We think the following issues are likely to have an impact over the next several years on the traditional U.S.-based asset managers we cover:
- A weaker regulatory environment for financial services firms
- Distribution channel disruption on the retail-advised side of the business
- Continuation of the ongoing shift from active to passive products
- Greater focus on relative fund investment performance and fees
- The inevitability of industry consolidation
- U.S. corporate tax reform
We expect the regulatory environment to become more favorable to the traditional U.S.-based asset managers. However, changes on that front are unlikely to alter the long-term trends affecting the industry, from a disruption of the retail-advised distribution channel (accelerated by the Department of Labor’s fiduciary rule) to the ongoing shift from active to passive products (driven by poor relative fund investment performance and a widening spread in the fees being charged for active products relative to passive offerings). We expect these trends to lead to an extended period of fee and margin compression for the industry as active asset managers are forced to reduce fees and spend more heavily on talent to improve investment performance and enhance distribution.
Passive Products Growing at Expense of Active
The amount of capital invested in index funds (including both flows and market gains) more than tripled to $2.9 trillion during the past decade, while passive exchange-traded funds increased nearly sixfold to more than $2.5 trillion and the amount of capital held by actively managed funds increased just 50%. We expect this trend to continue the next five years.
Index funds and passive ETFs generated strong flows in 2016, with index funds pulling in $220 billion and passive ETFs picking up $280 billion in net flows. During 2012-16 and 2007-16, respectively, index funds generated annual organic growth in assets under management at 8.9% and 8.6% compound annual rates, while passive ETFs produced 14.1% and 17.7% annual rates of organic growth.
While the organic compound annual growth rates for actively managed fund assets under management were negative 0.3% and positive 0.8%, respectively, during the past 5- and 10-year periods, we think either rate of annual growth would be ambitious going forward, especially with interest rates expected to rise.
In addition, a lack of outperformance has plagued active equity fund managers. Actively managed U.S. large-cap equity funds, which represent 75% of the assets under management invested in active U.S. equity funds and make up the majority of most asset managers’ equity assets under management, have struggled to beat their benchmarks the past decade. At the end of June 2016, less than 10% and 15% of active large-cap managers were outperforming their benchmarks over the previous 5- and 10-year time horizons, respectively
BlackRock and T. Rowe Price Are Our Favorites
Another byproduct of this regulatory environment will be industry consolidation, both internally, as fund companies consolidate funds to increase scale and eliminate underperforming offerings, and externally, as medium-size to large managers increase their scale and product breadth. We expect most of our coverage to be buyers rather than sellers.
As for fiscal policy, lower corporate tax rates could offset some of the impact that fee and margin compression will have on earnings. The biggest beneficiaries will be moatier firms with higher effective tax rates--like Eaton Vance
(with an expected average tax rate of 37.9%) and T. Rowe Price
(37.5%)--as well as firms with large amounts of excess capital trapped overseas, like Franklin Resources
, should there be a tax repatriation holiday.
With all of this in mind, we recommend long-term investors focus on BlackRock
, the leading provider of exchange-traded funds, which also garners more than 80% of its assets under management from institutional clients, and T. Rowe Price, which has the best and most consistent investment performance and derives two thirds of its assets under management from retirement-based products. The two firms not only are better positioned competitively, but also have more room to give up margin to generate growth; BlackRock and T. Rowe Price both closed out 2016 with operating margins of 41%, compared with the group average of around 28%.
As BlackRock and T. Rowe Price have traditionally traded at premiums to the group, finding good entry points can be difficult. We believe the best time to buy the U.S.-based asset managers tends to be during market downturns, as the group will generally trade down harder than the market, with their price/earnings multiples looking far more attractive on a relative historical basis. We would also note that during these periods of market dislocation, investors have had success finding greater value in some of the second-tier names in the group, like Eaton Vance, Invesco
, and Affiliated Managers Group