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Passive Investments Squeeze Profits for Asset Managers

A recent IBM survey suggests that an investor shift to more conservative options is pinching operating margins for asset managers.

In the aftermath of the credit crisis, regulators may have their rule books aimed at the big banks, but asset managers are hardly immune. Proposed regulations on transparency, capital and liquidity are likely to squeeze 5 percentage points off asset managers’ operating margins, a new survey by IBM Corp.’s business consulting unit ­suggests — on top of an estimated 4-percentage-point hit to margins as investors flock to more-conservative options.

“Investors want simple products they can understand, which have lower fees, and they want high-quality, unbiased advice,” says Suzanne Duncan, financial markets industry leader at the Cambridge, Massachusetts–based IBM Institute for Business Value.

The survey of 2,750 industry executives, including those at endowments, foundations and sovereign wealth funds, predicts that passive investments will eventually overtake actively managed funds. Today, 70 percent of worldwide assets are in active funds, which charge an average of 1.25 percent.

But 65 percent of respondents planned to move to passive strategies, which charge less than 0.2 percent in comparison, within the next three years, Duncan says. Extrapolating the data suggests that in 20 years, 85 to 90 percent of assets will be in passive strategies, with the remaining 10 to 15 percent in hedge funds, private equity funds and other high-risk, high-return alternatives.

A couple of factors are driving the trend: First, defined contribution sponsors are under political pressure to move into passive products to reduce costs for investors. Second, asset managers want to lower the risk associated with manager selection — the survey revealed that few investors believe they can pick outperforming managers.

Some say the move from active to passive strategies is inevitable. “It seems increasingly likely that investors will balance active allocations with passive investments, rather than pay active managers to run closet index funds,” says Mark Phelps, CEO and director of global investments for W.P. Stewart, a New York–based active manager. A larger percentage of investment advisers are offering asset allocation models using exchange-traded funds to make sector and regional bets, he notes.

Others argue that the outlook for asset management profit margins — which hit the 30 percent mark even in 2008 — is not so bleak and that good active managers, in particular, stand to gain. ­Robert Reynolds, CEO of Putnam Investments in Boston, says active managers outperformed index managers in 2008 because they were able to sift through the wreckage left by the credit crisis. “The more money that goes into index investments, the easier it is for active managers to find value,” he adds.

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