard’s move into PE may change the landscape forever
Asset Management Innovation and fads
Indeed, for too long asset managers – and clients – have been lazy when it comes to innovation, following fads and ultimately damaging themselves. Investors have followed past performance blindly to such extremes that, as we have seen, almost 100 percent of flows go into top star funds, imbuing the industry with a blockbuster culture. In the past, too many new products were rushed out too often without much regard for their inherent value. What’s worse, as we know, a ‘winner takes all’ industry leads to a ‘one size fits all’ business model, which is doomed to fail both clients and manufacturers.
Neither approach can be called innovation. Innovation means creating new ideas that add value to clients—often taking the form of investment strategies that scale with greater predictability in outcomes. Unfortunately for asset management, ‘innovation’ became an overused, misused and abused word in the investment lexicon.
Nevertheless, with attractive margins and reliance on traditional business models, the industry has long been seen as ripe for disruption. At the moment, we are going through yet another wave of asset management innovation: digital transformation. But is the industry treating it as yet another fad, or have we learned lessons from the recent past, when myriad industries were all too often caught unawares by advances in digital technology?
The photography, music and travel industries are stark examples of the disruptive impact digital transformation can have.
Tailwinds to Headwinds in Asset Management Innovation
Asset managers have heretofore enjoyed one unique advantage: they have consistently raked up profit margins well north of 30 percent, while deploying zero capital of their shareholders. Lately, however, this profit base has increasingly come under attack: as much as 87 percent of its growth in the period 2009–2016 has been attributed to the market’s artificial rise, fuelled by central banks’ ultra-loose monetary policies. The organic component of growth has been declining. There is ample recognition among asset managers that, as central banks rewind their policies, the current level of profitability will be unsustainable.
Data is telling us that this has already started to happen. A McKinsey report tells us that while average assets under management (AUM) in North America edged up nearly 7 percent for 2018 to $43 trillion, the industry’s aggregate revenue pool gained just 1 percent and, facing a rising cost bill, industry profits fell nearly 4 percent. This pressure has started to translate itself into market valuations. In 2018, stock prices of publicly listed asset managers hit historic lows – both in absolute and relative terms – trading in a range of 10 to 12 times earnings. This modest valuation was a sharp reversal from the baseline of the past 10 years, when asset managers earned historic high valuations of 14 to 18 times – a meaningful premium relative to the broader financial services sector, and even to the market as a whole.
A number of structural factors are exacerbating this trend: sustained low levels of real interest rates, an expectation of limited organic growth due to debt deleveraging, greater efficiency in the public markets, an aging client base, the rise of intermediaries, and increasing regulatory intervention.
Yet, organic growth can still be found. There is a healthy demand for fixed income as a foil against volatility; private markets as a source of idiosyncratic returns; portfolio-level solutions (for example, outsourced chief investment officer and liability-driven investment mandates) to help manage complex liabilities in the face of uncertain markets; and innovative vehicles such as ETFs as tools for delivering precision intraday risk exposures.
For an industry that has enjoyed a post-crisis decade of steady revenue growth – and enviable operating margins of 30 percent and higher – it is clear that for things to stay the same, quite a bit will need to change. The industry as a whole will need to pivot away from a mindset of zero-sum competition in a stagnant pool, toward a new story about how asset management innovation and investment excellence can enable tapping into new sources of demand, be they unmanaged assets (e.g., cash and securities), shifting client needs (e.g., retirement) underpenetrated markets (e.g., emerging Asia), or financing solutions to new global challenges (e.g., climate risk).
What’s needed is a fundamentally new narrative of growth. Indeed, the search for cost-effective organic growth has intensified for the asset management industry, turning the spotlight on digitization – but not without hesitation.