Global market volatility unleashed this year amid surging inflation, geopolitical tensions and pandemic-snarled supply chains has wreaked havoc on investors' portfolios. But it has also fundamentally impacted asset managers by shaking up core assumptions that have driven the industry's record growth.
After two years of record profitability, North American asset management firms have hit a "speed bump" in their near-term economic trajectory, according to a new report by McKinsey & Co.
What the consulting firm called "the Great Reset" is a shift in "the rules that have underpinned the business of asset management over the past decade." The changes, the report said, "will require more rapid restructuring and reinvention of North American asset management and could lead to radical shifts in the competitive landscape."
The annual study is the latest to look at an industry facing a sudden shock. In a May 2022 report,
The headwinds have big implications for how financial advisors will position advice and investment products for individual and institutional clients going forward. And they impact firms ranging from BlackRock, Fidelity Investments and Vanguard to Wall Street banks to regional and smaller brokerages and fund managers. Amid anemic returns across most asset classes, uncertainty about where the global economy will land, macroeconomic policy pressures on central banks and the "wild card" of geopolitics, clients "are questioning previously reliable recipes for portfolio construction and long-term investing," according to a draft version of McKinsey's "The Great Reset: North American asset management in 2022."
'Changing of the guard'
The industry began the year with $126 trillion in global assets, a high-water mark that represents a 23% increase on a decade earlier. Industry revenues swelled to $526 billion, more than double that of 10 years ago. But 2022 soon brought on a "radical shift" in investors' appetite for risk, in turn prompting a "changing of the guard" in the industry.
Last year, a record $1.6 trillion in new money flowed into funds and investments. By contrast, the first half of 2022 saw net outflows of $281 billion.
Even if headcounts become more diverse, progress will stall if the culture of the industry isn't addressed.
The most notable shift revolved around fixed income, long seen as a rock-solid generator of positive flows. In the first half of 2022, $170 billion of fixed income open-end fund assets disappeared as inflation and higher interest rates hammered their returns. Equities, with a modest $79 billion in net inflows for the period, scraped out a sliver of organic growth as investors rebalanced their portfolios.
Winners and losers
The reversal in flows sharpened a line between winners and losers in the industry. "Continuing a trend we have tracked over the past few years, the gap between the best and the rest continued to widen considerably," McKinsey said.
Two-thirds of the growth of the industry's asset base over the past decade has come from soaring markets. In the last 10 years, the industry's cost base has grown at about 6% to 7% per year, double the organic growth of assets in the industry. Asset managers could afford to spend heavily thanks to strong markets that grew client money.
But during the first six months of 2022, just over one in three asset managers, mostly large, diversified firms, continued their 2021 organic growth, hauling in a net new $258 billion. Meanwhile, one in four firms gave up some of 2021's gains, ceding $352 billion of outflows — an amount equal to more than half their gains from the prior year. At the bottom is 28% of the industry, which suffered outflows both in 2021 and during the first half of 2022.
The bottom group "largely consists of asset managers who were facing challenges in the investment performance of their flagship strategies" in traditional product categories, the report said. "Outflows in this group accelerated meaningfully from $196 billion for the full year of 2021 to $222 billion for the first half of 2022."
Costs are an Achilles heel
The gap between winners and losers is most evident in firms' revenue growth.
Asset managers in the top quartile outperformed their peers in the bottom quartile by 29 percentage points, compared to 19 to 20 percentage points in the last two years. "While profitability improved for the asset management industry overall, the gap between the best and rest remained considerable," with a 37-percentage-point difference between top- and bottom-quartile firms.
Revenues are impacted by costs. Last year, North American asset management firms ramped up their spending by $13 billion to a record high of $167 billion. That 8% increase on 2021 is just over half the overall rate of the industry's asset growth, but almost double its rate of organic growth. Firms spent the most money on investment management costs — meaning hiring executives, advisors and other professionals — followed by technology, operations and legal and compliance functions.
'Ossified"
As asset managers have spent more on complex products, platforms, sales channels, data and analytics, they've also spent heavily on talent. Almost half of all cost growth was driven by increased compensation, while one-quarter came from increased headcount.
"The reality is that with greater business complexity has come growing cost of talent, in terms of both volume and price, and often in areas where costs are fixed in the near term," the report said.
An industry group contends that the commission is overestimating RIAs' control over outsourced services.
McKinsey pegged growth in the size and complexity — "and the potentially increased rigidity" — of the industry's cost base as a "key vulnerability" for North American asset managers." With the cushion of consistent asset growth over the past decade, operating models have grown in complexity, and cost structures have ossified."
Stark warning
"The volatility of the first half of 2022 serves as a reminder that growth cannot be taken for granted, and the continued uncertainty in the macroeconomic environment raises a natural question: How much of that cost base can be supported in an era of more tepid growth?" the report asked. "The asset management industry's costs have been variable on the upside, but exactly how flexible will these costs prove to be on the downside?"
Trendy asset classes and products
ETFs: Exchange-traded funds, which had a record year in 2021, are a counter note to battered competing products and may be on track to have their second-best year in terms of flows.
ESG: Clearer standards and higher-quality data "will ultimately be helpful for the long-term growth prospects of sustainable investing." At the same time, "near-term uncertainty around rules will likely lead to a pause, at least in the regulated fund segment."
Direct indexing: "Technologies related to direct indexing, which allow portfolio customization at scale, will extend the ability of asset managers to offer advanced portfolio solutions to smaller clients, including retail investors."
Six-point agenda
"The Great Reset of 2022 has loosened some of the foundational assumptions behind several of the past decade's defining trends, including the internationalization of products, clients and capital sources; rapid growth of risk-on and leverage-oriented business models; and a wave of commoditization borne out of the surging demand for bulk beta — assumptions on which the North American asset management industry had built its growth trajectory," the report said.
McKinsey concluded that asset management firms must:
- Engage clients strategically
- Recalibrate investment processes and approaches to risk management
- Embrace hybrid sales practices
- Invest only where it counts. "The current environment requires a zero-based approach to resource allocation that re-underwrites and ring-fences growth investments and reins in the undisciplined pursuit of more."
- Take a knife to structural costs by "reengineering" operating models
- "Reposition the franchise"
- Offer clients private market investments, new investment vehicles and portfolio solutions
- "Unlock new possibilities for opportunistic M&A, talent/team lift-outs and partnerships that can help accelerate these critical transformations."
