Profit margins in the asset management sector could suffer a hit of five to 10 percentage points over the next to to three years as regulatory headwinds blow harder, according to research by Morgan Stanley and Oliver Wyman.
In a blue paper report on wholesale banks and asset managers, entitled Learning to live with less liquidity and published on March 13, the two institutions said asset managers were starting to come under sustained pressure from multiple headwinds for the first time since the crisis.
They wrote: “We estimate that a greater focus on risk management will be a 5% drag on economic profit over the next two to three years. This net drag could double as a result of pressure on margins, particularly for traditional active managers.”
The worst-case five-to-10 percentage point profit margin drop would be triggered in a bear case scenario involving greater market dislocation, outflows and a more onerous regulatory response.
The report stressed earnings could be preserved if assets under management were increased by between 5% and 8% a year. But gains of this scale cannot be guaranteed across the board: “Pressure is likely to be most acute on mid-sized traditional firms as many drivers favour scale players and alternative firms.”
Morgan Stanley’s base case is that profit margins will fall by between 50 and 100 basis points – far less than the bear case. Over the past year, it stressed, with the exception of emerging markets: “Mutual fund outflows have been below the historical stress cases, and less than feared.”
While large asset managers have escaped being tagged systemically important in the same way as the banks, the way they interact with capital markets will come under greater regulatory scrutiny. The ability of asset managers to deal with a run on their funds will be an important focus, according to the authors. “Managers are already moving towards categorisation of assets according to their liquidity, prompted in part by regulatory pressures.”
Morgan Stanley sees the shutting of a high-yield credit funds managed by Third Avenue as an outlier, rather than a trend-setter. But there have been heavy outflows at a small clutch of other funds, including some that invest in emerging markets. A surge in redemptions could increase the pressure, raising questions of “whether investors were fully aware of the liquidity or implied valuation risks of the products”.
According to the report, this will lead to increased scrutiny of how managers handle heavy outflows and interact with counterparties.
Morgan Stanley and Oliver Wyman said managers would face other cost and organisational pressures from regulators, not least from the growing attention on conduct issues, which they believe the asset management industry is underestimating.
European regulators are wanting to see evidence of “value for money” from products, partly stemming from action being taken against products charging an active fee which hug the index too closely. Morgan Stanley and Oliver Wyman warned that 70% of managers have failed to provide proof they are delivering value for money. UK managers are currently dealing with a review of their activities by the Financial Conduct Authority.
“The growing focus on conduct raises the possibility of litigation and fines. This is likely to heighten scrutiny on the resilience of the asset manager as well as individual funds.” At present, there is a marked difference in the capital adequacy demonstrated by managers, with the best capitalised boasting three times more capital than the least.
Managers have responded to the lack of liquidity in the credit markets by trading less often. The report noted that holding periods for high-yield assets had increased by nine months over the last five years.
Managers have managed to make use of their traditional dealing networks, but the report warned they need to manage risk better, potentially by accessing buyside-to-buyside models. Stress-testing by regulators will lead to better risk modelling and product structures.
The report said: “Asset managers have traditionally been viewed as lightly regulated with not very capital-intensive business models. As such the industry has generated returns on equity greater than 15%… Across traditional managers this view could change.”