This is a tough time to be managing money. Bonds and equities are both expensive, and persistent policies of financial repression more or less force managers into lending to governments at rates they would never freely accept. With returns under pressure, the prices they charge for asset management are coming under ever greater scrutiny.
A survey of more than 300 global insurers for State Street, for example, finds that 59 per cent are planning to improve the cost-effectiveness of their investment strategies over the next year – meaning reducing the number of managers and reducing fees paid – while 49 per cent will add to their experiments with alternative managers, such as hedge funds.
None of this is good news for large asset managers, but it is not surprising. Customers have shown great wariness and scepticism since the financial crisis, making life particularly hard for the active managers offering equity funds, who traditionally dominate profits in the sector – but who have very great difficulty beating their benchmark indices. All asset managers have found it extremely difficult to navigate the strange investment environment since the crisis.
Remuneration is also under threat. With lower returns expected in future, the belief is growing that asset managers pay themselves too much, and must start shifting rewards away from portfolio managers and towards their clients. This week, a move in the European parliament to impose a cap on fund managers’ bonuses, like the one already imposed on bankers, was only narrowly foiled.
Asset managers do, however, have one big consolation. Their share prices are on an epic tear. This is true for every branch of the industry. So far this year, the insurance sector leads all others within the US S&P 500, with asset management specialists predominating. Genworth Financial has gained 58 per cent this year, while big managers such as Prudential Financial, MetLife and Principal all have gains of 30 per cent or more.
In Europe, where the FTSE Eurofirst 300 has gained only 4 per cent for the year, companies such as the UK’s Prudential (not related to its US namesake) and Legal & General have gained 24 per cent or more.
Specialist US managers have also fared well, gaining 21.7 per cent for the year, against 14.5 per cent for the S&P 500. Over the past 12 months, they have beaten the market by almost 18 percentage points. While their shares remain below their pre-crisis highs, specialist asset managers have far outperformed banks, and are now valued at 1.6 times book value.
Why? First, asset managers’ fortunes are intimately linked to equity markets. Stock markets are prospering and this feeds into rising assets under management.
Further, investors in the US have recovered some of their animal spirits and put money back into funds – until the exodus from bond funds in the past month, inflows for the first half of the year were set to be their strongest since the crisis. Even after bond funds’ bad June, inflows were still the best in three years.
Favouring the biggest quoted asset managers, the industry is taking on what Amin Rajan of Create Consulting calls “winner takes all” characteristics. Pension funds would rather minimise risk to their careers, and raise their chance of agreeing a discount, by signing up one big well-known manager for many mandates, than spread money around smaller companies.
But the most important driver may concern asset managers’ capital structure. They generate a lot of cash and, compared with other financial companies, who have increasingly onerous regulatory requirements, they have relative freedom over how to use it. In a report, Robert Lee of Keefe, Bruyette & Woods points out that 11 traditional US fund managers either raised or paid out a special dividend last year, and that dividend payout ratios remain on the low side at 41 per cent.
Mr Lee also points out that asset managers’ share purchases in recent years have not made much dent in the number of shares outstanding – implying that this has largely been an exercise in limiting the impact of the issue of new shares for executives. So if asset managers are prepared to pay themselves less, they have even greater potential to pay dividends.
This implies that asset managers’ stocks might continue to outperform, even as the portfolios they manage for clients fail to do so, if the dynamics of the market stay favourable. The events of the past weeks suggest that the hunt for yield, which has led many to buy dividend-paying stocks as “bond substitutes” may be coming to an end, particularly in the US. If so, the other pressures on asset managers suggest that they are not a great buy.
But bond yields remain low by historic standards. If asset managers use their capital structure to give investors the cash they want, and maybe pay themselves less, their rally could yet continue.