Table of Contents
The financial crisis which commenced in 2007 has been widely acknowledged as the major catalyst to an unprecedented period of change in the Fund Management Industry.
Since then, many unqualified assumptions and urban myths have circulated around the industry relating to the impact of the financial crisis. Certainly the credit crunch, the collapse of Lehman's and the sharp fall in global equity markets triggered structural change in fund management, but there is no clear understanding or consensus as to what those changes have been. Through our work with EY we hope to bring some clarity to the real changes which have taken place across the European Funds landscape over the last six years.
In these last six years we have seen significant change in both Institutional and Retail Investor behaviour; step changes in cost/income ratios, new approaches to fund distribution and accelerated product innovation. One thing which is clear to all is the scale of new regulation emanating from Brussels, which has further fuelled the magnitude of change in the industry.
As a partner to many of the world's financial institutions it is important for BNY Mellon to understand the changes which have resulted from the aforementioned events, and to reflect upon the likely ramifications to our partners. To this end, our work with EY leverages new data analysis and some existing survey results to answer some of these questions:
- Is consolidation in the Fund Management industry accelerating?
- Are the Big getting Bigger? Or
- Are smaller firms gaining market share?
- Which types of firms are best at driving innovation?
- Is the cost of active management reducing rapidly?
- Can active management be bought at ETF levels of TER?
- What is the likely cost of compliance with new regulations?
In the following paper, we provide an overview of our analysis, the answers to the above questions and draw some conclusions from our findings. We believe that these findings will serve as a catalyst for further study and debate as global financial institutions look to navigate through today's rapidly evolving investment landscape.
Head of Global Financial Institutions (EMEA)
Fund management is a highly regulated, complex and resource intensive business where success is richly rewarded, and margins can be high for organisations able to deliver long-term outperformance. Because of this, new entrants to the space are numerous and competition is fierce.
Most recently the fund management industry has been experiencing downward pressure on product revenues from a number of areas, including competitive factors, regulation and a shift to a more passive product mix. At the same time the industry is facing rising pressure to increase costs, due predominantly to new regulation. This paper seeks to combine industry surveys, data and our own insights to explore the reasons for and impacts of these threatening trends focussing on what fund managers should be doing now to mitigate the effect on future profitability.
Using data from Watson Wyatt, we began by comparing the structure of the fund management industry in the decade preceding 2012, and how assets under management are now distributed amongst the main industry players (Top 20 fund managers by ownership). We found evolution rather than revolution in the make-up of the largest industry players.
The single biggest driver of costs across the industry is the requirement to comply with an abundance of new regulations. EY estimates the costs of compliance will lie within a range of $0.3bn-$0.5bn over the coming three years, exclusive of headcount. This translates into a significant increase in cost-income ratios over the next 3-5 years; we ask if these cumulative costs of regulation will undermine the assumed drive towards low cost fund management.
Firms will need to discover and implement new, innovative ideas to protect their margins in the future. Leveraging the EY 2012 survey on Innovation, we comment upon how different sized firms currently innovate and how they will need to create a more structured framework to encourage a culture of innovation in a highly regulated, risk-adverse environment.
Finally, the paper focusses on some of the initiatives that fund managers could be considering to protect future profitability, highlighting four recommendations that will impact both sides of the cost / income equation.
Changes in the Structure of the Fund Management Industry
A comparison of the global fund management industry since pre credit crunch (see Figure 1) shows that AUM have recovered, there are more independent fund managers, and the top 20 is US dominated in terms of ownership. We expect banks will continue to sell their fund management businesses and it is likely that large independents will continue to acquire them. Recent examples that demonstrate these trends are Blackrock / BGI and Aberdeen Asset Management / Credit Suisse Asset Management.
Figure 1: Profile of the 'Top 20' asset managers by ownership
Source: Watson Wyatt 2012
The rate of consolidation has remained constant between 2001 and 2011, however Q1 2013 saw a rise in the number of fund management transactions (Freeman and Co 2013 Asset Management transaction survey). This single quarter rise in number of transactions may become a trend if the valuation gap between buyers and sellers continues to narrow further. Increasing barriers to entry surrounding the regulatory and accountability framework, specifically in relation to the cost of implementation have started to deter start-ups and force consolidation at the bottom end of the market.
