By Greggory Warren, CFA
With investors continuing to plough money into fixed-income funds at a record pace, and equity valuations starting to look fairly stretched after close to two years of market gains, we're left wondering what 2011 will hold for the asset managers. Over the last two years, the more broadly diversified asset managers have held the strongest hand, not only seeing a recovery in their equity assets under management, or AUM, as global stock markets rallied, but also picking up most of the fixed-income inflows coming from U.S. investors. While the more singularly focused equity-heavy asset managers have seen a dramatic increase in their total AUM, almost all of the improvement in their managed assets has come from market gains, as opposed to investor inflows. Meanwhile, firms with significant exposure to money market funds have seen a fairly dramatic reversal in their fortunes, as much of the capital that was parked in these funds during the bear market has found its way into higher-yielding, fixed-income products.
Given investors' ongoing appetite for risk aversion and capital preservation, we think most of these trends will continue this year. As such, we expect the more broadly diversified asset managers to continue to hold the strongest hand in 2011, with an added boost going to firms that can either provide access to exchange traded-funds, or ETFs, or have a fair amount of international business in their portfolio. With two significant regulatory issues still hanging over the industry, revolving around proposals to reform of 12(b)-1 fees and others aimed at preventing another "breaking of the buck" in money market funds, investors will need to tread even more carefully when putting money to work in the asset managers.
What the market does in 2011 is not quite as important as how investors respond to the market--at least, that is, when thinking about the sustainability of the improvement seen in the AUM of asset managers since the market bottomed in March 2009. A look back over the quarterly asset allocations among U.S. open-end equity, fixed-income, and money market funds over the last five years provides some indication of just how volatile things have been for the asset managers. The dramatic decline in equity AUM during the second half of 2008 was driven as much by the collapse of the equity markets as it was by investor reaction to it.
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According to data provided by Morningstar Direct, investors pulled close to $80 billion out of U.S. stock funds during the final two quarters of 2008. As the markets continued their downward spiral during the first quarter of 2009, investors withdrew another $22 billion from U.S. stock funds. While $21 billion did flow back into these funds during the second quarter of 2009, inflows have been overwhelmingly negative over the last six calendar quarters. In fact, if our estimates for the fourth quarter of last year pan out, then 2010 will go down as the second-worst period of outflows for U.S. stocks funds since Morningstar started keeping track more than ten years ago.
With most markets up more than 60% off of their bear market lows, and the S&P 500 Index (SPX) posting double-digit returns in both 2009 (up 26.5%) and 2010 (up 15.1%), one has to wonder what it would take to get investors interested in actively-managed U.S. stock funds again. While some of the redemption activity can be traced to investors swapping into exchange-traded funds, which pulled in more than $26 billion in 2009 and close to $40 billion last year with U.S. stock-based ETF offerings, it doesn't explain the whole story. In our view, the real root of the problem is the fact that annualized market returns over the last ten years have been less than 2%, with investors subjected to a roller coaster ride of annual returns in order to achieve those meager returns. According to a study conducted last year by Franklin Resources (BEN), more than 50% of percent of Americans believe that stocks are too risky to invest in. This is a big turnaround from the attitude that had retail investors jumping right back into equities after the bursting of the dot-com bubble, the calamity of September 11th, and the market-timing scandal in 2004-2005.
What's different this time around is that both the housing and employment markets are in disarray. We feel that this is having a major impact on how retail investors look at money and investing. With housing prices still searching for a bottom, amid ongoing foreclosure activity and concerns over the shadow inventory of unsold homes that still exists, it could still take several more years before the housing market normalizes.
That's bad news for homeowners, many of whom are currently underwater on their mortgages. No longer able to tap into the equity in their homes, many homeowners have pulled back on discretionary spending, and are putting less money into their retirement savings accounts. A need to have more cash on hand has also pushed hardship withdrawals from 401(k) accounts to their highest level in more than a decade. With so many people still out of work, and many that are working concerned about their own job security, we believe this will be a difficult trend to reverse. Even harder to overcome will be the shift from equities to fixed income that has occurred in the portfolios of many retail investors. Putting safety over returns, investors have pumped close to $600 billion into fixed-income funds over the last two years, with both 2009 and 2010 representing record years of inflows for bond funds.
