3Q16 Call Reports

The Times They are A-Changin’

Call Reports

After a rough start to the year, the asset management industry is facing a new reality dominated by passive managers and rising regulation.  Although most publicly traded active managers have benefited from a relatively stable third quarter, management comments suggest fee pressure is on the rise and margins have compressed as pricier offerings from hedge funds and PE firms continue to underperform the market.  However, the greatest concern this past quarter has been the impending Department of Labor’s Fiduciary Rule.  The ruling prohibits compensation models that conflict with the client’s best interests, and is expected to create pressure on active managers to provide lower-cost, passive products and to complete the shift from commission-based to fee-based accounts.1  With the final implementation date less than six months away, we expect the ruling and its consequences will be the topic of discussion for several quarters to come.

As we do every quarter, we take a look at some of the earnings commentary of pacemakers in asset management to gain further insight into the challenges and opportunities developing in the industry.

Theme 1: With a better understanding of the various requirements of the DOL’s Fiduciary Rule, asset managers are focused on reassuring investors of their compliance and anticipating costs of implementation.

  • Well, the rule is slightly less onerous than was originally proposed, so compliance with it will be more manageable than it might have otherwise been. We don’t anticipate any significant issues in complying with it. […] But I do think the DOL changes are going to have – and we’ve all talked about this, all meaning all people in the industry have talked about it – are going to have significant adjustments to how financial advisors engage with their clients all over the country.  And it’s going to have a significant effect on what those clients actually populate their accounts with, meaning active versus passive.  It will have a significant effect on the fees that managers charge, the manner in which those fees are charged and the manner in which the advice is given.  It will have an effect on how services are arranged, how services are modelled, how risk controls are actually reviewed, how firms actually create consistency around their risk management and around the advice they give in that channel. […] None of it is particularly clear, meaning specifically clear.  Generally, it’s absolutely clear, meaning that as transparency goes up, there is more fee pressure, the character of the assets in the funds are going to be subject to greater scrutiny from a firm-wide point of view.  – Alliance Bernstein’s Peter Kraus
  • If clients believe they have a fair opportunity to be in the market to build a better financial future for themselves, if they believe the Department of Labor rules gives them that security that people are working on their behalves, and they put more money to work and keep and keep getting, moving money out of all this cash into bank deposits into the financial markets, we will be the best-positioned firm for that. So we welcome these changes.  – BlackRock’s Laurence Fink
  • Fee pressure is not new, and so, this is sort of a grinding long-term pressure on the industry. I don’t think we’re going through a fork in the road right now, specifically.  I think the DOL legislation creates additional pressure, more grinding.  – Janus Capital’s Richard Maccoy
  • We believe success under the new DOL construct will require a more institutionalized process for both investment management and the sales and marketing parts of our organization. By institutionalize, I mean the ability to clearly articulate a product’s investment philosophy and process with all relevant data analytics related to portfolio construction, risk parameters, attribution analysis, sources of alpha generation, etc. – Waddell & Reed’s Philip James Sanders

Theme 2: Despite slightly improved market conditions, the plight of the active manager remains challenged as both regulation and consumer sentiment continue to favor passive management.

  • For the market, the past quarter was a solid performance period across most asset classes and a generally better environment for the performance of active management. And while one quarter does not make a trend, we are encouraged by this, as we benefited across a number of our portfolios.  2016 investment performance has gradually improved across the complex as the year has progressed, but we understand that this is a process and will take some time to get back to our historical levels of success.  I will note, however, that the improved investment performance of active managers industry-wide did not translate into active management flows regaining traction versus passive.  – Waddell & Reed’s Philip James Sanders
  • I don’t think there’s anybody that I’ve spoken to in the active world that doesn’t see the DOL as a challenge in the active to passive debate. […] And so yes, I think the early on reaction is going to be to keep it simple, passive is going to be easier, it’s low cost. How do you argue with low cost? But over time that low cost solution is going to have a cost. Unless you assume that there’s just no alpha in the world, and that’s a pretty tough assumption, because we know there is alpha in the world. The question is what do you pay for it.  – Alliance Bernstein’s Peter Kraus
  • As we’ve been reading almost every day in the press and as we discussed in our 2015 Letter to Shareholders, most active managers are battling significant headwinds. Disruptive innovation, waves of new regulations and unprecedented market interventions are adversely affecting broad swaths of active only, active long only and alternative managers.  This has manifested itself in persistent organic decay and fee pressures for a majority of these managers, but especially for those that are focused on core style boxes.  We are anticipating that going forward these trends will intensify rather than abate. – Cohen & Steers’s Bob Steers

Theme 3: In light of continued fee pressure and shrinking margins, most companies within the RIA industry are pausing to take a hard look at their expense structures.  As we discussed a few weeks ago, the industry is in need of consolidation as the current market has exposed a number of weak performers.

  • Well, I think that the lower growth environment is clearly going to make companies think hard about how do they expand their income, if not their margins. On a standalone basis that becomes more and more challenging.  And so that does lead people to think about consolidation.  The interesting question is how much expense can you take out when you put these organizations together?  And that, I think, that remains a challenging transaction or a challenging process for the industry.  –  Alliance Bernstein’s Peter Kraus
  • Looking ahead and taking into account current industry trends, we are planning to closely manage expenses while also selectively investing in people and new products to compete globally for a share of asset allocations. This will mean adding select investment vehicles and fund share classes, both here and intentionally, selectively adding depth to our existing investment teams, and being competitive and forward-looking with regard to investment management fees and expenses.  – Cohen & Steers’s Bob Steers
  • We have viewed this as an opportunity to rethink our internal structure within this changing, converging industry context. And as a result, we are bringing together many elements of retail, unaffiliated and institutional efforts, including relationship management, marketing and product, and in addition, restructuring some aspects of wholesale sales management.  We believe this will make us more efficient and responsive to industry trends and also create meaningful expense savings.  – Waddell & Reed’s Thomas W. Butch

End Note

1 “Implications of the Final DOL Fiduciary Rule for Asset Managers.” DST Kasina. April 2016.