Smart diversification pays off for managers

Profit margins on the rise for firms that are ready to handle changes in markets

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Boston Consulting's Brent Beardsley said he has been seeing more “divergence in profitability.”

Publicly traded money managers that strengthened their business models through the market downturn generally reported profit margins in 2013 that often either matched or exceeded their pre-crisis levels.

“We're seeing more divergence in profitability,” said Brent Beardsley, partner and managing director at Boston Consulting Group, a management consulting company based in Boston. “There's very little correlation between profitability and total (assets under management). It really depends on how you grow AUM.”

Scale, performance and operating costs continue to be key contributing factors in raising operating margins, but increasingly important is a diversified business model that is resilient against varying market conditions and investor trends, according to consultants, analysts and money managers.

Offsetting earnings potential is a whole host of sector challenges, including pressure on fees, increasing regulatory constraints that increase operational costs and more expensive distribution, sources said.

Good times

BlackRock (BLK) Inc. (BLK) was cited as one of the most obvious examples of how diversification helped to stabilize operating margins. As of Dec. 31, the company's operating margin was 37.9%, according to its annual report, climbing from 37.7% in 2012 and 27.1% in 2009, following the acquisition of Barclays Global Investors.

“It's important to look beyond scale (at BlackRock) and focus on the strength of the product capabilities,” said Macrae Sykes, an analyst at Gabelli & Co. Inc., New York, who covers BlackRock.

Other analysts said BlackRock's corporate structure — which encompasses traditional long-only as well as faster-growing exchange-traded funds, alternatives, and investment and risk management analytics platform BlackRock Solutions — helps to neutralize sensitivity to different market conditions in comparison to its competitors.

For example, Allianz SE, parent company of Pacific Investment Management Co. LLC and Allianz Global Investors, reported last week that operating profits for asset management fell 23.3% in the fourth quarter to e703 million ($963 million) compared to the same quarter in 2012.

“The debate surrounding the timing and extent of a tapering in the Fed's bond purchases in the second half of the year led to significant net outflows for traditional PIMCO products,” Michael Diekmann, Allianz SE CEO, said at a Feb. 27 news conference in Munich.

Asset management operating margins for the fourth quarter also declined to 40.6% from 45.7% for the same quarter in 2012. However, the asset management profit margin for the entire year remained relatively flat, around 44%, compared to the previous year, mainly as a result of a strong first half.

Allianz also predicted lower operating income from its asset management division for 2014, ranging between e2.5 billion and e2.9 billion compared to e3.2 billion in 2013. (PIMCO typically contributes more than 80% of the total profits at Allianz's asset management unit.)

The estimated average operating margin among listed managers in the U.S. was about 31% in 2013, according to data provided by Keefe, Bruyette & Woods, New York. The range varied widely among managers. For example, the operating margin was about 16% at Legg Mason (LM) Inc. (LM), 37% at Franklin Resources Inc. and 47% at T. Rowe Price Associates (TROW) Inc. (TROW)

“The operating model is a growing source of strategic advantage,” Mr. Beardsley wrote in a report published by BCG last year. “For many managers, an aggressive operating-model review will be required to realize their growth ambitions.”

In the next three years, active management of traditional core assets will likely shrink to 44% from the current estimate of about 50%, with the share of global revenue squeezed to 30% from 33%, according to BCG data.

“Asset management has become much more of a share-stealing game,” Mr. Beardsley added.

The squeeze in core assets doesn't mean that traditional active managers can't improve profitability. T. Rowe Price, Baltimore, which primarily manages active traditional equity and fixed-income assets, surpassed its pre-crisis operating margin of 44.7% in 2007.

Robert Lee, a research analyst at KBW who covers asset managers, wrote in a recent report that T. Rowe's above-average profitability is partly due to a more diverse business mix, including a large number of scaled, high-fee products.

'A reminder'

“The financial crisis was a reminder of the benefits of having a diversified business model,” said Martin Gilbert, chief executive of Aberdeen Asset Management PLC, Aberdeen, Scotland. Aberdeen continued to improve operating margins to 45.4% in the year ended Sept. 30, compared to 40.6% the previous year, despite net outflows of 2.5 billion ($4.16 billion) due largely to weaker sentiments in fixed income. In 2009, the company's operating margin was 22.7%.

Managers able to improve margins in the future, however, will more likely be those that can diversify their business using existing platforms so as to minimize additional costs, said Geoffrey Bobroff, president of Bobroff Consulting, a money management consultant firm in East Greenwich, R.I.

Mr. Bobroff cited AQR Capital Management LLC, as an example. David Kabiller, co-founder and head of client strategies at Greenwich, Conn.-based AQR, said the firm has benefited from having “a set of strategies that has diversification in and of itself.”

The same research platform at AQR supports three business lines — hedge funds, traditional long-only strategies and risk parity. In 2013, long-only strategies benefited from robust equity beta, while risk parity outperformed in the years immediately following the 2008-2009 financial crisis. In the past couple of years, AQR also has been developing capabilities in credit strategies to further diversify its business.

AQR, a largely institutional money manager, has also successfully introduced alternatives mutual funds to the marketplace to further diversify its client base. In the past five years, AQR has gathered about $16.9 billion in mutual fund assets, and separately subadvised another $19.3 billion.

Business diversification may not result in improved margins, particularly in the short term when the cost of adding new capabilities outweighs increasing AUM.

Schroders PLC, for example, has made several acquisitions to diversify into new businesses, including the purchase of wealth manager Cazenove Capital Holding Ltd. in July. But while assets under management have increased 37% to 256.7 billion as of Sept. 30 vs. 187.3 billion at year-end 2011, net revenue margins dropped slightly to 55 basis points from 57 basis points during the same period. Schroders does not report operating margins.

“There is a J-curve effect with new products and markets, but this is just one aspect of the entire picture,” said Miles O'Connor, head of pan-European institutional distribution at Schroders in London. “There are hundreds of other things happening behind the scenes (driving profitability). When we look at how to develop our business, we do look at new opportunities as an integral part of laying a strong foundation for growth in the long term.”

“Our multiasset, multistrategy business model allows us to play different market trends amid changing regulatory conditions,” Mr. O'Connor added.

Others have had to diversify for survival. At Record Currency Management, a business model that was heavily dependent on carry-trade strategies prior to the 2008-2009 financial crisis was forced to undergo a drastic transformation due to market sentiment away from active currency management.

When Record was first publicly listed in 2007, active currency strategies accounted for about 50% of total assets under management and about 90% of revenue, said James Wood-Collins, CEO of Record, Windsor, England. As of Dec. 31, only 5% of the total AUM was invested in active currency strategies, which contributed 14% to the company's revenue.

Dynamic hedging and passive hedging accounted for 24% and 71% of the total AUM, respectively, and 64% and 22% of the revenue. The hedging strategies don't command fees as high as active currency strategies, and Record has also reduced fees in certain currency risk management strategies to remain competitive.

Timothy Pollard, P&I's data editor, and Yi Du, digital producer intern, contributed to this story.

This article originally appeared in the March 3, 2014 print issue as, "Smart diversification pays off for managers".