Investors Favoring Risk Aversion and Capital Preservation
While some of this can be attributed to the aging of the baby boomers, who were likely to start shifting away from equities as the first wave of retirees hit 65 this year, it has been more than just retirees flowing into bond funds. And the focus on risk aversion and capital preservation has not been exclusive to retail investors alone, as institutional investors have also poured most of their capital into fixed-income products over the last two years. Again, some of this can be attributed to the aging of the baby boomers, especially among those running pension plans, but we have to believe that most of it is tied to concerns over capital preservation after returns were so severely impacted during the collapse of the credit and equity markets. It's also interesting to note that some institutional investors are starting to move away from more traditional asset class allocation models, which tended to be product-driven, in favor of solutions-based advisory relationships with asset managers. Rather than picking managers to handle individual asset class mandates, these institutions are now looking for managers capable of providing multi-asset class solutions, with an increased focus on risk management. Firms like BlackRock (BLK), which has a broadly diversified product portfolio and one of the strongest advisory businesses in the industry, are expected to benefit the most from this movement.
So what will it take to get investors interested in U.S. stock funds again? If the pundits are to be believed, domestic stock markets could post a third consecutive year of double-digit gains in 2011, something that hasn't happened since the late 1990s. While we believe that we will see continued improvement in the U.S. economy this year, which could lead to an acceleration in job growth and a reduction in the unemployment rate, and feel that the government is less likely to be as involved as it has been since the collapse of the credit and equity markets, we're not sure if its going to be enough to get investors off the sidelines--even with the prospect of double-digit gains in domestic stock markets. We believe risk aversion will continue to rule the day, with investors likely to gradually increase their risk appetite during stable and expanding markets, and pulling back dramatically during market declines.
We saw this scenario play out twice last year. First, when investors pulled money out of U.S. and international stock funds in May in response to the European credit crisis, as well as the "flash crash" trading glitch that knocked the Dow Jones Industrial Average down more than 600 points in a matter of minutes. The second time we saw this behavior was in November, when investors started pulling money out of municipal bond funds at a rabid pace over fears that state and local governments, which have had their tax revenues savaged by the downturn in both the economy and the housing market, would no longer be backstopped by the federal government. While some of the outflows were likely tied to anticipation (and then acknowledgment) that the Bush-era tax cuts would be extended, it doesn't fully explain the rush for the exits that took place during the final two months of the year.
So even with the U.S. economy on the mend, it is plainly evident that there could be similar types of events that would cause investors to pull back dramatically--and not just in U.S. stock funds. We believe that the large influx of capital into fixed income funds over the last two years, which has helped drive bond yields down to historic lows, will ultimately reverse itself when the Fed starts raising interest rates. When this does happen, it will not only wake investors up to the risks that do exist in bonds, but could finally push them back into equities where the risk-reward tradeoff might look more appealing.
More Diversified Asset Managers Have the Strongest Hand
With the uncertainty that still exists in the economy and markets--and investors' overall penchant for risk aversion--we think the more diversified asset managers in our coverage remain the best-positioned to capitalize on the current environment. That said, we believe it pays to be selective when looking at the firms - BlackRock, Franklin Resources, Invesco (IVZ), Legg Mason (LM), and AllianceBernstein (AB) - that fall into that category. Of these five names, we continue to have concerns about Legg Mason, which has had more trouble than most maintaining its AUM. The firm's problems started well in advance of the bear market, as poor relative fund performance in its Western Asset Management division, which accounts for 70% of managed assets and is the main source of Legg Mason's fixed-income AUM, started a flood of outflows from the firm. The collapse of the credit and equity markets only added to its woes, as Bill Miller's Legg Mason Value Trust (LMVTX) significantly underperformed, and exposure to structured investment vehicles in its money market operations undermined its reputation. While the firm has done a lot over the last two years to restructure its operations, we're discouraged by the level of outflows Legg Mason continues to experience, even as the relative performance of many of its fixed-income and equity offerings has improved.
