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Perspectives

The new balancing act in investment management

How can managers survive industry consolidation?

The US investment management (IM) industry is in a period of massive transformation. Product design, pricing, and distribution are all changing to meet customer (and regulatory) demands.

July 17, 2017

A blog post by Doug Dannemiller, Investment Management research leader, Deloitte Services LP

These changes are taking place on the backdrop of increasing household penetration of retail investment products and a significant bull run in many markets. Let's look at the balancing act that the IM industry faces as it adapts to changing customer demand while working to meet financial performance expectations.

Cost appears to be a growing component of the investor decision process across the board. Investors are choosing lower-cost investment vehicles in both mutual fund and exchange-traded fund (ETF) markets, with exceptions for strong performance and differentiation (note private equity).

Average total expense ratios for mutual funds dropped from 1.46 percent in 2008 to 1.28 percent in 2016,1 and ETF expenses also dropped over the same period, from 0.59 percent to 0.52 percent.Interestingly, investors as a whole are moving from active management in mutual funds to ETFs at a rate of more than $200 billion per year.3 4

This transition away from active management may taper off as active managers drive down expenses (perhaps through active ETF products or advanced analytics). Passive products with scale have an inherent pricing advantage over active management, dictating that active products compete on other metrics.

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Balancing appeal with profitability

For IM firms, the balancing act is to develop a product line that has multi-segment appeal and can be offered profitably. Index funds with scale can be one such product, and there will be other solutions that meet the challenge. However, more than 40 percent of ETFs have less than $50 million in assets under management (AUM),5 the average break-even level for an ETF. With more than 1,700 ETFs offered in the United States,6 launching new ETFs should be considered carefully. In fact, new ETF launches in 2016 declined from the prior year, while the number of merged or liquidated funds increased five-fold from 2011.7 Economies of scale are important contributions to both profitability and investor appeal.

The largest public investment managers are outperforming their smaller competitors on two important fronts: profit margin and AUM growth. The top three public IM firms had an operating margin premium over other IM firms of 50 percent in 2016.Correspondingly, the share of assets managed by the largest five firms rose to 47 percent in 2016, up from 36 percent in 2005.9 These firms improved their profitability not solely driven by asset growth or product mix. Cost control at the largest managers was also very strong. Operating expenses grew at just 1.3 percent at the top three public investment managers compared with 7.9 percent growth at a set of seven smaller IM firms.10

For IM firms, the balancing act is to develop a product line that has multi-segment appeal and can be offered profitably.

Striking the right balance

The key question is: Will this higher spending growth at the smaller IM firms or new entrants translate into brand value? And, if so, will improved brand translate into AUM growth at these firms?

One thing we know from experience, AUM growth can be stimulated through market-beating investment performance. Investment processes are one area for IM firms to explore. Some firms are considering refreshing these processes to utilize the rapidly growing pools of nonfinancial data that may provide investment valuation or buy/sell signals.

Another potential brand-boosting area is customer experience. While a bit of a catch-all, customer experience includes both ease of working with the IM firm and the opportunity to match desired outcomes and approaches for investments, such as themes or socially responsible investing.

Active IM firms are faced with striking the right balance between improving customer experience, generating alpha, and controlling expenses. Scale and fee pressures complicate this age-old conundrum. The ability to strike this balance is likely going to contribute to IM firm survivability in the scale-driven consolidation potentially coming to the IM industry.

Will this higher spending growth at the smaller IM firms or new entrants translate into brand value? And, if so, will improved brand translate into AUM growth at these firms?

Do you think IM is poised for consolidation? Will the scale advantage held by a few be challenged through innovation? What do the numbers tell you?

Investment Company Fact Book, Investment Company Institute, April 26, 2017.
Ibid.
2017 Investment Company Fact Book, Investment Company Institute, April 26, 2017.
Eric Balchunas, US ETFs 2017 outlook, Bloomberg Intelligence, Bloomberg, February 6, 2017.
Rachel Evans, Dani Burger, and Sabrina Willmer, Passive War, Bloomberg Markets, Bloomberg, ‎June‎ ‎5‎, ‎2017‎.
2017 Investment Company Fact Book, Investment Company Institute, April 26, 2017.
Ibid.
Deloitte Center for Financial Services analysis of financial statements.
2017 Investment Company Fact Book, Investment Company Institute, April 26, 2017.
10Deloitte Center for Financial Services analysis of financial statements.

QuickLook is a weekly blog from the Deloitte Center for Financial Services about technology, innovation, growth, regulation, and other challenges facing the industry. The opinions expressed in QuickLook are those of the authors and do not necessarily reflect the views of Deloitte.

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