Money managers face reduced margins in 2019

If institutional money managers had a tough time being profitable in 2018, sources said this year could be even harder.

That's because managers' earnings, hurt by fee compression last year, could be exacerbated by expectations of more market volatility, the threat of a correction or even a recession, and reduced margins from lower fees and fewer institutional assets up for grabs.

"For the last 20 years, it's been a great business — probably too great," said Alan Johnson, managing director, compensation consultant at Johnson Associates Inc., New York. "The shifts to lower fees mean asset managers have had to find other ways to maintain margin. … Earnings are likely to be down, with layoffs in the first or second quarter — and those will be technology-driven."

Added Michael Falk, partner at Long Grove, Ill.-based money manager consultant Focus Consulting Group Inc.: "To be a money manager, you have to be ambiguity-tolerant. I have this view that the ambiguity in the world is the greatest it has been in any given time. Think about populist politics, trade and tariff issues with the U.S. and China, general geopolitics coming from the U.S., where interest rates have been globally, the aging of the global population. That ambiguity is a major headwind to the money management industry."

Among the issues cited by sources that could hurt manager profits in 2019:

• Continued increases in institutional investment in lower-cost passive mandates, away from more profitable active strategies.
• Greater use of fulcrum or performance-based fees that result in less predictable income.
• More money manager mergers and acquisitions.

Money managers — particularly those that are publicly traded — got a sneak peek at potential turmoil ahead with their equity performance in October. From Oct. 12-31, when most publicly traded managers reported third-quarter earnings, the S&P 1500 Asset Management and Custody Bank index fell 4%, while the Dow Jones U.S. Asset Managers index was down 3.97%. The S&P 500 total stock index, despite losing 6.84% for the full month, only declined 0.56% from Oct. 12-31, while the Dow Jones U.S. Total Stock Market index, which fell 7.5% for the month, edged down 0.77% from Oct. 12-31.

"October was very telling," said Jonathan Doolan, principal, head of Europe, Middle East and Africa, in the Frankfurt office of money management consulting firm Casey Quirk, a practice of Deloitte Consulting LLP. "The markets got very shaky and firms tried to protect their margins and cut costs … I don't think (October 2018) was an anomaly. ... There was broad belief in the time horizon of how quickly markets would reset themselves. We're just waiting for the shoe to drop; that'll be the catalyst of this. There's already been a 40% to 50% loss in sales productivity to command flows."

Across the 26 publicly traded money managers followed by P&I, the average return was -26.2% (-27.2% on a price-weighted basis) through Dec. 31. Quarterly revenues were up 4% in the third quarter relative to the third quarter of 2017, but down 25% compared to the fourth quarter of 2017. Total assets under management across the cohort grew 1.8% between the end of 2017 and Sept. 30; total AUM was up 17% in 2017.

"Two things drive earnings: fee compression and asset mix shifts," said Timothy O'Neill, New York-based vice chairman of Goldman Sachs Group (GS) Inc. and co-head of the company's investment management division. "Both are related. The shift from active to passive management causes fee compression. Technology tools can be used to cut costs, but the bottom line is managers' investment styles and the fees used for them. At the highest level, it's a value proposition for the client. If clients see no alpha coming from active, they'll go passive. That's why institutions are asking for performance-based or fulcrum fees. I expect that to continue."

Shawn Lytle, deputy global head of Macquarie Investment Management and president of Delaware Funds by Macquarie, Philadelphia, said there is a growing trend of declining net flows that "weigh on active managers," and he expects the gap between top and bottom performers to widen. However, he added, "There is also a correlation between the markets and passive market share and so as equity markets soften, we expect the favoritism toward passive to slow down."

Large firms with scale will continue growing their asset base in 2019 through acquisition, said Jason Schwarz, president, Wilshire Funds Management and Wilshire Analytics, Santa Monica, Calif. Also, he said, smaller managers will survive if they can contribute "additive alpha," creating a barbell pattern with successful large and small managers.

"There will be a lot of firms lost in the middle," Mr. Schwarz said. "That's where you'll see managers start to experiment with fees; that's where you'll see the experimentation bucket. You'll also see more (environmental, social and governance) strategies, social screens, different performance fees. Those will be some ways those firms in the middle will try to differentiate themselves."

The best things money managers can do this year is increase their fee transparency as well as expand the use of fulcrum fees, said Mr. Falk of Focus Consulting.

"It behooves managers to increase transparency on their investment processes, how they go about doing their work and how that differentiates them," Mr. Falk said. "That way, managers can look at justifying their fees, what they're doing to create alpha. And at the end of the day, starting with a drip before becoming a fire hose, are fulcrum fees. The industry is going to move toward reshaping its relationship with the client, where they will pay beta-like fees unless managers provide alpha and then add fees. That's the definition of a fulcrum fee."

However, while active strategy money managers will become more willing to go to performance-based fees to increase their institutional business, Amanda Walters, New York-based senior manager at Casey Quirk, said some institutional clients might hesitate in agreeing to those fees.

"In my experience, managers are willing to use them," Ms. Walters said. "But then clients start thinking about what fulcrum fees mean to them. It's a tougher sell because they might end up paying more if performance is very good."

Another issue with fulcrum fees, Ms. Walters said, is that it makes it harder for firms to budget their revenue. "Then the client wants (traditional) management fees," she said. "It's a vicious cycle. So instead (managers) might give discounts (to clients) for staying longer."

She said managers are "looking at whether they can think about pricing in a different way. It won't be discussion, but implementation, I think, that will happen in 2019. Pricing is a hot-button topic among firms. I think there will be some interesting solutions in the next year or two."

Regardless of how fees shake out this year, sources said larger money managers with both the appetite and the ability to acquire other managers will look to build their businesses.

"I think you'll see continued consolidation," Mr. O'Neill of Goldman Sachs said`. "Scale matters. The pools of assets are so large, institutional investors will have to go to large firms for beta and the fringes for alpha through boutiques."

Brad Morrow, St. Louis-based head of manager research, Americas, at Willis Towers Watson PLC said: "Managers will continue to compress. Finding high-margin business will be very difficult. It's an industry one could argue that destroys value — active managers don't make enough outperformance to justify their fees. The client has equity market exposure, but the trick is to find true diversifiers."

Casey Quirk's Ms. Walters agreed there will be more mergers and acquisitions in 2019, although they won't just involve buying traditional managers but "also other kinds of M&A … like data providers, technology capabilities and other areas peripheral to institutional management and wealth management. Both big-box managers and smaller niche firms will be doing this. They won't necessarily be required to survive, but managers will have to become innovative."

Continued limited asset growth in institutional assets will fuel competition and consolidation, Wilshire's Mr. Schwarz said. "Peak assets have been driven largely by market gains," he said. "Institutional flows have been anemic; no new pension funds are being created. It'll continue to be a takeaway game — a smaller asset pie fueling more takeaways from one firm to another. Profit margins will be hanging tight; with operating margins around 33% to 35%, you'll likely continue to see some pressure there."

Despite the headwinds facing money managers this year, Mr. Johnson of Johnson Associates said the business will remain lucrative.

"Margins won't be back" to previous levels, Mr. Johnson said. "Fees were just higher back then. But you don't need to cry about these people. Unlike other industries, asset management is not really one in which one company dominates. It's a gigantic industry. Especially with smaller firms, anyone could double their market share. In most other industries, that's not possible. But if you're an asset manager with $100 in assets, can you go to $200? Regardless of how many zeros you put at the end of those, of course you can."