AllianceBernstein is another one of our well-diversified asset managers that has struggled with outflows over much of the last two years. Much like Legg Mason, the firm has seen a significant level of outflows from its institutional client base, with the main difference being that it has been AllianceBernstein's equity offerings that have taken the hit. While relative fund performance has been improving, it is still poor over the last three- and five-year time frames, which are important benchmarks for most institutional investors. With these clients pulling more than $95 billion out of AllianceBernstein's investment portfolios over the last two years, the firm has found it difficult to increase its AUM (even with close to half of its managed assets in equity strategies). We think AllianceBernstein's inability to halt the outflows is impacting not only its turnaround efforts, but its competitive positioning longer term. We'd also be remiss if we didn't note that AllianceBernstein is one of several firms we cover that could face some issues with the current SEC proposals to reform 12(b)-1 fees, which are used to cover the cost of marketing and distribution of mutual funds.
Financial Reform Not Over for the Asset Managers
While the SEC has yet to rule on its proposals, which would effectively cap the annual fees investors pay for marketing and distribution costs, we believe firms with heavier exposure to funds sold through brokerage distribution platforms - like AllianceBernstein, Franklin Resources, and Waddell & Reed - are more exposed to the changes the agency is recommending. That said, 12(b)-1 fees, which are counted as revenue by asset managers, tend to pass through the income statement, being offset (in most cases) by corresponding charges for marketing and distribution costs. All things equal, capping the amount that funds can levy for marketing and distribution costs will impact the top line of those managers who rely on brokers and advisors (which would be just about every one of the firms in our coverage) but would not have an immediate impact on operating income. But since all things are not equal, and brokers and advisors need to get paid for their sales efforts, we expect asset managers will ultimately bear the brunt of the marketing and distribution costs that will no longer be covered through 12(b)-1 fee arrangements.
The other regulatory issue hanging over the industry revolves around money market reform. The SEC adopted amendments last year to Rule 2a-7 of the Investment Company Act of 1940 to improve liquidity (by requiring money market funds to have a minimum percentage of their AUM in highly liquid securities that can be readily converted to cash to pay redeeming shareholders), improve credit quality (by limiting the amount of lower-quality securities that a fund can hold at any given time), and diminish the risks associated with interest rate movements (by shortening the average maturity limits for money market funds), and many in the industry thought that the regulation would end there. But with the President's Working Group on Financial Markets still bantering around reform measures aimed at preventing another "breaking of the buck," its looking like things are far from over.
Federated Investors (FII), which is the most exposed to money market funds (garnering more than three quarters of its AUM and more than half of its revenue from its cash management operations), remains firmly opposed to the idea of floating NAVs, as well as proposals for bank-like capital requirements for managers of money market funds. Instead, the firm favors the establishment of a "private liquidity pool" that would backstop money markets funds during financial crisis like the collapse of the equity and credit markets in 2008. With regulatory reform far from over, and the managers of money market funds still faced with the prospect of waiving fees on their cash management products (given the historically low interest rate environment), we remain a bit more cautious on firms--such as Federated and Legg Mason--that have traditionally had more exposure to money market funds in their portfolio.
