Asset Managers’ Troubles Aren’t Temporary

(Bloomberg Opinion) -- The share prices of listed fund managers fell, on average, by a quarter in 2018. They’ve responded predictably, shedding staff to lower costs, expecting business to recover in due course. What they don’t seem to understand is that they’re facing difficult, possibly insurmountable long-term problems that demand much more drastic changes.

Asset managers, especially diversified firms, benefited greatly from the economic and financial environment of the last several decades. As savings grew, funds aggregated them for investment. Frothy markets boosted returns, despite occasional reversals.

Those conditions may not hold much longer. First, assets under management, which drive fund managers’ earnings, aren’t likely to keep growing at historical rates. As Western societies age and retirees draw down investments to finance their post-income lives, fund outflows will increase. The money coming in may not fully offset withdrawals: Younger workers have lower savings due to stagnant incomes and discontinuous, precarious employment. Judging by their investment habits and attitudes to money, they’re also more skeptical of financiers and traditional investments.

Government and corporate-sponsored retirement schemes may also shrink in size. In an environment where fewer people can afford to stop working, they’re not likely to be paying much into retirement funds. Tax incentives to encourage saving, which are seen as favoring the wealthy, may be withdrawn or reduced, further reducing inflows.

The industry is seeking to counter these trends by expanding into emerging markets. However, North America, Europe and Japan still constitute around 70 percent of managed private wealth. Asian countries, which make up the largest proportion of the emerging market segment, face similar demographic challenges to developed countries. And, in any case, emerging-market investors favor domestic managers due to concerns about extra-territorial U.S. and European regulations which can be used to block, trace, freeze and seize funds.

Second, lower returns across asset classes are likely in the future. The problem of generating adequate returns will be exacerbated by markets that have been distorted by government intervention. Low rates and central-bank asset purchases have boosted prices, limited asset choices and reduced trading liquidity. They’ve also artificially suppressed volatility and increased the volatility of volatility.

Correlations between assets have become uncertain. Traditional relationships have broken down: Asset prices frequently don’t fluctuate in ways that are consistent with fundamental drivers or trends; cheap stocks don’t outperform expensive ones; and stocks with stronger finances don’t always outperform weaker ones. The dominant investment environment is risk-on/risk off, with frequent meltdowns and rallies, as happened in February and December 2018. Fund managers find it hard to navigate this type of investment environment.

They are struggling to find alternatives, from expanding index tracking funds, to employing quantitative strategies such as factor investing, to pursuing illiquid investments such as private equity and debt. None are a panacea. Asset managers geared to traded and liquid financial securities can’t switch easily to new markets. Many of those require managers to offer greater liquidity to fund investors than that afforded by the underlying investment itself. Others lack scale, being too small and uneconomical for traditional funds. Managers don’t have the skills required for some investments.

All these problems will crimp inflows as well. Adequate post-fee returns are needed to attract investors. Globally, rising asset values are responsible for around half of all increases in assets under management; the percentage is higher in developed markets.

Finally, as a consequence, fund managers’ margins will decline from their current range of 25-40 percent. Low-cost index and quantitative funds, including the zero-cost index fund Fidelity Investments introduced last year, will put even more pressure on fees. The latter are being slashed in active funds, too.

Meanwhile, regulatory and compliance costs are rising rapidly. The post-MiFID need to pay for research or bring it in-house raises expenses. Funds will need to explore major changes in their fee structures, perhaps charging for performance on realized returns, or for expenses only.

There are things fund managers can try to improve performance. They might focus on absolute returns rather than their performance relative to market indices. They could adopt dynamic portfolio composition, which allows unconstrained allocation between asset classes, or permit funds to go both long and short. They’ll need to increase active trading, the use of derivatives or structured products, and leverage. Fund structures will have to incorporate long lock-up periods to reduce redemption risk and allow for investments with different liquidity profiles.

Such measures, however, won’t increase returns for everyone in the zero-sum world of markets, where someone’s gain is another’s loss. The asset-management industry may bifurcate into a few large, index-fund managers exploiting economies of scale and smaller, specialized managers taking advantage of their expertise in specific strategies. For many large and mid-sized asset managers, on the other hand, an inability or unwillingness to change will mean increasing irrelevance.

To contact the editor responsible for this story: Nisid Hajari at nhajari@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Satyajit Das is a former banker whose latest book is "A Banquet of Consequences." He is also the author of "Extreme Money" and "Traders, Guns & Money."

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