Consider the following. At time of writing, March 27, Dow futures are down again after being up 20% from its low close on March 23, technically a bull market again. Overall, March 2020 holds the record for how quickly stock prices dropped into a bear market – only 16 days after the S&P hit its last closing high on February 19. VIX, or the “fear index” hit almost 83 on Monday 16th March, surpassing the peak level of 80.74 on November 21, 2008.
The federal government has approved a $2 trillion stimulus package and has effectively shifted from being “lender of last resort for banks” to a “commercial banker of last resort” for the broader economy. The severity of the economic impact of Coronavirus remains largely unknown. What’s an asset manager to do in this quickly changing environment?
I’ve discussed in Banking Exchange and elsewhere, innovation has been a point of weakness for the asset management industry—both for managers and clients. Following decades of raking in profit margins well north of 30 percent while deploying zero capital of their shareholders, asset managers have increasingly seen their profit base come under attack. This is a sure signal that something fundamental has to change. Even before the current global COVID-19 crisis, which has forced rapid-fire digital innovation for businesses across the industries, asset management has seen several waves of pseudo-innovation that are ultimately unsustainable.
The first such wave, in 2013, was one of product proliferation. The most stark example of this was Blackrock’s announcement that the firm had some 70,000 share classes in the fund universe. However, nearly 100 percent of inflows were directed to a fraction of a percent of these share classes—only about 185 of them.
The second wave of unsustainable innovation, which has characterized the last few years, takes the shape of a race to the bottom. To illustrate, in the first quarter of 2019, Vanguard saw $62 billion in inflows by managers and other looking for low-cost passive strategies. This accounted for nearly half of all fund inflows in North America – more than its three biggest competitors combined.
While the current market shakeup may be a temporary setback, we can look back and see that in many ways, both of these waves of change resulted from the 2008 global financial crisis, as the subsequent rise of a low-yield environment intensified the search for blockbuster products and cut-rate services. Also looking historically, we can see that the success of these strategies has rested on luck, more than on judgement. Decisions and investments have most often been driven by clients’ wish to chase the next rainbow, or more simply, by prevailing market sentiment.
Innovation means creating new ideas that add value to clients—often taking the form of investment strategies that scale with greater predictability in outcomes. In that sense, neither of these approaches can be called true innovation. Unfortunately for asset management, the buzzword ‘innovation’ has been badly misused in the investment community. It’s time to invest real meaning and value in the term, not just give it lip service.
What Happened to Innovation?
With its attractive margins and reliance on traditional business models, the industry has long been seen as ripe for disruption. Right now, we’re going through yet another wave of asset management innovation: digital transformation. But the industry seems to be treating this, too, as just another fad.
The time is ripe to learn lessons from the recent past and even more so, the immediate present, wherein a myriad of industries are speed-ramping up their digital game. While the photography, music and travel industries are grave historical examples of the disruptive impact of digital transformation, one only has to look at what’s happened to retail (massive shift to online), education (remote) and yes, physical banks, since the start of this crisis.
In the past, too many new products were raced out onto the market without much consideration of their inherent or lasting value. Even worse, we’ve learned that a ‘winner takes all’ industry leads to a ‘one size fits all’ business model, which is doomed to fail both clients and manufacturers.
The reality is that asset managers – and clients – have had a long, hard nap when it comes to dealing with innovation. Ultimately damaging themselves, they’ve followed fads and past performance blindly. As noted, this has reached the extreme of top star funds receiving almost 100 percent of inflows go into top star funds, imbuing the industry with a blockbuster culture. In a world of personalization and small startups, this is no longer going to fly.
Blue Skies to Storm Clouds
From 2009 to 2016, as much as 87 percent of the asset management industry’s growth has been attributed to the market’s artificial rise, fueled by central banks’ ultra-loose monetary policies. The organic component of growth has been declining. There is ample recognition among asset managers that if central banks rewind their policies, current pandemic notwithstanding, the current level of profitability will be unsustainable.
A McKinsey report offers proof that this is already starting to happen: while average assets under management (AUM) in North America edged up nearly 7 percent for 2018 to $43 trillion, the industry’s aggregate revenue pool gained just 1 percent. Facing a rising cost bill, industry profits fell nearly 4 percent. Market valuations have begun to react to this pressure, as well. In 2018, stock prices of publicly listed asset managers hit historic lows – both in absolute and relative terms – trading in a range of 10 to 12 times earnings. This modest valuation was a sharp reversal from the baseline of the past 10 years, when asset managers earned historic high valuations of 14 to 18 times – a meaningful premium relative to the broader financial services sector, and even to the market as a whole.
Can Innovation Get Us Back to Where We Were
The downward spiral of valuations has been exacerbated by a number of structural factors. Real interest rates have been riding at sustained low levels—now they’re zeroing out. There’s been an expectation of limited organic growth due to debt deleveraging. Other factors, such as greater efficiency in the public markets, an aging client base, the rise of intermediaries, and increasing regulatory intervention have all exacted a toll.
Regardless, organic growth can still be found. And after this crisis is over, there will still be a healthy demand for fixed income. It’s likely that we’ll still see expansion of private markets as a source of idiosyncratic returns; innovative vehicles such as ETFs as tools for delivering precision intraday risk exposures; and portfolio-level solutions (for example, outsourced chief investment officer and liability-driven investment mandates) to help manage complex liabilities in the face of uncertain markets.
Even without meaningful innovation, this is an industry that has coasted through a post-crisis decade of steady revenue growth and enviable operating margins of 30 percent and higher. However, for things to stay the same—and now that might be better stated as ‘get back to the Old New Normal’—a lot must change. What’s needed is a fundamentally new narrative of growth, with an emphasis on digitization. Indeed, the search for cost-effective organic growth has intensified for the asset management industry, but without technological innovation, it will eventually be left behind.
The industry as a whole needs to begin changing its mindset of zero-sum competition in a stagnant pool—a race to the bottom—and look toward tapping into new sources of demand, whether unmanaged assets such as cash and securities, shifting client needs in retirement and pension plans, financing solutions to new global challenges such as the effects of COVID-19 and climate risk, or underpenetrated markets such as those emerging in Asia. We need a new story about how investment excellence can enable true asset management innovation.
About the Author: Martijn Moerbeek is group director of Digital Strategy & Innovation at Legal and General, a forward-looking, UK-based financial services and insurance firm managing over $1.4 trillion in assets.
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