On the verge of disruption

 
 
About the author

Michael Spellacy is a Senior Managing Director at Accenture and the company’s Global Capital Markets Practice Lead. He has over 25 years of expertise at the highest levels of Asset & Wealth Management and Capital Markets. As an executive, investor, and advisor he offers critical insight and proven results to Boards and C-Suite executives. Michael was previously a senior executive at Bridgewater, and a Senior Partner at both BCG and PwC. Michael has been recognized as a member of the Global 100 Irish Business Leaders and has published and been cited in leading news sources, journals and periodicals.

 

It’s when an industry is seemingly at its peak that disruption happens. Such is the position of the capital markets industry today. Industry-wide revenue leapt to over USD1 trillion last year, bringing with it more than USD100 billion in economic profit according to Accenture’s latest industry analysis; its Capital Markets Vision 2022.¹ This article looks at specific disruptive trends and suggests how asset managers should position for the future.

Asset managers, a key segment in capital markets, have benefitted particularly from the long bull market. Assets under management grew by 12% in 2017 – however, most of this growth was due to rising asset prices and only some 3.5% could be attributed to net inflows. And as recent equity market volatility is already showing us, disruption is coming.

Specifically, our global analysis of the capital markets industry indicates the industry is about to experience an accelerating decoupling of the link between assets under management and revenue. This is the foundational relationship of the buy-side ecosystem, from private wealth managers and hedge funds to pension funds and large mutual fund operations. Since the buy-side generates approximately 90% of the economic profit in capital markets according to this analysis, any disruption in this segment will force fundamental shifts across the industry. The impact will also be felt by infrastructure entities, such as exchanges and clearing houses, investment banks and brokerages of all sizes.
 

Signs of coming disruption

The signs are already apparent. Over the past ten years, asset managers have mostly seen rising assets under management due to market movements, but revenues have not increased at a corresponding rate. Hence, what is described as fee compression in the industry has resulted in declining revenues relative to assets under management. This compression has been partially sparked by investors flooding into passively managed, index-based instruments and strategies from actively managed funds.

Active management has long been the cornerstone of the asset management industry. From 1988 through 2006, roughly USD1 trillion flowed into active equity strategies. Since 2007, about the same amount has flowed out of active and into passive, according to Alliance Bernstein. It’s no secret that ETFs and passive strategies in general command far fewer management fees compared to money managers who pursue alpha.

Individual investors have led the shift. They became enamored with low-cost strategies that simply sought to match market performance. Then the pension funds, endowments, sovereign wealth funds and other large-scale investors started following their example. They’re now weaving passive strategies into their portfolios, too. So really, the passive revolution is far from over but spreading across the investment management industry.
 

Changing profit dynamics

By 2022, we expect worldwide assets under management will balloon to more than USD100 trillion. Yet, revenue growth will be slower than past rates, and long-standing metrics of performance, such as revenue per investment professional, will continue to drop. This means that the basic dynamic of capturing economies of scale in revenue and profits by adding assets under management, the strategy which financial services executives have long pursued, is no longer valid.

In fact, our analysis finds that while, structurally, the buy-side industry segment should be a scale game, in practice it is not. Generally speaking, most asset managers – both large and small – are keeping as economic profit anywhere from 10% to 20% of revenue, with “plain vanilla” retail fund companies occupying more of the low end of that scale and hedge funds the top end.
 

 

Every bull market comes to an end, and once the current one does, asset managers can no longer depend on the market to paper over the misaligned cost and strategic structures that have developed. Even if the bulls regain their legs here and extend their run for an unprecedented few years more, the industry will still suffer the effects of the fee dynamic. Under the most optimistic scenario, Accenture’s Capital Markets 2022 analysis projects buy-side revenues rising by more than 10% through 2022. However, under a squeeze scenario, buy-side revenues could fall below the 2017 level of collective industry cost and taxes. We believe that all buy-side players should prepare for such a squeeze scenario in which assets under management will likely grow but margins will continue to shrink; the question is more by how much and how quickly.

