More Consolidation Is Expected Within The Asset Management Industry

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Includes: ABDNF, BLK, CRZBY, DB, HNDGF, JNS, SCGLY, SLFPY, TROW
by: Labutes IR

Summary

The rise of passive investing is creating structural headwinds for active asset managers.

Fees and Assets under Management are falling and recent M&A within the industry has been motivated by this issue.

Consolidation should continue to be an important theme as asset managers adapt to the current operating landscape.

The asset management industry is facing a challenging operating environment, with the rise of passive investing leading to pressure on fees and Assets under Management (AuM) on a global basis. These are structural headwinds for active asset managers and the recent mergers in this industry are to a large extent motivated by this context.

For investors who like to play the Mergers & Acquisitions (M&A) theme, the asset management industry is a good choice because more concentration is expected over the next few years.

Industry Landscape

One industry that recently saw an increase in the number of mergers & acquisitions has been the asset management industry. Recent deals include the merger of equals between Janus Capital (NYSE:JNS) and Henderson (OTCPK:HNDGF), Amundi's acquisition of Pioneer and the merger of Standard Life (OTCPK:SLFPY) and Aberdeen (OTC:ABDNF). This trend of industry consolidation is expected to continue given the current industry landscape for active asset managers.

Globally, asset managers have been challenged by the rise of passive investing and the pressure on fees. Much of recent M&A in the asset management industry is a response to these structural issues, which should continue in the next few years.

Even hedge funds, which historically have charged very high fees due to good long-term return track records, have been out-of-favor by investors since the global financial crisis. As more investors switch from active to passive funds, like exchange-traded funds, AuMs decline for asset managers and the need to retain customers leads to lower management fees.

Asset managers can grow their earnings basically from two sources: higher assets under management or higher fees. However, the rise of passive investing over the past few years has resulted in downward pressure on those two metrics. Passive investing has risen to about 38% of global equity AuM and in the U.S. is even higher. This has resulted on continued net outflows from equity funds during the past decade in the U.S., showing that investors' preference for passive investing is not tactical or market-driven.

Over the past few years, the price of buying a passive fund has come down significantly and the focus on fees in the fund selection process has gained importance. On the other hand, fees for actively managed funds have remained relatively stable over the past 10 years, justifying to a large extent the shift of active to passive investing. Additionally, most active managers do not beat their benchmark after fees on a consistent way, making active funds even less attractive. Within fixed income, this trend is also starting even though the shift is much more recent.

Furthermore, there are also new products that in the past were considered active and now are regarded as passive investing, like smart beta funds. These funds are not particularly new, they simply use factor investing and quant strategies which have been used for over 25 years, but cost a lot less than active funds and are growing in popularity. Assets in smart beta ETFs have risen to about $500 billion and should continue to grow in the future as more investors switch assets to alternative investments.

Consolidation

Taking into account this industry landscape with top-line and AuM under pressure, asset managers are trying to offer a better service and improve their efficiency to remain profitable. This means that cost control is very important and one way to rapidly achieve higher efficiency is through consolidation. Additionally, scale is important within the asset management industry given that it enables fees to be kept low, an important factor to combat low-cost products, and provides a wider distribution network.

While the pressure on active asset managers from the rise of passive investing is a key factor for industry M&A, there are other forces at work, though. Given the current low interest rate environment globally and the need to take more market risk to generate meaningful returns, the importance of cross-asset funds and asset allocation are increasing and this is an area where asset managers can add value.

One competitive advantage of asset managers compared to banks and other financial providers is that they offer clients with better advisory. Banks tend to sell products, while asset managers focus on long-term relationships and asset allocation.

The global financial crisis of 2008-09 has made this point quite clear, with the banks losing market share versus asset managers, which were able to retain existing clients and attract new clients. Therefore, successful asset managers in the future need to provide a full service package to clients instead of just providing products, as a way to distinguish themselves from the competition.

This means that regarding M&A, asset managers should target multi-asset managers as a key part of the defense and growth of active investing. In the past few years, multi-asset funds have been growing AuMs in contrast to the rest of active funds and this trend is expected to continue.

Taking this into account, M&A is expected to remain a key theme in the asset management industry investment case. Given the rising importance of passive investing and smart beta, active managers who currently don't have an offering in this area may want to acquire passive businesses.

However, scale is very important for passive investing to be profitable and therefore this can only be achieved for a small number of players, including BlackRock (NYSE:BLK) or Vanguard. Moreover, building a competitive business of passive investing from scratch seems quite hard given the large size of established players. Nevertheless, some deals may happen from banks' divestments, like the ETF businesses of Deutsche Bank (NYSE:DB), Commerzbank (OTCPK:CRZBY) or Societe Generale (OTCPK:SCGLY), given that it is not among the core activities of these banks.

In addition to the passive investing capability, international reach will be more important in the future as a way to diversify AuM and grab market share in markets where passive investing has less penetration. Strong investment track record is also a distinctive factor to sustain AuM in the active industry, with managers like T. Rowe Price (NASDAQ:TROW) possibly being a takeover target for other larger asset managers with less impressive fund returns.

Conclusion

The active asset management industry is facing tough times right now due to the rise of passive investing, which is leading to pressure on fees and AuMs. Recent M&A in the industry seems to be driven to a large extent by this situation, a trend that is expected to continue in the next few years.

Asset managers with a balanced business mix between active and passive investing operations have a better profile to adapt themselves to the current landscape, while traditional asset managers should focus more on cross-asset solutions and asset allocation to add value for their clients. Asset managers with strong investment track records may be takeover targets, like T. Rowe Price which I've analyzed in more detail a few weeks ago.

Disclosure: I am/we are long TROW, SCGLY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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