The gloom - and bright spots - of asset management in 2023

Volatile markets causing painful losses in stock and bond prices in 2022 portend that many asset managers will bring in less revenue and post thinner margins.

Those same market conditions are expected to continue in 2023 and should again weigh on asset management firms' profitability and could potentially reshape the industry, experts in asset management say.

"Asset managers have limited pricing power," said David Lebovitz, managing director and global market strategist at J.P. Morgan Asset Management based in New York. Mr. Lebovitz is also part of the firm's global market insights strategy team. So, the new market conditions, and increasingly cost-conscious investors, are going to make for an interesting year, Mr. Lebovitz said.

In a red flag for asset management, Moody's Investors Service Inc. lowered their outlook in December for the global asset management industry from stable to negative in response to fundamental business and economic conditions.

The operating environment is now "vastly different" than it was a year ago, before central banks began raising interest rates and Russia invaded Ukraine, according to Moody's. Industry assets under management neared an all-time high of $126 trillion at the start of 2022 and Moody's estimated in its report that its total AUM as of Dec. 8 had declined by more than 15%.

A new market regime has put "significant stress on asset managers' revenue given their high correlation to market performance. We expect industry AUM levels to remain under pressure in 2023 with a sharp rebound unlikely, but AUM growth will ultimately be influenced by overall market performance," the Moody's report said.

The average U.S. asset manager EBITDA margin rose to nearly 50% in June from just above 30% in December 2019, according to Moody's. But in June 2022, margins had already fallen below 30%. The credit rating and research firm does not expect margins to decline like they did during the global financial crisis in 2008, when they were halved or worse. However, if the market environment doesn't change, margins will remain squeezed.

Two of the most prominent trends in asset management — downward pressure on fees and rising costs — have been present for years and will persist in 2023, according to managers and consultants.

Almost no asset managers are raising their fees. Many continue to lower fees, either because they've underperformed relative to peers or have achieved enough scale that they can afford to; what they gain in new assets may overcome what they could have earned with a higher fee, managers and consultants said.

Beta and smart beta strategies that blend passive and active investing — once something that investors were willing to pay more for — have become ubiquitous and those managers are also lowering fees to stay competitive against each other, JPMAM's Mr. Lebovitz said. Funds that track popular indexes have been undercutting each other for years, which is why investors can pay just a few basis points, he said.

Investors, Mr. Lebovitz said, are still willing to pay for alpha if they can get it. But where it comes from will be different in the future.

"Alpha is increasingly going to come from benchmark-agnostic managers and strategies," he said.

Meanwhile, the cost of operating as a money manager continues to rise. During the past 10 years, asset management costs in North America have grown by more than $71 billion, according to a McKinsey & Co. paper published in the fall.

The cost of necessary supporting technology and services, compliance and regulation-related expenses, personnel and insurance have all increased, and sources expect that trend will continue into 2023 and beyond.

George Mussalli, the chief investment officer and head of equity research at PanAgora Asset Management Inc., a $43 billion quantitative manager headquartered in Boston, said that even firms like his that have performed well and have good scale are subject to rising costs.

Data vendor prices increases are "relentless," he said.

With little pricing power, or the ability to cut significant costs without materially impacting their business, asset managers will struggle more than others on Wall Street as long as the current market conditions continue.

"Belt-tightening does not get rid of $71 billion in costs," Ju-Hon Kwek, senior partner at McKinsey & Co., said in an interview in October.

Asset managers are generally segmented into three groups: huge firms that have achieved scale by managing hundreds of billions or trillions of dollars; small boutiques focused on a niche with as little as $1 billion or less; and all the other managers in between. All the managers in between tend to have thinner margins and are facing a fork in the road, especially in a down market, said Sean McKee, the national practice leader of public investment management at KPMG LLP.

"The middle is the part that struggles," Mr. McKee said. "What they are trying to figure out is, 'how do I get to the $1 trillion club, or how do I [become] the niche player?'"

In addition to pressure on fees and rising costs, managers without good performance are going to face another growing challenge in 2023: fewer places to sell products.

Intermediaries, or financial advisers, an important distribution channel for many asset managers, are relying more on in-house and third-party outsourced chief investment offices to build portfolios and using fewer funds as a result, according to Dan Kemp, global chief investment officer of Morningstar Investment Management.

"There's fewer opportunities for some of these squeezed asset managers," said Mr. Kemp, who is based in London. "I see that continuing."

As a result of these headwinds, managers and consultants said there will likely be more mergers and acquisitions this year, although higher interest rates and cost of capital mean it's unlikely that mega deals will be struck. Rather, top-line revenue and margin erosion, as well as organic growth challenges, will encourage smaller asset managers to re-evaluate their strategic plans and consider becoming a buyer or a seller, according to the Moody's report.

But top-line revenue and margin erosion, as well as organic growth challenges, will encourage smaller asset managers to re-evaluate their strategic plans and consider becoming a buyer or a seller, according to the Moody's report. The firm expects deals involving smaller midsize companies to "flourish against the backdrop of intensifying competition and lower valuations."

"The case for M&A for these midsize players, in or around $500 billion (assets under management), is very strong," said Neil Pardasani, a managing director and senior partner at Boston Consulting Group, a management consultant based in Boston.

For much of 2022, uncertainty about markets slowed deal activity across industries, including asset management. But consolidation in asset management was happening before last year and it will continue into the future, said Justin Burchett, a managing director in the complex securities and financial instruments practice at Stout, an investment bank and advisory firm headquartered in Chicago with more than a dozen offices and clients in more than 80 countries.

But managers and analysts question mergers and acquisitions purely for the sake of growth and scale.

"Scale is important but not a panacea; industry lessons learned indicate that adding scale for its own sake is often not a successful strategy. Asset managers will continue to eye opportunities to add AUM, but they will be more selective in doing so," Moody's said in its report.

Money managers will more likely pursue deals to "accelerate reorientation of their business models" and target firms and opportunities that stand to benefit from growth trends, such as wealth management, ESG and alternatives, according to Moody's.

The firm also anticipates that asset managers will keep divesting from subscale businesses. That could be any funds or strategies without scale at firms, for example, a bond manager with a few small equity funds.

It's not all doom and gloom for managers this year. Those running ETFs, private market funds and sustainable investments are expected to attract the biggest inflows in 2023, sources said.

Martin Sanders, the head of pension investments at AXA Investment Managers who is based in Hague, Netherlands, said he thinks the world's transition to renewable energy from fossil fuels is the beginning of a new sort of industrial revolution. Investors are supporting that in spirit and increasingly with their portfolios, he said.

Global impact investment funds surpassed a total of $1 trillion in assets for the first time in 2022 and the momentum will continue this year, Mr. Sanders said.

However, impact investing still has maturing to do, said Christopher James, the founder and chief investment officer of Engine No. 1, the investment manager seeking to work with companies on energy transition and that elected three directors to Exxon Mobil Corp.'s board in 2021.

A fund that charges high fees for only excluding carbon producers, rather than investing to support decarbonization, "makes no sense," Mr. James said. And disagreements over terminology, coupled with inadequate rating systems, have misguided investors, he argues. There has been a "failure of imagination" by fund managers and investors who are missing out on investment opportunities, Mr. James said. This year, he hopes there is progress toward determining what is impactful and not — in dollar terms.

"These are big questions that everyone in the investment industry is going to have to focus on," he said.