The year 2017 was a record year for the European fund industry, with inflows into mutual funds reaching a new all-time high, in conjunction with a generally positive market environment driving the assets under management to a new all-time high.
Chart 1: Assets Under Management in the European Fund Management Industry
Source: Thomson Reuters Lipper
With this tailwind the European fund industry should be in a good position to maintain its growth in 2018, if the general environment for the securities markets stays positive. That said, the year 2018 started with a bumpy ride for a number of European asset managers that had failed to deliver the necessary documents and data points to fulfill the MiFID II requirements for their distribution platforms, which led to a suspension of some funds on the platforms. This meant that the year 2018 started with low sales numbers, even for funds that had been investors’ darlings in the past.
Chart 2: Estimated Net Sales for the European Fund Management Industry
Source: Thomson Reuters Lipper
Regulation drives changes in the funds landscape
Asset managers nowadays have to deal with changes in regulations all over the world. Market authorities want to avoid a new financial crisis, and asset managers have to increase their efforts to comply with the new regulations. Even though it was to be expected that some non-European asset managers would struggle to fulfill the MiFID II requirements, since they might have underestimated the needed effort, it was quite surprising to see that some large European asset managers, which should have had the needed resources, also struggled to fulfill the MiFID II requirements.
It has become clear that the MiFID II regulation has put a lot of pressure on the European fund industry. Especially for some of the asset management boutiques that run a small number of funds with comparably low assets under management, the additional costs coming with the regulations might be eating up a lot of their overall profits.
Even the managers of large funds complain that their revenues will be hit by costs coming from the new regulation, since not all of these costs can be passed on to investors. It is hard for small companies that already maintain very efficient operating models to increase profitability by becoming even more efficient; they might need to unlock some economies of scale. In contrast to asset management boutiques, large asset managers in Europe seem in general to have a sufficient margin that, although it might be affected by higher costs, it won’t turn into a loss. It’s possible that the shrinking margins and/or the increasing demand from regulators might lead to a consolidation of the global fund industry, since more and more asset managers have to rethink their business model to maintain their profitability.
One way to maintain profitability is to unlock economies of scale. Enacting economies of scale might be just a thought exercise for small asset managers, since—as mentioned above—they normally manage a limited number of funds with a quite efficient staff base. In contrast, large asset managers (especially when they are running hundreds of funds) can easily unlock some economies of scale. The most obvious solution would be to merge funds with similar investment objectives. In the product ranges of large asset managers there are always a number of funds that invest in the same region and/or that have the same investment objective. A good example of this would be balanced mixed-asset funds; some asset managers maintain a number of funds in this category that have only slightly different investment guidelines with regard to the percentage they can invest in equities. If these funds were merged, the asset manager would have to create fewer sales materials and would need less staff to observe and fulfill the regulatory demands. In addition, cleaning up product ranges would make it easier for investors to find a fund that suits their needs, since fewer funds would lead to lower complexity in the product ranges.
The U.S. fund market is a good example of this process. Even though the asset management market in the U.S. is much bigger than the market in Europe, the number of funds available for sale is roughly a third of the number of funds in Europe, while the average assets under management per fund are roughly six times higher. So, there could be a lot of room for improvement in the European funds industry.
Another way to unlock economies of scale might be a merger between asset managers—another trend we witnessed in 2017. Contrary to common expectations that large asset managers would buy small- or mid-size asset managers, we experienced mergers of large asset managers such as Aberdeen and Standard Life, along with Janus and Henderson, and in the passive space the merger between Invesco Powershares and Source. We expect more of these mergers to happen over the course of 2018, since acquisitions are a quick way to grow the asset base and/or to expand the footprint of asset managers in markets where they haven’t been active in the past.
Investors as drivers of change
Change in the European and global funds industry is not driven only by regulations and earnings pressure on asset managers. It is also driven by investor demand, since investors ultimately decide in which funds to invest. This power of investors is shown by the trend toward cost-efficient passive-investment vehicles, mainly ETFs. Therefore, it is not surprising that more and more promoters of actively managed funds are entering the ETF arena to take their share from the global trend toward ETFs. As a result of this trend the markets for ETFs will become more complex, and investors will have to do proper due diligence to find the right ETFs for their needs. From my point of view it seems the days when an investor could buy any ETF in a given classification peer group, since the differences between the products were only marginal, are definitely over, and investors have to use the same process to select ETFs as they use to select actively managed funds.
Chart 3: Estimated Net Flows in the European ETF Industry
Source: Thomson Reuters Lipper
With the unbundling of research costs being one of the key topics of the MiFID II regulation, I have noticed that some asset managers in Europe have apparently decided to pass research costs on to the investor as an additional layer of fees. From my point of view this is an absolute no go, since the investor already pays a management fee that should cover all costs related to management of the fund. But in reality, the management fee is split into two parts; one part covers the costs of fund management and also contains the profit margin for the asset manager. The second part, normally quite substantial, is used to pay an ongoing service fee to the fund distributor.
The payment of ongoing service charges to fund distributors is under scrutiny with the inception of MiFID II. However, asset managers should be able to pay for the research they need from the management fee paid by the investor without there being a huge impact on their balance sheets.
The global trend toward passive products makes it clear that investors don’t want to be “cash cows” for asset managers, giving them their money to become more cash rich and in some cases without getting any additional value. In other words, investors need to and will think twice about whether they want to invest in a fund that charges additional fees on top of an already-high overall fee for the management of a fund that may or may not deliver any outperformance.
There is a trend toward more investor-focused fee structures of active asset managers. Fidelity, Allianz Global Investors, and AB recently announced new fee models in which they combine a low base fee with a performance-related fee. While the last two companies will test their new fee structures in the U.S. at first, Fidelity will also introduce them in Europe.
I have heard rumors that some asset managers would like to get more involved in securities lending to offset some of the costs coming from the new regulatory efforts and to increase their earnings. From my point of view these practices probably will not be accepted by investors, since they are already reviewing their funds’ current involvement in securities lending. Investors don’t think this additional effort will add value for them, even though fund promoters may share any additional revenue with them. In this regard I would assume we will witness a split of the industry concerning securities lending and a review of this practice by regulators, especially for retail products.
All in all, it can be anticipated that we will see a lot of change in the global asset management industry over the next three to five years. But from my point of view, all the challenges that might come with the new regulations or possible rough market conditions also contain opportunities. Asset managers can make their business models “future proof” by building them around the needs and in the best interests of their investors, rather than running the company only to become bigger and more profitable. In addition, asset managers who can think outside the box and invest in a well-educated and dedicated staff base as well as in potential new business drivers (such as digitization) to keep their businesses responsive to the demands of investors should be well positioned to participate disproportionately in the future growth of the global asset management industry. With all the efforts they undertake to increase their profitability, asset managers need to bear in mind that, in addition to performance, reputation is one of the key factors investors look at when they buy funds. Therefore, asset managers should act as fiduciaries and make sure all their business decisions are in the best interests of their investors.
The views expressed are the views of the author, not necessarily those of Thomson Reuters.