The costs of complying with regulatory change to the European fund management industry could be between $300 million and $500 million per year over the next three years, according to a study by BNY Mellon and Ernst & Young.
The study, entitled “The Impending Profitability Challenge for European Fund Managers,” highlights the increased pressure on firms as compliance costs rise and investors demand cheaper products. The paper says the costs, which is exclusive of headcount, could translate into a conservative 3%+ increase in cost/income ratios over the next three to five years, correlated with approximately 2%+ uplift in total expense ratios over the period (assuming profit pools remain at current levels), which will counter the rate of TER decay highlighted above. However, the desired delivery of low cost fund management models will not necessarily be undermined by the cost of regulatory compliance, when one considers that not all of the expenditure can be passed on to the underlying funds.
Most recently the fund management industry has been experiencing downward pressure on product revenues from a number of areas, including competitive factors, regulation and a shift to a more passive product mix. At the same time the industry is facing rising pressure to increase costs, due predominantly to new regulation. This paper seeks to combine industry surveys, data and insights of BNY Mellon, EY and other companies to explore the reasons for and impacts of these threatening trends focusing on what fund managers should be doing now to mitigate the effect on future profitability.
Firms will have to be creative to manage revenue up and costs continuously down, which means constantly challenging their business models and looking for short-term opportunities to aggressively restructure their funds ranges, says the study. There are a multitude of initiatives that fund managers could consider in the face of falling profitability and rising cost/income ratios to prevent the increasing likelihood of becoming an acquisition target, it adds.
As the top 20 fund management houses gain market share there is a noticeable change in asset balance, with passive funds and ETFs growing at twice the rate of active funds, according to the study.
Other key findings of the study include:
– a comparison of the global fund management industry since pre-credit crunch shows that assets under management have recovered, there are more independent fund managers, and the top 20 list of fund managers is U.S. dominated in terms of ownership;
– banks are expected to continue to sell their fund management businesses and it is likely that large independent fund managers will continue to acquire them;
– increasing barriers to entry related to the regulatory and accountability framework, specifically in relation to the cost of implementation, have started to deter start-ups and force consolidation at the bottom end of the market;
– the focus on the transparency and governance agenda—from both regulators and investors—will inevitably exert downward pressure on fees;
– that downward pressure will apply particularly to the ETF segment, where average European fee levels are similar to those of passive funds and falling at an average rate of 1% per annum depending on the instrument. Case studies conducted by the Investment Companies Institute and Lipper in 2012 show that it would take over two decades (if at all) for these TERs to converge fully if likely increases in regulation charges come to fruition as expected, according to the study. Expense ratios have fallen in the European fund industry over the past decade.
– both investors and regulators exhibit a growing thirst for passive funds, and as a consequence these funds are growing at twice the rate of active funds, resulting in margin compression.
“There are a multitude of initiatives that fund managers could consider in the face of falling profitability and rising costs/income ratios. These include reconsidering the opportunities of long term restructuring and building partnerships with third party providers for middle and front office functions. This is not just an issue for CIOs, but also something that needs to be focused on at the CEO level,” says Daron Pearce, EMEA head of Global Financial Institutions at BNY Mellon.
The study also finds that those firms that already run outsourced models are contemplating outsourcing middle-office disciplines such as stock lending, FX hedging and collateral management to their asset-servicing partners. Fund managers, who in the past have been slow to consider outsourcing components of their business model, will find it necessary to reconsider their decisions, and even extend their thinking to include some automated front-office activities offered by global custodian banks, for example market connectivity/FIX, CSA administration, research management, agency brokerage and market/reference data solutions. The middle office of the medium-sized firms could be one of the domains of highest impact and therefore greatest opportunity for cost containment.
Similar to costs, the study identifies four revenue initiatives for fund managers:
1) “Comply and Explain”—Regular, razor sharp focus on the strategic direction of the fund range. Whilst rationalization of fund ranges will deliver cost benefits, material revenue benefits will also be realized.
2) “Think Big; Start Small; Scale Fast”—To avoid start-up costs and unnecessary risk, acquire going concerns that complement the strategic product range as well as deliver value.
3) “Don’t keep digging up the road”—Adopt a structured approach to product innovation well in advance of regulations to avoid cost increases later.
4) “Maximize the Profitability of the Possible”—Ensure that fund manager CEOs/CIOs interface more closely with their asset-servicing opposite numbers much earlier in product cycles. Stronger, more effective dialogue between the C-suite and their opposite number will enable fund managers to better communicate their business strategies to their asset-servicing partners. Global outsourcing arrangements are strategic partnerships and asset servicers are (and will continue to be) ever more integral to the success of fund management businesses.