In recent years, the operating theme for many asset managers has shifted to capital preservation, particularly in their efforts to serve the large and growing number of baby boomers and commercial clients managing pensions. This is a reasonably expected change when considering that many investors lost a significant amount of capital during the Financial Crisis, many of which are still recovering. The ramifications of the credit crunch have led to requirements for increased transparency and regulatory compliance, adding structural costs to the asset-management business model, but this is only one side of the coin.
The volume of investable assets is set to increase to a whopping $102 trillion by 2020 from ~$64 trillion today, fueled by an increase in the number of individual retirement plans and a rising number of high-net-worth individuals across the globe. The demand for income growth and real-asset investment approaches has surged, even as the mindset of clients has changed to require more prudent capital allocation. Savvy investors are causing asset managers to evolve and develop differentiated products for customers that demand unique investment products fitting specific needs. The trend toward alternatives and passive products will also present both opportunities and challenges for asset managers.
As a result of the credit crunch of last decade, customers of asset managers have become more informed about their own risk management, and in general, have become more risk averse. The notion of increased transparency has also led to a greater focus on real returns, calculated after fees and other expenses. Ongoing market volatility and growing global economic concerns will inevitably test the ability of asset managers to evolve and adjust their operations in real time to meet client objectives. Not only will regulatory fees be a greater part of an asset manager’s life, but investments in technology and data management will become ever more important as well.
Though adaptation and the evolution of financial products are paramount to the sustainability of an asset manager’s success, having a trusted and distinct brand is perhaps one of the most important advantages of an asset managing company. Client confidence goes hand-in-hand with a strong brand, and increased customer loyalty generally means increased assets under management over time as the “leaky bucket” syndrome with client assets is plugged. The operating leverage associated with increased assets under management is significant for such firms, as there are minimal incremental costs associated with bringing on additional assets; the asset management business model is quite scalable.
Along with a strong brand comes an increased ability to evolve distribution relationships, as many asset management companies can benefit from increased efficiency in the manner in which their products are distributed. Trusted brands also have a better opportunity to influence the client learning process, indoctrinating them with preferred higher-return, long-term approaches, and managing expectations to mitigate the possibility of losing assets under management during underperforming periods. Maintaining a significant amount of assets under management during times when overall investor confidence is low remains vital to ironing out cyclical tendencies for the asset manager. Leveraging a strong brand against lesser-known new entrants in a weak investing environment remains an ongoing pattern, but competition has only grown more intense.
As more and more assets become index-linked, the broader market activity has become more and more of a driver behind asset management returns. There are a few broader themes worth mentioning in this area. First, the slowdown of economic growth in China has had a negative impact on global multinationals and export-dependent countries, specifically those of heavy commodity producers. A sustained recovery in crude oil prices is not guaranteed, and the metals and mining industries remain suppressed, both dynamics impacting derivative plays across almost every sector of the global economy. In the US, investors remain concerned with the impact of changing interest rates, and the recent market volatility of the past few months will likely have an impact on investor confidence, if it hasn’t already.
All told, the asset management industry, despite ever-strengthening rivalries and ongoing pressure from heightened regulatory costs, remains a very good one, even if it will forever be tied to the vicissitudes of the broader markets. The scalable aspect of their business model with respect to hoarding client assets results in a high return-on-asset proposition that’s not going to go away anytime soon. Though we don’t hold any asset managers in the newsletter portfolios, let’s take a look at the performance of some of the most popular asset managers on the market today.
Blackrock is the largest asset manager in terms of assets under management, and by a wide margin. As of the end of the second quarter of 2015, the firm had over $4.7 trillion in assets under management, which is down 1% from the first quarter of 2015. Despite this, it was able to generate 7% revenue growth from the first quarter, driven mainly by increased base fees. This is a prime example of an asset manager’s brand giving it a competitive advantage. The company was able to realize solid net cash inflows in the first half of 2015, a good portion of which came into higher fee products, which is how it drove its gain in base fees. Blackrock’s operating margin expanded significantly in the quarter, and its bottom line reflected its ability to lever its impressive amount of assets under management. The name of the game for asset managers is confidence, and Blackrock clearly has the confidence of investors. We like the firm’s brand and the fact that it has an incredibly massive amount of assets under management.
Franklin Resources saw its assets under management fall in the second quarter of calendar 2015. The firm has $866.5 billion in assets under management, and solid product mix. Only its smallest segment, cash management, saw positive net cash flow. Each of its other three segments–equity, hybrid, and fixed income–experienced net cash outflows of 2%, resulting in a decline in total assets under management of 2% from the first quarter of calendar 2015. Operating income fared better than assets under management at Franklin Resources, as the company appears to have managed its expenses wisely. It was able to cut costs across a variety of categories, while growing its information systems and technology spending significantly. This should pay dividends down the road for the firm as the investing world becomes more dependent on technology to increase efficiency. We like the disciplined spending structure, but we would like to see Franklin Resources return to positive net cash inflows. How the recent market volatility affects its assets under management in the third quarter of calendar 2015 should be a solid indicator of how it might fare as we move into a period of increased uncertainty in the market.
As of June 30, T. Rowe Price witnessed its assets under management grow by over $26 billion in 2015, only $0.3 billion of which came in the second quarter, to a total of $773 billion. Market appreciation was the source of growth for the firm, as net cash flows were negative in the first half. Investment advisory fees grew by 10% in the second quarter, while the amount of fees waived by the company to maintain a positive yield for its customers in the quarter was down $2.5 million compared to the second quarter of 2014. The company expects to continue voluntarily waiving fees at a similar rate for the remainder of the year. The majority of T. Rowe Price’s assets under management are held in mutual funds, which, as a whole saw market capitalizations fall in the second quarter. A promising note for T. Rowe Price as we head into a period of increasing uncertainty in the markets is the fact that the firm had no debt as of the end of the second quarter. The company’s financial strength allows it to continue to invest in developing its talent, broadening its capabilities, and gaining efficiencies, all of which will be necessary to continue to compete effectively with the likes of Blackrock and Franklin Resources.
There are many ways to slice and dice the definition of an asset manager, and the three companies above are perhaps the most recognizable, with the strongest of brand names and the most resilient business models, in our view. Our general exposure to the financial sector in the Best Ideas Newsletter portfolio remains the Financial Select Sector SPDR (XLF) and the SPDR S&P Bank ETF (KBE). The former offers a more diversified approach than an individual stake in any one manager and notes Berkshire Hathaway (BRK.B) as its largest holding. Though it does hold a number of investment banks, it has some of the best lenders in the business as well. The SPDR S&P Bank ETF captures some of the smaller regional banks that are relatively immune to global contagion tendencies, offering less risky exposure to the financial sector. We’re generally risk-averse when it comes to dabbling in shares of banking entities.