A New Era for Asset Managers

Traditional U.S.-based asset managers have hit record levels of assets under management after a long bull market, but they are up against stiff headwinds: Investors are demanding better fee structures and performance and migrating to lower-cost index-based products. Meanwhile, asset managers are bearing higher distribution costs while increased regulations raise the costs of compliance and technology. All this has put profit margins under pressure. In this highly competitive environment, only two of the asset managers on Morningstar’s coverage list, BlackRock BLK and T. Rowe Price TROW, have wide Economic Moat Ratings.

In a recent Asset Manager Observer, Morningstar senior equity analyst and strategist Greggory Warren laid out several different paths that asset managers can use to negotiate this shifting landscape—such as scaling up existing products, broadly diversifying operations, or pursuing specialized expertise. Warren expects most of the firms under coverage to consolidate internally, with many pursuing external consolidation. I spoke with Warren on Feb. 23 about the challenges and opportunities ahead for asset managers. Our discussion has been edited for length and clarity.

Laura Lallos: Can you give a quick overview of the secular and cyclical headwinds that asset managers are facing?

Warren: The bull market in equities has helped mask a lot of the issues that have impacted the industry. Active equity flows have been negative for 15 years now, historically concentrated in the large-cap equity side of the business. Most of that has come from increased competition from low-fee-charging index funds and exchange-traded funds.

Here in the United States, the Department of Labor’s fiduciary rule, even though it’s defunct now, accelerated a lot of these shifts in 2014 and 2015. Gatekeepers for retail-advised platforms started weeding out managers with fees that were too high or performance that was too far out of whack. It got harder and harder to get onto and stay on these platforms and other distribution routes. Some firms, like Franklin Resources BEN, historically prided themselves on their relationship with their distributors. It was about promoting your products to get on the platform. Now, it’s strictly fees and performance—and rightly so.

There’s been a shift in the balance of power. The distributors and the end investors are now in control. That means that some of the costs that have traditionally been borne by those investors—such as distribution and marketing expenses—are now being borne by the asset managers. Then you throw in regulators looking for more transparency, which increases their costs for compliance and technology.

The cyclical issue is that this bull market that has been running for more than 12 years. We’ve had some corrections—some major corrections, even—along the way, but at some point, we’re going to have a sustained bear market. That’s going to hurt a lot of these guys, especially those that are struggling to generate positive flows.

Lallos: BlackRock stands out in this tough environment. How has it differentiated itself?

Warren: BlackRock has diversified its portfolio to the point where it’s somewhat agnostic to market changes. It started as a bond shop and then got equity exposure when they bought Merrill Lynch’s business in the mid-2000s. But it was the purchase of the iShares business from Barclays during the financial crisis that really helped. Two thirds of BlackRock’s business now is passive, and that’s been the big trend to ride.

Over the past 15 years or so, they’ve not had much volatility overall in either their asset levels or their revenue. That’s because as money flows out of equities, it’ll flow back into fixed-income or money market funds and vice versa. That’s helped them generate more consistent revenue and earnings growth relative to their peers, even at the size they are now.

BlackRock might have $10 trillion in assets, but there are still ways for this company to grow. They’ve got the potential for growth in environmental, social, and governance trends. They’ve got the potential for Chinese growth. They’re committed to growing their alternatives business as well as their multi-asset business. And the passive trend continues to generate anywhere from 5%–10% annual organic AUM growth, which is unheard of for a lot of players in the industry.

Lallos: It’s interesting to see your data on how significant passive funds have been to Fidelity’s growth, given that they are the epitome of active management.

Warren: They’ve built their own self-indexing-based business that allows them to offer zero-basis-point products to investors, as they aren’t paying licensing fees for the benchmarks to S&P or MSCI or anyone else. It’s a great way to get money in the door—it’s been phenomenal.

Lallos: You mentioned BlackRock’s ESG growth. Is it essential for asset managers to develop an ESG presence?

Warren: Yes. It may be hard for those of us in the U.S. to see, but when you look at demand in Europe and Asia-Pacific, it’s very high. We are seeing demand now on the institutional side here as well. Therefore, if you don’t have the ability to offer up that kind of product and adhere to the standards clients are looking for, you’re going to be at a disadvantage.

The question for BlackRock is how much of the growth that it generates with ESG-related products will be new growth, and how much will be cannibalizing existing funds. I don’t think we’re far enough along in the process to get a good sense of what’s happening there yet, but there will be some cannibalization. If you open up a new product that’s comparable to something else you have but is ESG-specific, you’re likely to lose the assets from the original.

Lallos: China is another opportunity, but how many asset managers are positioned to take it on?

Warren: Few. I see China as a big black box. I’ve been in this space long enough to have covered consumer products firms in the 1990s in China. The Chinese were always happy to invite companies in, especially companies that had expertise that they didn’t have. But they weren’t very good about guaranteeing their rights.

Hopefully, this is different. China is opening its markets up a lot more. BlackRock got the first right to offer funds in its own name in the country last year. (They did have a joint venture with one of the main banks before that, and Invesco IVZ has had a joint venture there for almost 20 years now.) I just don’t know if it’s going to be the huge bonanza that everybody seems to think it is. I find it hard to believe that China is going to let BlackRock do whatever it wants to build out its business.

