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Special report: Outlook 2019

Tougher future in store for European managers

Regulation, spending on technology will be largest roadblocks to profitability

Luba Nikulina said margins of managers are being squeezed because they must spend more.

Investment management firms operating in Europe will see a tougher year in 2019 as costs are going to eat away at money managers' profitability from multiple angles.

Expenses associated with relocating offices to Europe when the U.K. leaves the European Union and lower revenues in more volatile macroeconomic conditions as Europe ends quantitative easing are just a few sources of pressure.

The bulk of costs, sources said, will come from having to adapt to regulations and investing in technology.

As a result of regulation, Luba Nikulina, global head of manager research at Willis Towers Watson PLC in London, said, "margins are getting compressed because money managers' costs are increasing."

According to a study by McKinsey & Co., the costs of managing portfolios for firms in Western Europe have been the highest since 2007, increasing 10.2% in 2017 compared to 2016. These portfolio costs were followed by a 5.2% increase in costs associated with investment in technology in the same period.

"Money managers have had to step up the level of reporting and (enhance) systems that can keep up with the level of reporting that is required by regulation," Ms. Nikulina said.

Glenn Poulter, head of business development, global markets, at Northern Trust Capital Markets in London, said it is especially difficult for midsize managers, those with less than $100 billion in assets under management. While all managers face the increases in overall operating costs, some 95% of net new assets went to the 10 largest managers in 2018, he said.

"These (midsize) managers are getting squeezed out as average outflows in 2017 were around 6%, which is three times greater than managers running $500 billion or more. Average gross margins could fall as low as 27% from 38% with a market correction. In 2017, assets grew by 13% at the same time revenues grew 9% but so did operating cost to 8%," Mr. Poulter said.

MiFID II costs

These rising operating costs are effects of the Markets in Financial Instruments Directive II, which has mandated money managers to cover the cost of research previously sponsored by big banks providing execution services to them.

Looking into 2019, those circumstances are not going to change, sources said. Dominique Carrel-Billiard, deputy director to Amundi's general management in Paris, said the influence of regulation has been consistent since the global financial crisis and it hasn't stopped. "2018 was a good year but 2019 appears to be more challenging," he said.

Amid adapting their businesses a new regulatory normal, in 2019 managers will be focused on European strategies as the U.K. leaves the European Union. With passporting equivalence not secured that would allow U.K.-based managers access to the EU market, businesses are spending resources to build a presence in other European locations.

Lydia Buttinger, global head of regulatory engagement and risk governance at Aberdeen Standard Investments in London, said "We have an office in Ireland but we are now in the process of obtaining a Markets in Financial Instruments Directive license for our Irish hub." According to Ms. Buttinger, the status of being a MiFID investment company will allow Aberdeen Standard to remain active in the European Economic Area even if there is a no-deal Brexit. "London will remain a MiFID-licensed hub but we are hedging our options for Brexit." The license effectively guarantees the firm will be able to distribute products and transact portfolio management in the European Union.

Martin Davis, CEO of Kames Capital PLC and head of parent company Aegon Asset Management Europe, said a no-deal Brexit prevents U.K. money managers not only from investing freely in Europe but also from distributing funds that are invested in European assets to their U.K. clients.

To be able to manage the assets of its existing European Union clients, Wells Fargo Asset Management obtained a license in Luxembourg that permits discretionary portfolio management and investment advisory services, the firm said in a news release Dec. 27. Deirdre Flood, London-based head of international distribution for WFAM, said in the release: "With the prevailing uncertainty around Brexit, this small but meaningful change to our current structure will ensure continued service for all of our existing European Union clients and will facilitate the future development of WFAM in this key market."

In a similar move announced in January 2018, M&G Prudential began to relocate its institutional funds for non-U.K. clients to Luxembourg.

Taking a toll on some managers' business in 2019 will be additional regulatory scrutiny and confusion associated with the implementation of mandates under existing regulation.

For example, under MiFID II, investment firms are obligated to report trades for all financial instruments. But money managers say there isn't one provider that is authorized under the directive to collect data and provide trade reports on volumes in real time so they can comply with this requirement.

"I would say that a single consolidated tape like in the U.S. is one of the areas of MiFID II that is still outstanding" to provide the right level of transparency, said Richard Withers, head of government relations, Europe at Vanguard Group in London.

Additional scrutiny

In the U.K., money managers are additionally facing scrutiny from the Financial Conduct Authority as they have to prepare for the Senior Managers and Certification Regime, which goes into effect in December 2019. Under this regulation, the FCA is forcing managers to improve governance standards "on fund level, not just firm level," Mr. Davis said.

Money management firms will be expected to allocate specific responsibilities and specific accountability to an individual portfolio manager under the new regime. "To look at all of our business and understand it is going to require considerable resources," Mr. Withers noted.

Fund managers will need to show that they have taken reasonable steps and make decisions in their roles appropriately, sources said. Aberdeen Standard's Ms. Buttinger said the regulators will be looking at the "evidence trail behind decisions that have been taken to give the flavor of the conversation" at the time of the decision-making. "The regulation will reveal how decisions are being taken and will highlight individual accountability and roles rather than in a group," Ms. Buttinger added.

"It's quite a cultural change," she noted.

Managers are also preparing for the discontinuation of London interbank offered rate indexes in the U.K., much of which will take place in 2019. Fixed-income money managers will see many of their instruments move to a new reference rate, which is likely to significantly affect valuation, risk management and fees, sources said.

Damon Batten, managing consultant at regulatory consultant Bovill in London, said that in Europe money managers additionally will deal with the EU Benchmarks Regulation. "If a money manager calculates their own indices, (the regulation) will have an especially profound impact. For money managers who are also benchmark administrators, they must comply with an onerous set of rules in order to continue running their own benchmarks."

Effective in 2018, the benchmarks regulation requires money managers to use only benchmarks authorized in the EU. Money managers that were providing investment strategies based on other benchmarks had to adapt strategies to the new requirements.

Sources said both passive and active managers might have a tougher year in 2019 as regulatory and monetary policy pressures will intensify volatility spikes. Will Lucken, global head of products at Allianz Global Investors in London, said in the institutional world globally the demand for performance-based fees is increasing.

"Passive markets have led prices to fall. The performance of active managers has been questioned and asset managers have had to respond with their own innovation," Mr. Lucken said.

But he does not think fees will go up anytime soon. "We will see the pressure continue in the passive market to offer innovation in pricing. Some passive managers offer less than a basis point (but) I don't think this is a sustainable model," he said.

"The largest passive managers are competing for market share and it is more important than revenues," he said.

AllianzGI introduced performance-based fees for some of its U.S. products over a year ago and in the U.K. in January 2018, bringing the (base) fee level to 20 basis points from 75 to 80 basis points.

Money managers are discovering that their clients' expectations are also changing as they seek lower base fees and prefer performance- based fees. "Different clients have different requirements," he said.