This situation will probably create several victims, as those firms that have survived thanks to the exceptional environment of quantitative easing and low interest rates see the lucrative inefficiencies they feasted on disappear. Yet as a corollary, the situation will also create unique opportunities for forward-thinking and agile companies.

We believe that all buy-side players should prepare for such a squeeze scenario in which assets under management will likely grow but margins will continue to shrink; … This situation will likely create several victims, … Yet as a corollary, this will create unique opportunities for forward-thinking and agile companies. Michael Spellacy, Senior Managing Director, Accenture Global Capital Markets Practice Lead
 

 

Three trends to prepare for

We see three dominant trends that will define the future.

1. New economics.

This is the continued shift to passive investment at the expense of active management. Beyond traditional active managers seeing passive siphon away funds, we will also see a shift in the mix of what remains active. We expect more funds being invested in “alternative” investments such as private equity, real estate and more aggressive alpha strategies like hedge funds. A final piece of this shift will be the further emergence of niche management firms, where sector- and strategy-focused firms are able to capture high levels of profit margin. The days of being all things to all people are over.

2. Digital disruption.

The asset management industry’s digital capabilities tend to fall far short of digital-first businesses. Correcting this is key. In the years to come, management firms that are able to unlock value from digital will upend the industry. By doing so, they will also extend the disruption to their “sell-side” counterparts and the central price discovery mechanism.

3. Business model evolution.

Tomorrow’s asset manager will need to behave very differently. Their business models must evolve to adapt to the digital age and changing consumer sentiment. Firms need to ensure that their operation model will make them both agile and able to efficiently execute a flexible approach to change.
 

Legacy system owners will face digital disruption

For a variety of reasons, from acquisitions of competitors to an ad-hoc approach to meeting new regulatory and business technological requirements, the financial services industry has allowed itself to become encumbered with typically custom-built technology systems. This has put the industry overall in the odd position of having spent many billions of dollars on bespoke technology only to be locked into siloed legacy systems. To execute in a low-fee, low-profit context, a rethinking of technology is imperative. Artificial intelligence (AI), for one, could bring firms more powerful alpha extraction. AI could also be a powerful multiplier of innovation. Longer term, we believe there is the potential for AI in general to boost industry growth rates up to 80% through 2035 according to our research.

Digitization will democratize products by lowering the cost-to-serve, allowing more sophisticated strategies to be used by a wider set of investors. As these strategies are put into place, it will feed into a beneficial feedback loop where new services and products could be introduced to market faster and with less operational risk to the firm offering them. Asset managers can begin combining a series of recent advances, including the cloud, distributed ledgers, big data and analytics, and artificial intelligence to concurrently cut costs and improve customer servicing. Especially, AI will dominate the front office where consumers will expect intelligent and automated services that will be smart, adaptive and customizable to their needs.
 

Position to make disruption your strategic advantage

All of these portend a need to rethink the asset-management business model. The industry must become sleeker. Throughout financial services, there seems to be a resistance to a digital-first approach, enabled by the large revenue and profit flows. However, only half of the costs in asset management are actually spent on the core value proposition of creating, packaging and selling investment products. The rest is swept up by the so-called ‘back office’ functions of internal servicing demands and external interactions with other Wall Street players.

In capital markets as a whole, more than USD100 billion is spent annually on simply getting all parties involved in a single agreement on basics like trades and holdings. That is one example where technology could smash the old cost structure to pieces. Distributed ledger technology could recover vast amounts of that USD100 billion by making clearance and settlement operations unnecessary. Accenture’s analysis finds that there is potential costs savings of up to 70% on central reporting and up to 50% savings on centralized operations.

Executives right now need to start formulating their strategic response to the disruption of the AUM-profit dynamic and how to shift toward technological opportunities. Is there a way to focus on brilliant basics and cutting new ground? How can you reset the value-to-cost ratio while doing so? From a customer-facing perspective, how will asset managers become anticipative and discover new sources of value? The industry – and each firm within it – needs to start articulating a vision of the implications of this new environment and how that will be realized successfully through new platforms, philosophies and ecosystem-driven services.

 

1. https://www.accenture.com/us-en/insights/capital-markets/capital-markets-vision-2022