The Strategic Outlook for Asset Management

2017 was a challenging year for the asset management industry, with buoyant markets masking underlying financial and business model difficulties. The next several years are unlikely to be any easier, and the degree of difficultly may increase significantly if the tail wind provided by strong investment returns reverses. As the calendar turns to 2018, this is an opportune moment to refocus on the strategic forces likely to influence the industry in coming years. I think the most impactful disruptions will come from asset managers implementing creative efforts to reduce costs and boost efficiency, rather than competitors delivering new product innovation, reimagining distribution or tapping new markets for the industry’s services. While opportunities will abound for imaginative thinking in support of profitable growth, prioritization and strategic focus will remain imperative. 

Historically, asset management has been a very attractive business – industry margins are normally quoted in the 30%+ range. However, margins have been under attack from both revenue challenges and rising costs. 

Sources of revenue pressure include:

• Asset flow from active to passive strategies
• Assets moving from equity to fixed income, often at a lower management fee
• Price compression on asset management products, particularly index, smart beta, low conviction benchmark-relative active, and anything else that can be replicated with a rules based approach
• Client insourcing

Cost pressures are arising from a variety of sources, including:

• Proliferation of regulatory requirements since the global financial crisis
• Greater transparency demands – enhanced client reporting, technology-enabled tools to view portfolio exposures, augmented disclosures, etc.

To address margin contraction, asset managers must target both sides of the P&L. 

Cost-focused innovation will be a key driver of success. 

Technology will be critical to reducing costs and improving outcomes. IT innovations will target efficiency gains at all points on the value chain – distribution, client on boarding, portfolio construction, risk management, alpha generation, operations, client reporting, and other areas. 

Separately, asset managers will need to look carefully at their operating models and determine which functions provide an “edge.” That edge can be investment alpha, sales alpha (mores sales than would be expected given product positioning, hat tip to McKinsey for the concept), superior client relationships, proprietary operational processes, etc. - anything that differentiates a manager from competitors and can impact an investor’s purchasing decision. Managers should cultivate and nurture their competitive advantages; everything else should be done as cost effectively as possible. Opportunities for cost reduction include outsourcing and offshoring, along with aforementioned automation. 

Opportunities on the revenue side

Asset managers should re-evaluate their product line-ups, seeking to align investment offerings with organizational competitive advantages and commercial opportunities in granular, well-defined market segments. 

Investors will continue to pursue value for money, thus indexing and smart beta will see sustained growth. Competition in these areas will be hot, fueled by both new entrants and active managers repackaging alpha signals as smart beta. AUM in indexing and smart beta will increase, but revenues may not, as price compression on commoditized strategies will drive management fees closer to zero. The asset managers who win in indexing and smart beta will be those who attain cost leadership (largely via technology and operating model innovation), or managers with an alternative mechanism to monetize client relationships, allowing index and smart beta mandates to serve as a loss leader. 

High conviction active and alternatives strategies are attractive to both return-starved investors and revenue-starved asset managers. High quality, differentiated strategies will see demand, and firms that offer a diversified suite of competitive, difficult to replicate capabilities are best positioned for sustained success. Advancements in computing power and data acquisition/processing capabilities create new opportunities for alpha generation. Similarly, traditional fundamentally driven investment processes will become increasingly “quantimental,” as managers leverage technology to uncover attractive new investment opportunities and better understand existing investments. In a low expected return environment, many investors will need to hold risky assets and active strategies to generate required returns. At the same time, investors will focus on downside protection, as memories of the global financial crisis and the tech bubble are fresh. Active strategies with embedded tail risk protection and illiquid strategies where lack of daily price discovery masks the inherent volatility of the investments will win new inflows. 

Product innovation must focus on solving clients’ (individual clients or precisely segmented groups with very similar requirements) investment problems. It is not enough for a manager to outperform a benchmark if the index’s beta does not help the client reach its targeted outcome. Outcome oriented strategies, including packages of index, smart beta and active underling portfolios, will remain appealing to investors. A continuing challenge for asset managers will be scaling the “solutions” business without diluting the client-centricity required of a proper investment solution. 

Key takeaways for asset management firms

• Focus on your cost base. Have a hard look at your operating model to identify opportunities to gain efficiency and take out costs. IT strategy is critical – technology will impact all facets of the industry. 
• Choose your battles. Concentrate on attractive commercial opportunities where you have or can build a competitive advantage, targeting specific, granular market segments.
• “Standing in the middle of the road is very dangerous; you get knocked down by the traffic from both sides” (Margaret Thatcher). Both at-scale providers of commoditized investment products and specialized managers of alpha-seeking strategies have the opportunity to thrive. If your focus is on commoditized strategies, target cost leadership. Active and alts providers should seek quality and differentiation. Firms offering a suite of competitive, uncorrelated active capabilities leveraging efficiencies offered by centralized distribution, governance and infrastructure are well placed for sustained success.  

Note the views expressed on this article are mine and do not necessarily reflect the views, strategies or opinions of anyone else, including my employer.