There is an increased dominance within the funds industry from top US managers, with BlackRock's acquisition of BGI being a major factor, particularly noticeable in certain asset styles including passive funds and ETFs; passive managers grew at double the market rate over the past ten years. As quoted in the August 26th edition of FTfm, BlackRock, State Street and Vanguard control the ETF market, holding just over 80% of the ETF assets held in the US ($1.26 trillion), thus creating a significant barrier to other entrants. Further, the top 8 largest firms have consolidated their positions. The share of AUM for the 'top 8' firms has consolidated at a rate of 1% per annum on average — from 17% in 2007 to 22% of total global AUM by 2011. With regards to the product mix of the top 20 firms, there has been a shift towards passive / ETF's and margins have fallen as a result, particularly for passive funds, but should we expect the same rate of margin contraction on active funds?
Expense Ratios Have Fallen Over the Past Decade — But Will Total Expense Ratios (Ters) for Active Funds Converge with Those of Passive Funds/ETFs in the Near Future?
Fees for both active and passive funds are falling (see Figure 2) in the range of c1% in TER/annum. Case studies conducted by the Investment Companies Institute and Lipper in 2012 show that it would take over two decades (if at all) for these TERs to converge fully if likely increases in regulation charges come to fruition as expected (see Figure 2).
Figure 2 // Comparison of the declines in fee (TER) levels for European actively and passively-managed funds
Despite this relatively slow decline in active TERs, the focus on the transparency and governance agenda (from both regulators and investors) will inevitably put downward pressure on fees. This will apply particularly to the ETF segment, where average European fee levels are similar to those of passive funds and falling at an average rate of 1% per annum depending on the instrument.
Expense ratios are useful 'catch all' indicators of financial and operational efficiency in any industry, with lower expense ratios equating to lower costs for the end investor. Expense ratios have fallen in the European fund industry over the past decade (see Figure 3). These are almost certain to fall further in the short term, given the concerted impact on costs from regulations, changes to tax regimes, systems upgrade, and development of database technologies required to deliver greater investment transparency.
Figure 3 // Indicative revenue and cost projections for the next 3-5 years under projected regulatory pressures in Europe
Source: EY 2013
So, we know product mix and competitive pressures have pushed revenues down; combined with a risk adverse, highly regulated atmosphere with regulators encouraging investors towards more plain vanilla, transparent products all of which drive towards a reduced fee environment. However the dichotomy is that at the same time, regulation, the single biggest expense facing the industry, one still yet to be fully accounted for, is likely to put equal pressure on costs. So revenues are being driven down whilst costs are being driven up!
Will Cumulative Regulatory Costs Over the Next 3-5 Years Actually Undermine Attempts by the Industry to Deliver Lower-Cost Fund Management Models?
Complying with multiple regulatory measures is singularly the biggest driver of cost across the industry. To bring much needed consumer confidence back to the industry, Governments, regulators and investors are demanding greater transparency and accountability.
EY estimates that the cumulative additional costs of the regulations directly applicable to European fund managers lie within a range of $0.3-0.5bn per annum in terms of extra expenses incurred over the coming three years. This could translate into a conservative 3% + increase in cost/income ratios over the next 3-5 years, correlated with approximately 2% + uplift in TERs over the period (assuming profit pools remain at current levels), which will counter the rate of TER decay highlighted above. However, the desired delivery of low cost fund management models will not necessarily be undermined by the cost of regulatory compliance, when one considers that not all of the expenditure can be passed on to the underlying funds. Against this backdrop, each firm will be challenged to find diverse methods of delivering its regulatory programmes.
