European Fund Management Is Bigger And More Profitable But Must Change, Says McKinsey

The European asset management industry has 18% more assets under management today than it did a year ago
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The European asset management industry has 18% more assets under management today than it did a year ago, and profitability has increased by 2 basis points thanks to an increase in net revenue margins and a decline in relative costs, but fund management costs remain high, especially in the UK. These are among the findings of the annual survey of the economics of the European fund management industry by consultants McKinsey.

“The days of a homogenous asset management industry are past,” says Andrew Doman, McKinsey Director in the European Asset Management Practice. “As natural selection occurs, we see the emergence of a new breed of more diverse and specialised players, fiercely competing in a broader arena of styles, geographies, products and client segments.”

The survey this year is based on data collected from 198 European and US participants with third-party assets under management (AuM) of around €13 trillion. The key findings are:

1. Third party AuM grew 18% over the last year, driven largely by strong equity market performance and a doubling of net new inflows

2. Profitability increased by about 2 bp to 16.1bp as a result of gradual increase in net revenue margins (from 33.1bp in 2004 to 34.3bp in 2005) and decline in relative costs (from 19.2bp in 2004 to 18.2bp in 2005).

3. Retail and institutional markets are diverging as the environment matures, each responding to strong competition from different quarters. Institutional managers are already significantly more pan-European than before, while retail managers show early signs of progressing along a similar path.

4. In retail markets, there is growing use of third party distribution in local markets; and offshore platforms for cross-border sales. Meanwhile, competition from non-asset management substitution products persists.

5. In institutional markets, a broader pan-European playing field leads to price pressure and greater demand for sophisticated products from clients which has intensified competition amongst asset managers.

6. Differentiated strategies generate a clear profitability advantage. Asset managers who have a clear focus in terms of asset class specialism, product innovation and distribution strategy have higher growth and profitability than those players who follow an undifferentiated approach.

7. The environment will be much more competitive and growth to continue but be distributed unevenly across markets, asset classes and players

8. The industry will build upon its professionalism towards true distinctiveness along the value chain. Many small or mid-sized players will focus on becoming solution wrappers or managed account platforms. Only the fittest generalists will survive by virtue of their large scale or distribution stronghold.

9. The industry will become more pan-European or indeed global, as players use their distinctive strategies to grow across borders.

McKinsey says 2005 was a “terrific” year for the industry when AuM rose by 18% to € 8.9 trillion, after the moderate 9% growth of 2004. Retail AuM increased by 14% and institutional AuM grew by 20%. New inflows doubled from last year to 6% of AuM growth, but the effect of market performance at 12% was by far the major contributor of growth. In comparison, US survey participants reported a 10% rise in total AuM of which only 2% was due to new inflows. Highlights were:

1. Scandinavia and the UK again enjoyed the highest growth rates with 28% and 22% respectively, driven by strong equity market performance. While in the UK net inflows were only 3%, Scandinavia showed the highest net inflows (10%) of all western European countries.

2. Switzerland, France, the Netherlands, Germany and Iberia all experienced double-digit growth of 10% – 20% in 2005. Although capital markets in some of these countries appreciated even more than in the UK, it was not reflected in overall AuM growth owing to the lower share of equity in these countries.

3. Italy, like last year, had the lowest growth rate in Europe of 9% in 2005. Its stock market index (MIB30) appreciated by 13%, but low investor confidence and low levels of equity investment dampened overall growth.

Average profitability in Europe (ie, operating profit per AuM) increased from 13.9bp in 2004 to 16.1bp in 2005. Relative costs declined for the second consecutive year, while revenue margins stabilised. In the US profitability growth was more modest: from 11bp in 2004 to 12bp in 2005.

Net revenue margins increased from 33.1bp last year to 34.3bp in 2005, almost reaching the levels of the late 1990s. This was the result of strong gains in retail offset by some margin erosion in institutional. Conversely in the US retail net revenue margins decreased from 59bp in 2001 to 48bp in 2005 and institutional margins increased from 33bp to 37bp.

Greater cost consciousness and professionalism have led to a decline in relative cost margins for the second year in a row to 18.2bp in 2005 from 19.2bp in 2004. Most of the improvement of relative cost levels in the last 2 years has been in areas with fixed costs, such as IT and operations, which in turn are driven by AuM scale effects.

However, fund management costs remained stubbornly high. Relative fund management costs are at a historical maximum of 6.5bp, in an environment of high growth and intense competition for talented professionals.

Looking at profitability growth across individual countries, McKinsey noticed the following patterns.

1. UK asset managers’ profitability grew by 35% to 11.1bp, by far the highest growth rate of all European countries. But the UK still had the lowest level of profitability in all of Europe, which is a reflection of greater share of low margin institutional business. The UK also had the highest operating cost (24.7bp) of all countries, a high proportion of which was fund management cost.

2. Italy, Iberia and France were all able to improve their profitability significantly in 2005. Italy and Iberia had the lowest AuM growth in Europe, but showed the strongest operating profitability due to a 30-50% lower cost base than the European average. France, on the other hand, achieved profitability growth through higher net revenue margins.

3. German, Scandinavian and Swiss asset managers struggled to improve radically their profitability, and all dropped well below European average profitability growth this year. Players in these markets did not reduce costs substantially while revenue margins were at best stable or declining.

4. The Benelux countries, after experiencing the highest profitability improvement in 2004, disappointed in 2005 as operating profitability fell by 11% or 1.7bp, largely driven by a strong increase in operating costs.

McKinsey points out that retail and institutional markets are diverging. Retail asset management had strong AuM growth (+14%), owing to favourable capital markets performance and a rebound in net inflows at +6% (from 3% in 2004). However, net inflows varied starkly across Europe depending on the popularity of substitute products such as unit-linked funds and life insurance contracts. These products clearly stole the march in France and Italy, where retail investors preferred lower risk options with better tax advantages in some cases.