Our Top Three Asset Manager Picks Coming Into 2011
Given investors' continued aversion to risk, our expectation that the markets still have a few hiccups left in them, and the uncertainty that has been created by regulatory reform, we expect the more broadly diversified asset managers to hold the strongest hand this year, as shocks to any one asset class are more likely to be offset by gains elsewhere. Firms that can either provide access to exchange traded-funds (ETFs) or have a fair amount of international business in their portfolio should get an added boost. We firmly believe that companies with some relative stickiness in their asset base (whether through a diversified product offering or a niche that allows them to hold onto assets over longer periods of time) will outperform in the long run, especially if they're capable of generating new business. While less diversified niche managers like T. Rowe Price (TROW) and Eaton Vance (EV) would normally fit this bill, we think T. Rowe Price's current stock price fully reflects the strength of its hand, and fear that the extension of the Bush-era tax cuts at the end of last year have cut into Eaton Vance's ability to generate stronger-than-average inflows in the near term.
This ultimately leaves us with just a few names in the space that we feel confident will outperform in the current environment. While none of these firms' stocks are attractively priced at the moment, we think investors should keep these three names at the top of their lists if the sector pulls back this year. Although none of these names is completely immune to the regulatory issues hanging over the industry, we feel the strength of their operations should allow them to get through them with less difficulty than some of the other names in our coverage universe.
We believe BlackRock has the widest moat in the asset management industry. Besides being the largest asset manager in the world, with more than $3.5 trillion in AUM, the firm's diverse product portfolio and ability to offer both active and passive investment strategies gives it a huge leg up over competitors. BlackRock's ownership of iShares, the leading provider of exchange-traded funds, leaves it with not only a strong growth vehicle, but a tool for building out its presence in the retail channel. With a significant portion of BlackRock's AUM sourced from institutional clients, the firm has one of the stickiest asset bases in the industry. The firm is also more geographically diverse, with clients in over 100 countries, and more than one third of its AUM coming from investors living outside of the U.S. and Canada. We expect cross-selling opportunities within BlackRock's traditional base of institutional clients, which have shown a growing interest in passive investments, and efforts to expand the firm's reach into the retail channel, to drive solid near-term growth. With much more stable cash flows than many of its peers, we feel BlackRock should be able to continuously reinvest in its business, making it all that much harder for some of its smaller competitors to keep pace.
With around $670 billion in managed assets, and close to a third of its managed assets sourced from clients residing outside the United States, Franklin Resources is one of the larger global asset managers. The firm's wide moat has been built on the scale of its operations, the strength of its brands, and the diversity of its AUM by asset class, distribution channels, and geographic reach. While Franklin has traditionally been more equity-heavy, the dramatic shift in investor risk appetite over the last couple of years has left it with a much more balanced portfolio. The firm has also been one of the better organic growth stories in our coverage universe, generating a significant amount of inflows through its fixed-income division over the last two years. While Franklin will likely see outflows from its bond fund offerings once interest rates rise and investor risk appetite increases, we feel it is perfectly placed on the equity side of the business (especially with its global/international funds) to capitalize on the shift in investor sentiment. Given the strength of its product portfolio, highlighted by solid investment performance across both its fixed income and equity platforms, we believe Franklin is one of the better-positioned asset managers coming into 2011.
Of all the acquisitions Invesco could have done, the purchase of Morgan Stanley's (MS) retail fund operations provided it with the best possible mix of products and distribution. With Invesco's strong positioning in the defined contribution and defined benefit channels, and Van Kampen having a strong presence in the broker-dealer channel, Invesco will now be able to cross-sell the best products from each fund family through these different distribution networks. The deal has also expanded the platform that Invesco can tap into to grow its PowerShares exchange-traded funds operations. While the acquisition has increased Invesco's exposure to both retail investors and U.S.-based customers, the firm remains fairly well-diversified across asset classes, distribution channels, and geography. The most important aspect of the deal, though, is that it has given Invesco (with more than $615 billion in AUM) the additional size and scale that it will need to remain competitive in an industry that is being reshaped by the bear market's impact on investors and the financial services firms that cater to them. While there is likely to be more integration risk involved with Invesco's acquisition of Morgan Stanley's retail fund operations than we saw in BlackRock's purchase of Barclays Global Investors, the company has the potential to grow at a much faster rate longer term than BlackRock, given that it's starting off from a smaller asset base than the industry giant.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.