The industry's approach to delivering multi regulation compliance through single regulation siloed projects is unsustainable. Firms need to take a holistic view of their 3-5 year regulatory compliance plans. Medium-sized entities (AuM in the range $600bn<AuM<$50bn) who were thinking sequentially about regulations will be penalised in terms of consultancy spend, headcount or capital provision. Larger firms have bigger budgets but undoubtedly bigger compliance issues too due to the complexity, geographical spread and volume of their product ranges. However, potential revenue opportunities may be uncovered by offering value add services to fund managers, such as financial planning or decumulation products.
As we have seen, this comes against the backdrop of average fees reducing due to changes in the product mix. Fund managers need to reverse these trends to protect profitability. However, future regulations are likely to take them down the same low margin path as they favour transparent, vanilla investing, which generates lower margins.
When adding these rising cost trends to the downward revenue trends in section 2, it is clear that profit margins within the industry are facing a pincer attack.
Figure 3 demonstrates the margin squeeze effect.
Most firms initiated a regime of cost reduction programmes in response to the credit crunch. Schroders for example increased operating margin from 27% in 2009 to 36% in 2011, mostly from cost savings as opposed to acquisition benefits. While this scale of cost compression is impressive, further reductions within business models will be harder to find, with extended lead times.
Consequently, it is essential that firms think outside the box to identify, and deliver, new margin enhancing initiatives through creativity and innovation.
Firms Will Have to Work Differently to Create Frameworks that Encourage and Support an Innovative Environment
The post credit crunch era has brought higher barriers to entry to the industry and increased complexity of reporting; a state of flux still exists and much is still to be defined and implemented. Industry profitability is under threat as regulators and investors push for transparency and less complex fund structures. Firms that put in place frameworks to encourage creative solutioning to solve this conundrum, along with robust implementation programmes will be better placed to enjoy future revenue and cost benefits.
EY 2012 Innovation Survey of 36 firms gives insight into how firms currently innovate. The survey found that all firms, regardless of size had similar catalysts of innovation; namely end clients, regulations and technology, (see Figure 4). Small fund managers tend to be particularly focussed on product innovation whilst larger firms also leverage their scale, infrastructure and broad product offerings to develop new and distinct revenue streams such as their solutions, wealth businesses and financial planning services as delivered by HSBC. Interestingly, some larger fund managers have embraced regulation and see it as a catalyst to stimulate innovation; probably they are more able to do this as a result of their greater discretionary budgets and lobbying power. To support this activity, these firms have invested in strengthening their product development teams. Smaller firms are considerably more dependent on the CIO function to drive innovation with very little support from Product Development. To extend their reach they may be more likely to put a greater emphasis on working with academia to generate ideas.
Figure 4 // Comparison of the drivers of innovation with internal function drivers within firms
Source: EY Innovation Survey 2012
Fund managers should embed a framework in order to identify different ways to realise cost/income benefits. The traditional innovation drivers within an organisation may have to collaborate more readily with areas such as sales and marketing to ensure well rounded initiatives are delivered. Embedding such a framework will probably reflect a cultural change for the industry. However, mitigating the threat of margin compression will only be accomplished by focussing the innovation effort on margin enhancing products, services and cost reduction programmes.
Fund Managers Must Re-Examine Their Ideas for Mitigating Costs
As we have seen, it has become ever more important for firms to closely manage their cost / income and total expense ratios, and look for more innovative ways to do this. On costs, a complete review of strategic direction and a continuous evaluation of operating model options should be assessed (see Figure 5) such as:
1) 'Be Cruel to Be Kind' — Constantly re-appraise product ranges and manufacturing capabilities. Firms should review their product portfolios and develop more sophisticated mechanisms for splitting the middle ground into 'products to kill' vs. 'products to invest in'. Recently, there have been cases of fund managers shutting funds, or share classes — BlackRock reported as ready to close 250 funds on 25th June 2013, and Deutsche Wealth & Asset Management closing 18 struggling ETFs and 18 struggling ETCs on 5th July 2013 being two recent examples. Threadneedle Asset Management has embarked on a fund rationalisation programme and claim the European fund management community will enter an 18-24 month period of rationalisations, as cost pressures signal the beginning of the end for oversized product ranges.