Multi-local players increasingly leveraged Luxembourg-based offshore products for distribution across multiple markets. Even domestic markets further opened up their distribution platforms which in many cases led to an increasing share of flows into foreign products. These patterns were most strongly evident in Germany and Italy: for example in Germany, offshore funds from domestic and foreign players amounted to nearly € 47 billion in new inflows in 2005, compared with only € 8.8 billion for onshore funds.

Retail revenue margins increased by 3%, from 49.3bp in 2004 to 50.7bp in 2005. Change in product mix was the main positive driver behind increase of gross revenues. Growth in equity funds increased overall gross revenues, as management fees remained stable. But distributors continued to gather a large share of revenues: from over 75% in Iberia to about 59% in Germany and 51% in the UK.

The institutional market grew at a rapid rate of 20% in 2005, again bolstered by strong equity performance. Institutional investor demand was increasingly polarising to either pure beta investments (such as index-linked products) or pure alpha products, leaving traditional balanced mandates at a clear disadvantage. Revenue margins decreased slightly from 20.9bp in 2004 to 20.7bp in 2005, with a strong contribution from performance fees offsetting downward pressure on management fees.

McKinsey notes that differentiated strategies generate a profitability advantage. The US survey revealed three distinctive winning strategies – scale, multi-boutique and focused-asset players – in that market. Firms pursuing one of these strategies generate, on average, pre-tax profit margins of 12-15bp of AuM, compared with firms that take a broad approach – the so-called ‘stuck-in-the-middle’ players, with profitability of only 9bp.

A similar trend is appearing in Europe. In the UK, independent players with strong brands have much higher profitability (15 bp) than captive players dependent on their parent bank or insurer brand (6bp). In Italy, adviser-oriented firms and those captive players that have explicitly invested in their investment process and distribution again have a distinct advantage over captive players that operate more as back-room factories for the retail banking network.

In the institutional space, specialisation appears to be a key competitive weapon. Players with a specific asset class focus, recognized superior performance in certain products, or capabilities in tailored product offer for institutional clients have higher profitability (14 bp) than the institutional market as a whole. We do not argue that all asset managers have to fit into some pre-determined slots, but that they need to seek out their own sources of distinctiveness along the value chain.

Looking forward, McKinsey says industry economics in 2005 suggests that asset managers are in a powerful position to invest in their future. As retail and institutional markets continue to drift apart, the value chain disaggregates further, and the stage becomes more international, McKinsey advises asset managers to consider the following:

1. Uneven growth. Underlying growth will continue but will be unevenly distributed across markets, asset classes and players. Net inflows in retail vary widely between countries. Markets such as France and Italy will be governed by captive distribution and tax incentives, while more dynamic markets such as Germany and Eastern Europe will remain attractive opportunities. Profit growth will vary across products with sophisticated or innovative products commanding higher fees, while beta products face greater price pressure. At the same time, boundaries will blur between alternative products and classic long-only ones.

2. From professionalisation to polarisation. As players become adept at cost management in a world with ever more disaggregation of the value chain, distinctiveness will become very important. Many small or mid-sized players will focus on distinctive capabilities such as solution wrappers, managed account platforms, or retail product development platforms. Elsewhere, players are already splitting into global investment hubs, specialist boutiques, beta factories and the like. The fittest generalists will thrive by virtue of their sheer scale, powerful brand or distribution clout.

3. From local to pan European to global. As distribution opens up and cross-border players proliferate, McKinsey expects to see fierce competition before a phase of consolidation, at least in the retail market. Retail flows will probably concentrate around a small number of players with must-have brands and widespread distribution, as has happened in the US. Already in Europe, non-captive channels are demanding and pursuing preferred supplier arrangements with asset managers. These retail distributors will act as gatekeepers to consumers’ wallet and wield a powerful influence on fund choice. This in turn will place retail funds under even greater scrutiny. The institutional market is already fairly pan-European, and many large players also have a global footprint.

McKinsey concludes that “new breeds of players” are emerging to create a fund management industry that is more robust, still very profitable, but also one that creates more value for all stakeholders. “Asset managers are today the envy of the financial community with their admirable economic position,” says – Martin Huber, Leader of the European Asset Management Practice at McKinsey. “They need to ensure they capitalise on this to invest in the many growth opportunities that lie ahead.”

For the last four years the McKinsey survey has collected data from more than 110 European participants, representing about 70 per cent of the industry’s assets under management (€6.5 trillion). This year’s survey includes highlights of McKinsey & Company’s annual economic survey of the north American asset management industry, launched in 2002 and representing around 80 participants in the United States. Together, both surveys represent the views of 198 participants with third-party AuM of around €13 trillion. The 2006 survey analysed financial data from the full year 2005. The detailed quantitive and qualitative data for this survey was submitted by participants in the 2nd and 3rd quarters of 2006. The survey will be repeated in 2007.

The survey is based on two extensive questionnaires and interviews: the first is focused on quantitative operational data, such as amount and nature of assets under management (AuM), staff, revenues and costs, while the second gathers qualitative comments on major industry trends. All 198 participants provided 2005 results, focusing on third-party asset management activity. This excluded assets managed for affiliated companies through internal agreements, allowing fair comparisons between markets where players compete for mandates.

McKinsey points out that “obviously” significant differences exist in how players allocate revenues and costs, both within their asset management operations and between their asset management activities and parent companies. These differences have been established and clarified as far as possible through interviews with the participants but variations may remain and may slightly affect the final results. A small sample bias may affect the comparability of the survey’s results over time but the firm says the trends identified are confirmed by analysing the profit and loss information of companies that have participated for several years – roughly 80% of all participants.

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