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Holding the Line

Amid the turbulent markets of 2007, asset managers on the II300 list increased assets 12.2 percent. No. 1 Barclays Global Investors posted a 38 percent pretax profit margin.

Banks and brokerages are reeling from the turmoil in -credit and capital markets, but the -money man-agement business, though shadowed by growing economic concerns, continues to be a safe, reasonably stable -haven. Assets are growing, and -profit margins remain enviable. In 2007 total assets under management by the firms in the II300, Institutional Investor’s annual ranking of the biggest U.S. -money managers, increased by 12.2 percent, to $34.9 trillion; by comparison, the Standard & Poor’s 500 index rose just 5.5 percent.

“Asset management is an amazingly resilient industry,” says Kevin Quirk of consulting firm Casey, Quirk & Associates.

Underscoring this resilience, Barclays Global Investors, with $2.08 trillion under management, finishes first for a fourth straight year, followed closely by archrival State Street Global Advisors, which marks its fourth consecutive year in second place, with $1.97 trillion. In all, the top six firms retain their positions from last year.

To be sure, money managers have taken their share of hits in the financial markets, and there are signs that the going is getting -tougher. The II300’s growth rate was down -nearly 5 percentage points from 16.9 percent in 2006, and most of those gains came during the first half of the year, before the -credit markets -seized up. BGI’s pretax profit margin fell 5 percentage points, to a still impressive 38 percent.

A slowdown in the first quarter of 2008 could signal -broader troubles for U.S. -money managers. BGI’s index funds grew a negligible 0.3 -percent for that period, while SSgA -saw declines in most asset classes. The exceptions for SSgA were passive index bond funds, which grew by 10 percent, to $238 billion, and -money market funds, which grew by 8.1 percent, to $683 billion. Both businesses, though, are -low-margin.

“I’m not going to tell you we have hit the bottom. We could have another leg of the stool falling tomorrow,” says Laurence Fink, CEO of BlackRock, which repeats at No. 5. Capital Group Cos. remains No. 3, Fidelity Investments holds on to No. 4, and JPMorgan Asset Management keeps No. 6.

For all the caution, asset management remains an island of financial stability: Average operating profit margins were 33 percent in 2007, according to a study by II’s U.S. Institute and McKinsey & Co. Although that is at the high end of the range -over the past six years, “the average hides many sins,” says David Hunt, McKinsey’s North American asset management practice leader, who advises firms and led the survey. Margins reflect a strong first half and have been declining since the onset of the -credit -crisis. Moreover, the variation in performance from one firm to another “is the widest we have witnessed since the start of the survey,” Hunt says. Fund performance declined as well. -Only 42 percent of institutional asset managers surveyed by Watson Wyatt Worldwide beat the Lehman aggregate bond index before fees in 2007, down from 71 percent in 2006.

Even the strongest asset managers may find it hard to maintain last year’s strong margins. A flood of new --money drove net income at -JPMAM to a record $2 billion last year, up 40 percent from 2006. The firm’s pretax margin was 36 percent, up 3 percentage points from 2006. But -JPMAM CEO Jes Staley says performance “darkened in the latter part of the year.”

The darkening climate could lead to sweeping changes in the business. Gary Black, CEO of Janus Capital Group, foresees a wave of mergers and acquisitions this year and next. “There will be a lot of consolidation among -major players. Those that have weak or bad performance are getting -crushed,” Black says. Janus grew assets by 23.3 percent, to $206.7 billion, and -rises in rank from No. 43 to No. 40. He says, “I think in the next six to nine months we’ll see some combinations that we wouldn’t have expected.” Martin L. Flanagan, chief executive of newly restructured Invesco, which debuted at No. 18, predicts that some investment banks in need of capital will sell their asset managers. He doubts, however, that revenue-starved banks will make the opposite move and acquire asset managers as a source of stability. “There just isn’t the financing for it,” Flanagan says.

Among last year’s most eye--catching deals was the purchase of No. 41 Putnam Investments by Canada’s Power Financial Corp. for $3.9 billion. Black believes that more such deals are -likely. The most vulnerable firms, consultant Quirk says, will be midsize businesses that have yet to develop high--margin -alternatives -strategies.

Quirk says, how-ever, that -even if markets continue to fall throughout 2008, “relative losers” in the asset management business could still end the year with operating margins of about 25 percent. People will con-tinue to contribute to retirement funds, regardless of what happens to the financial markets or the econ-omy, and that money will make its way from pension funds and 401(k) plans to asset -managers.

The key for asset managers is for that -money to find its way to high--margin offerings. The news on that front is -mixed. Since the -credit crunch hit, -many investors have been on the defensive, stuffing cash -into low-risk, low-fee index funds. Assets in BGI’s fixed--income index funds jumped by 32 percent in 2007, to $263 billion. BGI’s exchange--traded funds, which track a wide range of indexes — from -equity to fixed income to commodities — grew by 42 percent, to $408 billion. In contrast, BGI’s actively managed fixed--income assets grew at a much slower pace last year, by 4.8 percent, to $66 -billion.

On the -other hand, asset man-agers are -also pushing -deeper -into alternative investments such as hedge funds and private -equity. Alternatives grew -faster than -any -other asset class, rising by 46.2 percent, to $1.9 trillion, and breaking 2006’s record of 39.8 percent growth. “There is a -longer-term trend of increasing -allocation to nonpublic -markets or non-traditional -strategies,” says Michael -Rosen, chief investment -officer of Angeles -Investment Advisors, who ad-vises pension funds on investment strategies. Last year, he says, “the winners were those who were short -credit and long commodities. Anyone who -owned an oil well or copper mine or anything that touched agriculture, from fertilizer to seed to land, did well.” The move -into alternatives is a boon to big, diversified asset managers such as BGI, which -started man-aging hedge funds in 1994. -Rosen estimates that BGI earns -nearly 8 percent of its profits from hedge funds, -even though they make up just -1.3 percent of the firm’s total -assets.

International Paper Co.’s $8.5 billion pension plan is steering more -money -into alternatives. -That’s generating -higher fees for its asset managers, which include BlackRock. As of December 31, hedge funds accounted for 10 percent of IP’s -equity and fixed--income assets — double the allocation ten years earlier. The com-pany put an additional 10 percent of its pension assets -into -other alternative investments, such as private equity funds, last year. That strategy -helped the plan grow by 9.6 percent in 2007, beating the 8.5 percent median performance of U.S. pension plans, as determined by consulting firm Wilshire Associates. Robert Hunkeler, IP’s vice president for trust investments, says the com-pany’s decision to increase its allocation to alternatives is the best response to a variety of threats facing defined benefit plans, including market volatility and new accounting rules that require plan sponsors to mark their assets to market. “Of course, we have been in close contact with all our hedge fund managers, trying to make sure they are in a good position to weather the storm that they are in now, which I think they are,” says -Hunkeler.

The rankings were compiled by Researchers Emily Kaemmerlen and Valentina McKenzie under the supervision of Senior Associate Editor Tucker Ewing. For a more in-depth look at the II300 ranking, visit our Web site, www.iimagazine.com.