2) 'There are Shared Solutions to Common Problems' — Deepen outsourcing/off-shoring routes to improve future flexibility, especially in the middle-office. Fund managers historically looked to defer future cost increases by outsourcing back office functions such as settlements, confirmations, custody and transfer agency. Now the reasons are more subtle, as outsourcing becomes recognised as the means to improve risk management and regulatory compliance, and realise flexibility and scalability globally. Regulators appreciate and are focussed on this continual shift, and are demanding transparent, well governed, strategic partnerships be in place between the fund manager and the service providers. This is evidenced in the recent FCA (UK Financial Control Authority) 'Dear CEO' letter relating to outsourcing that acknowledged that while services and functions may well be outsourced, responsibility for these provisions remains firmly with the fund manager; the FCA recommends that fund managers plan how they would mitigate against a failure of such a strategic relationship.
Dependency of fund managers on their servicing partners is on the rise. Those firms that already run outsourced models are contemplating outsourcing middle office disciplines such as stock lending, FX hedging and collateral management to their asset servicing partners. Fund managers, who in the past have been slow to consider outsourcing components of their business model, will find it necessary to reconsider their decisions, and even extend their thinking to include some automated front office activities offered by global custodian banks, for example market connectivity/FIX, CSA administration, research management, agency brokerage and market/reference data solutions. The middle-office of the medium-sized firms could be one of the domains of highest impact and therefore greatest opportunity for cost containment.
3) 'Think Outside the Box of Traditional Cost-cutting' — Explore innovative cost reduction programmes. Many large and medium-sized fund managers took advantage to reduce their cost bases tactically after the Financial Crisis of 2007 by rationalising their products and reducing the number of service provider relationships. To maintain this momentum, fund managers are already looking at other areas for cost savings through a top-to-bottom review of product ranges and fund rationalisation (as noted above), and a shift towards more indirectly held funds. Other areas such as procurement, where non-financial services industries have made tax and smart buying efficiencies, are now transferring to financial services to bolster cost reduction programmes.
4) 'Leave no stone unturned' — Rapid identification of cost reduction initiatives in less traditional areas such as communications. Strong and speedy decision making around other initiatives will be vital in areas such as technology joint ventures and other alliances involving distribution channels and social networking to improve interaction with the wider community. Businesses will be required to communicate more with their third party service providers and investors, refining data strategies to satisfy an unprecedented sprint for transparency whilst reducing cost / income ratios. This will encourage fund managers and service providers to work more closely to agree key performance indicators, management information and model options for each new investment or product type. After all in the future, if it can't be measured, it won't be managed.
Figure 5 sets out the potential cumulative impact on cost / income ratios through implementing further cost reducing initiatives over the short, medium and long term. The savings curve is illustrative as total benefits will depend on style of firm, current operating model structure, existing current product range and implementation success.
There Are Still Opportunities For Revenue Growth
Similar to costs, we have also identified four revenue initiatives. Many are predicting that the economic bounce back has begun. In the UK for example, the economy grew by 0.6% in the three months to June 2013 according to the Office for National Statistics (ONS). For some fund managers, it will mean they are developing growth strategies for the first time in eight years and need to invest wisely. Managers will need to raise their game to improve revenues and develop their thinking beyond their traditional 'buy and hold' models.
1) 'Comply and Explain' — Regular, razor sharp focus on the strategic direction of the fund range. Whilst rationalisation of fund ranges will deliver cost benefits, material revenue benefits will also be realised. Managers should be able to explain the strategic rationale behind their suite of funds as clearly as they do their investment process and provide evidence of the value-add to investors and regulators alike. Firms should therefore define their investment methodologies and reconcile the need for each fund into the overarching product strategy. Greater clarity around the business objectives will be welcomed by investors and regulators and enable sales and marketing teams to deliver a more cohesive message to the market. In the medium term, social media will become an increasingly important channel to articulate a firm's product strategy, so the development of a sophisticated programme is essential to ensure success in this area.