BlackRock is the dominant ETF player in just about every market where it competes except for Korea and Japan, because in those markets the local providers had first-mover advantage. And the Japanese government has been throwing a ton of money into Japan-based ETFs. I think China’s going to be somewhat similar.

BlackRock and iShares’ name recognition will help. The other players don’t have the same level of brand recognition there as they do here. Even Vanguard has decided not to go it alone in that market; it is going to continue its partnership with Ant Group.

Lallos: As noted earlier, the U.S. stock market has had a great run. Will we see investors returning to active funds to seek out performance?

Warren: It may seem surprising, but BlackRock has seen positive flows in its active equity operations over the past two years. Invesco had positive active flows in a couple of quarters last year. AllianceBernstein AB also had positive active equity flows. It does fly against the trend that we’ve seen.

But while we’ve seen negative flows overall over the past 15 years, especially on the large-cap side, firms that have outperformed consistently have tended to do better—5-star funds have more consistently had positive flows throughout that time frame. BlackRock’s positive flows on their active equity side came when they finally fixed their performance problems.

Now, the situation is tougher for some. T. Rowe Price has long had upper-quartile performance, though it wasn’t all that great last year. But they’ve faced huge headwinds because a lot of their assets under management come from retirement-based products. And for the past 10 years, you’ve had baby boomers in retirement phase, which means they are pulling their money out.

Lallos: You’ve noted that T. Rowe is the standout on your coverage list when evaluated by the Morningstar Success Ratio, which measures whether a fund company has delivered sustainable, peer-beating returns. Even so, it has struggled to generate positive flows. Can T. Rowe maintain its wide moat?

Warren: We’ve always said, if you want exposure to asset managers, you buy BlackRock if you believe in the passive story. If you want active exposure, the only name is T. Rowe.

T. Rowe has ranged from flat to 3% positive organic AUM growth the past four or five years. They’re now targeting 1% to 3%. They are feeling the pinch from the passive side because the target-date funds they offer to 401(k) plans are all active, and Vanguard and other index-based firms are offering up products at lower prices.

But after we get past 2025, I can see organic growth getting up into the midsingle digits. Millennials will hit their peak earning years around then, and that will help limit the impact of the retiring baby boomers. Before 2010, there were periods when T. Rowe was generating high-single- to low-double-digit organic AUM growth just because of the amount of money that was flowing into retirement-based products.

There are some tailwinds there: They’ve got automatic enrollment, automatic increases in people’s contributions to their plans working in their favor. As we look out over the next 20 years, I still see T. Rowe in a good spot. They run a very tight organization. They stay true to who they are and what they do, and that’s been a recipe for success.

Lallos: There’s been an uptick of interest in alternatives, as investors are looking for return. Can traditional asset managers successfully take this on?

Warren: They’re going to have to buckle down and dig into it. The challenge is figuring out a way to migrate alternative-asset products into a ‘40 Act world. The regulators are not all that interested in opening up those doors on the retail side because of the risks. What we are seeing around the edges is alts providers teaming up with life insurers to figure out ways to infuse less-liquid product sets into annuity offerings, which are better suited for these investments.

It requires a different skill set. T. Rowe buying that credit alt business [Oak Hill Advisors] last year is an indication of where some of these firms are going. You can buy an alts manager outright, but you then need to figure out a way to keep that management team in place, because they are compensated differently than traditional fund managers are. Franklin’s acquisition of private equity firm Lexington Partners hints at that—how they are going to structure performance-based and equity-based compensation over time for these managers on the alt side.

For BlackRock, it’s easier. About 80% of their client base is institutional, so they can offer up those products as they are to those clients. BlackRock’s total AUM for alternatives is already pretty close to Apollo AINV and KKR & Co. KKR, about $265 billion at the end of last year.

Lallos: You’ve written that consolidation is inevitable for asset managers. What might we expect there—any cautionary tales?

Warren: My cautionary tale is that it doesn’t always work. The asset-management business is a people business. We’ve seen plenty of examples where there just wasn’t the right cultural fit. BlackRock has done it right, partly because Larry Fink’s been sort of heavy-handed: “One BlackRock.” That has helped them to some regard.

Firms that face fee pressures have to figure out a way to offset that, and one of the ways is to scale up the business. Some fund companies have started merging funds as a way to eliminate additional staffing and lower the cost structure. But there’s only so much that you can do there, and you don’t necessarily want a fund to get too large because then you start having performance issues of your own.

You can broadly diversify the platform, bulk up, and fill in product holes in order to be agnostic to market changes, like BlackRock is. Invesco bought Oppenheimer; Invesco already had a global international-equity platform, but they bought a better one. That has marginally improved margins, but I think they have to keep doing deals in order to continue to hang on to those improvements over time. Or you can specialize, which might require divesting or eliminating some of your bad-performing products.

Analysts have been calling for big, scaled-up acquisitions, and we’ve not seen that yet. If you’re scaling up, you’ve got to be able to get the assets cheap enough that even if you lose some of the clients, you’re still coming out well. With the equity markets and valuations where they are, nobody’s selling cheap.

Lallos: Switching from the perspective of stock shareholders to fund shareholders: Will fund investors continue to benefit as the asset-management industry evolves?

Warren: The trends are definitely in their favor. Fees are going to continue to come down, especially on the active side of the business, as managers compete for business. But the fund managers are not hurting. They’re still very profitable businesses that throw back a ton of cash.