To paraphrase the Sage of Omaha, only when the tide goes out does the world get to see who’s been swimming naked. Warren Buffett’s oft-quoted comment is about to apply to the asset management industry big time.
During the second half of last year, the tide started turning for the $68.6 trillion North America investment management industry, according to a new report by consulting firm McKinsey & Co., with the retreat of net inflows to mutual funds and exchange-traded funds accompanied by a decline of more than 200 basis points in profit for the business as a whole. The first downtick since 2009 is driven by “shrinking revenue margins, stubbornly consistent costs (relative to AUM), and by the sudden reversal of the markets, which hitherto had provided a steady boost to the industry revenue pool,” the authors write.
In Thriving in the New Abnormal: North American Asset Management, published today, McKinsey predicts that market conditions for asset managers will get even tougher. The report calls the end to 30 years of above-average returns, a statistical anomaly driven by macroeconomic trends, such as growth in China and robust corporate profits, that are now winding down.
With the markets themselves giving out no more free lunches, managers will be left with even fewer places to hide. This comes at a moment when four other key industry-changing trends — a shake-up in asset management and the rise of low-cost indexing; assets moving into alternatives in search of alpha; a “true digital revolution” impacting investing, marketing, and distribution, among other areas; and heightened regulatory scrutiny — have taken hold.
“The rules of the game are being rewritten, and even outperforming managers will need to reinvent their underlying business models to succeed,” the report warns. McKinsey expects that as the U.S. goes, so does the rest of the world.
“A confluence of a set of trends that have been building in the industry for a while” are coming to a head, says McKinsey partner and report co-author Ju-Hon Kwek. Technology has finally caught up with investment management in the form of robo-advisers and other innovations, Kwek notes. Regulatory changes in the works for some time, particularly the new fiduciary reasonability rule for investment advisers, are starting to take effect. Then “you layer on that the macro overlay both of possibly the end of one of the greatest bull runs in recent history,” Kwek adds. In talking to managers and investors, he says, “the term ‘once in a generation’ comes up a lot.”
McKinsey’s asset management report is partly based on insights from the firm’s Performance Lens data and analytics solutions for wealth and asset managers and its 16th Global Asset Management Survey, whose 300-plus participants represent a total of $40 trillion in assets. The findings aren’t all bad news for money managers. For those able to adapt to the changing marketplace, “the future is bright,” McKinsey says. Those firms should be able to pick up revenue share as competitors stumble and new markets for investment management products emerge.
“We are actually quite excited,” Kwek says. “It is a moment where the old orthodoxies get challenged, and there is a huge opportunity for forward-leaning managers to get a share.” The asset management industry is heading into a time of flux; as a result, Kwek says, in five to ten years the league tables of the top investment managers will look quite different than they do today.
What remains uncertain is who the eventual winners will be. Kwek cautions that size still matters for investment managers, especially when it comes to economies of scale in meeting regulatory requirements, keeping costs down, and offering a diversity of products to fit client needs rather than pushing hot product.
But for successful managers looking to adapt, the innovator’s dilemma — the idea, popularized by the 1997 book of the same name, that innovators in an industry, particularly technology, can fail because they’re unable to capitalize on or drive later changes — and institutional inertia come into play. This creates openings for younger and startup firms, especially those that know how to use financial technology to their advantage.
“Ultimately, you are moving to an age where strategy really matters,” Kwek says. “It is not simply about doubling down on what you’ve always done and doing it better. It is about picking your spots better.”
Welcome to the Hunger Games, asset managers — may the odds be ever in your favor.