2) 'Think Big; Start Small; Scale Fast' — To avoid start-up costs and unnecessary risk, acquire going concerns that complement the strategic product range as well as deliver value. Fund managers continue to buy going concerns that fit both their strategic aspirations and enhance short term shareholder value. 2013 has seen an increase in M&A activity as US managers power up for expansion once again and the valuation gap between buyers and sellers narrows. However it is still premature to call a major consolidation in the fund management industry. Given the regulatory and operational costs associated with running boutiques, buying going concerns (as opposed to niche start-ups) will be the way forward for most firms.
3) 'Don't keep digging up the road' — Adopt a structured approach to product innovation well in advance of regulations to avoid cost increases later. Digging up the road over and over again to fulfil the requirements of every regulatory measure is not an effective or realistic option for many small and medium-sized firms, particularly as an estimated 20-40% of this future cost will arise from duplications involving client on boarding, booking models, transaction reporting and record retention. However, despite this fact, many firms choose to single-thread one or two regulatory measures each year, partly in view of resource contentions (e.g. managing demands from investors) and partly in view of the need to make remediation in response to local thematic concerns. Firms should weigh product innovation against the future regulatory maintenance required to service particular investor segments, and optimise their revenue projections accordingly.
4) 'Maximise the Profitability of the Possible' — Ensure that fund manager CEOs/CIOs interface more closely with their asset servicing opposite numbers much earlier in product cycles. Stronger, more effective dialogue between the C-suite and their opposite number will enable fund managers to better communicate their business strategies to their asset servicing partners. Global outsourcing arrangements are strategic partnerships and asset servicers are (and will continue to be) ever more integral to the success of fund management businesses. However, many outsourcing decisions are still driven by looking through the cost and risk lenses of Operations, Finance and Risk professionals as opposed to being driven by the CIO with a view on future profitability. The better the asset servicer understands the business, fund or operating model strategy, the more value the fund manager can derive from the relationship.
What Conclusions Can We Draw?
Whilst we are now back to record levels of Global AUM within the fund management industry, profitability is under threat and fund managers need to act now to ensure their future business is not undermined. The structure of the industry has remained broadly consistent, however at the top the very biggest managers are getting bigger and scale is becoming an increasing differentiator. Crucially both investors and regulators, have a growing thirst for passive funds with a consequence that these funds are growing at twice the rate of active funds. The result of this is margin compression.
Exacerbating the revenue threat is the rising costs associated with the "tsunami" of new regulations to come and the need to provide more transparency and disclosure. Regulations are the single biggest cost facing the industry with an estimated $0.3bn – $0.5bn over the next 3-5 years for European firms. This will significantly raise barriers to entry into the market and may force consolidation at the smaller end. Conversely, new regulations will generally favour larger fund managers who can lobby, resort to multi-asset styles and have the risk infrastructures in place to cope.
In general, costs have been managed well since the credit crunch, rendering further reduction initiatives harder to identify and implement. Consequently, firms will have to be creative to manage revenue up, and costs continuously down; constantly challenging their business models and looking for short term opportunities to aggressively restructure their funds ranges. Those firms (more prolific within larger companies) who can create a framework where innovative ideas are encouraged will be better placed to take the advantage, providing their infrastructure does not get in the way of their ability to implement.
There are a multitude of initiatives that fund managers could consider in the face of falling profitability and rising cost / income ratios to prevent the increasing likelihood of becoming an acquisition target. These include reconsidering the opportunities afforded by long term restructuring and building partnerships with third party service providers to outsource various middle and front office functions. CEOs and CIOs need to interface more strategically with service providers to examine "The Profitability of the Possible".
Where successfully implemented firms will narrow, and possibly reverse, the threat to profit margins over the long term. However, fund managers will need to go through operational and cultural change in the short and medium term to achieve this.
The stakes are very high; winners will lead fund management into a profitable new era, whilst the losers, those that fail to act now to protect their profitability, will face failure or, at best, be acquired.
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