UK: Asset Management In A Post-Crisis Environment - Reconsidering Profitability

Last Updated: 24 August 2011
Article by Deloitte Financial Services Group

Most Read Contributor in UK, August 2017

Why focus on profitability?

The 2008 financial crisis caused a severe drop in asset valuations and a sharp decline in revenue. The subsequent and intense pressure on fees has, at times, called into question the profitability of the prevailing industry model.

Earlier in the year, there was evidence to suggest that the overall economic picture was improving and so the industry was growing increasingly optimistic of a potential return to a pre-crisis environment. These positive trends have, however, proven to be both temporary and weak. The debt crisis, slow economic growth, foreign exchange imbalances, continued high unemployment in the US and a number of catastrophic natural disasters (including the earthquake in Japan) have all dampened hopes of a strong recovery. Thus, whilst asset managers enjoyed a comparatively positive investment climate in 2010, 2011 is proving to be more challenging.

Indeed, the key trends in the asset management industry that were evident in the aftermath of the financial crisis are still prominent today and may even become further entrenched by the destabilisers noted above. These trends are unlikely to reverse in the short to medium term.

This is reflective of the fact that the post-crisis world is fundamentally different to the pre-crisis environment. Deep paradigm shifts are evident in the structure of the global financial services industry, and this has significantly affected the cost-income ratios of asset managers.

Taking this into account, asset managers need to make fundamental changes to the way in which they conduct business to ensure survival in the market, focusing heavily on profitability management.

This article reviews current market trends in the asset management industry, looking at how they impact profitability. It then highlights the importance of access to quality information and the implementation of a profitability framework to refocus asset managers on areas capable of generating sustainable value.

Current market trends: Ongoing revenue pressure & increasing costs

The key trends highlighted below are becoming increasingly entrenched and are threatening asset managers' profit margins from both a revenue and cost perspective.

Risk averse clients – There has been a fundamental, perhaps even irreversible, alteration in client psychology. Investors have become increasingly risk averse and continue to limit the volatility of their portfolios, preferring absolute returns, and guaranteed income from investments and cash holdings. Fear and mistrust still lingers in the market, though to a lesser extent than immediately after the worst of the crisis.

Changing fee structures – Another characteristic of the post-crisis investor landscape is the increasing focus on value for money. Many asset managers are finding that clients are demanding a greater link to performance in fee structures as compared to the pre-crisis market.

Passive products – More passive assets with very low management fees are becoming increasingly popular at the expense of active products with high fees that no longer generate the sort of alpha possible prior to the crisis. Indeed, in today's environment, because of the higher fees demanded by active investment managers, net post-fee returns can be lower than returns from beta products. Global Exchange Traded Fund (ETF) assets rose 28.2% in 2010 to $1,482bn¹, and it has been estimated that the portion of global assets being managed passively could rise from 15% to 25% in the next ten years². Over 1000 new ETF products could be launched in the market during 2011³.

Demographic change – There may be opportunities for asset managers as younger generations become increasingly aware of the need to provision for retirement early, the growing unfunded public sector pension liabilities, and lower returns on regular bank deposits. However, this must be balanced against the effect of ageing populations. As affluent baby boomers enter retirement, demand for asset protection and draw down will increase, and there will be a slower accumulation of assets.

Increased regulation – In addition to falling revenue, the cost base of the industry is increasing, primarily due to the need to comply with a greater regulatory burden. New regulation will mean increased capital requirements, leverage limits, new disclosure requirements and changes to remuneration.

The Undertakings for Collective Investments in Transferrable Securities (UCITS) IV Directive, due to come into effect in July 2011, introduces new provisions including new rules for fund mergers, new rules for master-feeder fund structures, key information documents for investors, more efficient notification procedures and management company passports. The Alternative Investment Fund Managers Directive (AIFMD), a European Directive that will come into effect in 2013, aims to provide more transparency, robust governance and improved solvency within the alternative investment sectors (mainly aimed at hedge funds and private equity, but may extend to traditional asset classes).

The Foreign Account Tax Compliance Act (FATCA), signed into US law in March 2010 and effective from 1 January 2013, significantly tightens the tax reporting requirements of non-US financial institutions. Ensuring compliance with this stream of new regulation, of which the above is only a selection, will involve a large input of time and money from asset management firms.

Improving profitability to deliver sustainable value

So how do asset managers improve profitability, control the impact of the increasing pressure on the bottom line, and take advantage of potential new opportunities presented by today's market? Asset managers that have a clear understanding of the way their business works and a view of key financial metrics will be prepared to counteract the effect of current market trends. The availability of certain types of information is vital. If asset managers are able to positively answer the following questions, they will be better placed to make strategic decisions and improve medium to long-term positions:

  • Do I understand which products and clients are the most profitable?
  • Do I have insight into the distribution channels that bring in the assets with the highest margins?
  • What knowledge do I have of the products that generate the most fees?
  • How clear is my vision of the major growth opportunities ahead?
  • Are there processes in place to produce information and profitability metrics on my organisation, and can I access this information on demand?
  • Does the information allow me to clearly see how and by whom (products, clients, distribution channels and jurisdictions) money is made in my business?
  • Does the information provide me with an accurate and thorough view of the cost drivers of my business?

To answer the critical profitability questions, there may be a temptation to embark upon a one-off ad hoc tactical solution. However, a pragmatic, structured, and comprehensive approach to profitability management will deliver sustainable benefits. Indeed, profitability management should become one of the key components of strategic management.

Profitability management is complex and asset managers often struggle to obtain a clear picture of how profitable their products, clients, services and distribution channels are. Ideally, a framework will be established to facilitate the analysis of these four areas.

Depending on the chosen profitability 'lens' (products/ services, clients, distribution channels, jurisdictions), the framework should cover three key areas to provide an accurate view of profitability:

  • Revenues (e.g. gross revenue, trading revenue, revenue commissions/expenses, allocation key types and organisation).
  • Costs (e.g. people related costs, non-people related costs, allocations, distribution, allocation key types and organisation).
  • Profitability rules (e.g. governance model, financial control line items and aggregation levels).

This can prove challenging, but this approach will allow asset managers to take control of their business and be equipped to make decisions, enabling competitive gains. Activities such as product alignment, cost reduction, sales and marketing pushes, re-alignment of infrastructure and systems, and changes to the service model can then be undertaken with the knowledge that this is strategically the right course of action for the business and with a clear picture of what the financial benefits should be.

Conclusion

The global financial market has been fundamentally altered as a result of the financial crisis and revenues in the asset management industry have been significantly impacted. These revenues are unlikely to maintain a strong trajectory back towards pre-crisis levels due to increasingly risk averse, value seeking investors, competition from passive products, changes in fee structures and the impact of demographic change. In addition, cost bases are increasing significantly because of the higher incidence of regulation. As a consequence, the cost-income ratio in the asset management industry is worsening.

Asset managers must focus on the profitability of their businesses and should proactively manage profitability to ensure survival in this new landscape.

Easily accessible, structured, and up-to-date information on the business is required to support coherent decision-making. This is essential to avoid one-off tactical solutions to bridge the information gap. Asset managers need to re-focus their businesses on areas capable of generating sustainable value in this challenging environment, and as such, need to ensure that the right information is accessible to them on-demand.

Footnotes

1 'Rapid expansion across UK exchange traded funds industry', Financial Times

2 'Investment industry set for big shift into passive management', Financial Times

3 'Fixed Income ETFs are just getting started', Financial Times

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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