We are at an interesting point in the local asset management industry, with several headwinds facing asset managers. Where we have the ambition of looking for high-quality, stable investment propositions, these are generally quite hard to identify, and when we do find them, we have a permanent anxiety around their ability to sustain themselves at this high level.
The extent of organisational, process and people changes within an asset management business is higher than you would expect.
Human capital businesses, by their nature, have relatively low barriers to entry and so we find a fragmented industry, dominated by relatively few large players. There are over 80 separate, independent asset managers in South Africa. Profit margins in asset management are attractive, which attracts a lot of competition, but is there room for all of them?
Below we list a few of the headwinds we are observing across the industry, where we need to objectively evaluate the potential for these issues to impact our outlook for the funds we cover.
Headwind #1: Access to asset flows. No Money, No Honey.
The ability to build a sizeable client base has proven exceptionally difficult for smaller managers. In part, this is due to how the industry has migrated towards fewer “gatekeepers” – platforms, discretionary fund managers, multi-managers and the like, rather than establishing close relationships with the end investor. However, much of this “underachievement” rests with the managers themselves where the ability to build a good asset management business, in addition to a good investment process, is not something we have seen occur frequently.
The resourcing applied to good business management has been far outweighed by the value placed on investment-related intellectual capital. The problem is that in many cases, being a good fund manager does not easily translate into being a good business leader, and so their success in gaining market traction has been underwhelming.
A consequence of this is the migration of a number of smaller asset managers (“boutiques” in the colloquial, but essentially small asset managers) towards some form of distribution agreement or partnership whereby a business with a large footprint of fund buyers acting for the client creates a linked deal with individual asset managers looking for assets to manage. We count around 80% of the independent fund managers we cover having a form of “inhouse” distribution to get access to assets to manage. Relying simply on investors to “buy” funds seems to be a thing of the past.
By design, managers who need access to this asset pool also have less leverage in a fee negotiation, so they can potentially give up their “crown jewel” mandates at relatively low fees, creating longer-term business longevity questions.
Secondly, where smaller managers have partnered with fund distributors, they are often allocated mandates where they are not necessarily ready in terms of their capacity to manage the assets. A balanced fund for example requires the full suite of expertise: local and offshore equity, fixed income and asset allocation, and this requires a substantial investment over a long period of time to establish.
Ultimately the asset managers are becoming dependent on fund distributors, and this leads to headwind # 2: fees.
Headwind #2: Fee pressure. The Big Squeeze.
While assets have increasingly moved from large scale, low-cost institutional pools towards retail products, we have not seen a commensurate reduction in fees to reflect this. The average investor is still paying a premium for investment management despite the cost efficiencies of running larger unit trust funds. Why is this so? Common sense should tell us that many competitors should drive down high investment fees, not preserve them. We do see signs of this changing:
- A few of the smaller fund managers are reducing costs to try to entice new clients.
- “Premium” larger managers who have captured the lion’s share of the market have had mixed performance, undermining the premium fees they charge. Investors are questioning whether this premium is worth paying.
- With clients increasingly organised in collective groups, negotiating power is starting to shift from the fund manager to the investor. This trend is consistent with what we see in
the UK market, and has resulted in large-scale fee reductions to investors.
Fee pressure creates an additional business model problem, where small managers generally have a higher hurdle to make ends meet (small assets at lower fees), and large managers typically have high legacy cost bases to fund (large assets, declining fees). Offshore there has been a strong pattern of large managers merging to deal with the lower fees expected in future.
Headwind #3: Emigration risk. All My Bags are Packed.
Emigration is nothing new, but it comes at a time now when we do see vulnerability, especially in the larger managers. Looking back, today’s established winners made their gains building strong investment propositions in a market where life company asset managers held the majority of assets.
Rolling forward to today, these businesses have reached high levels of market share, managers have benefitted as a result, and so they can start to look outside of our borders given the success they have had. South African-specific risks also undermine the long-term stability of any management team. We have seen a few departures already and expect to see more soon. This does have the potential to hollow out investment teams, which do not ordinarily run with deep levels of cover.
Headwind #4: Offshore competition. David vs Goliath.
With similar trends offshore (fee pressure, distribution pressure) we have seen global managers increasingly come into South Africa to fill the demand for offshore assets from investors. In many cases there are high-quality fund managers coming into South Africa, at significantly lower fees. Not only does this lower the fee potential for existing local managers (headwind #2), it also reduces their potential market share (headwind #1).
Headwind #5: The value cycle. How Low can you Go?
Value managers gained prominence in South Africa in the post-dot-com era when overpriced new-economy share prices imploded, allowing the old-economy value managers to outperform. Asset flows chased performance and many investment products oriented toward a value style. Post the Global Financial Crisis (GFC) we have seen a difficult environment for value managers, where for the most part, expensive shares have stayed expensive, and cheap value shares have stayed cheap. This long-term underperformance has had several casualties where businesses have either closed doors, lost significant flows or needed to change their investment approach to survive.
With this value bias being prevalent in many investment processes, structural industry underperformance has been commonplace, and has led investors to question their fund managers, and move to alternatives including low-cost passive funds.
What can we expect?
We believe the trends highlighted above are relatively entrenched, bar headwind #5 where conditions today are very much in favour of the value-based approach. However, the trends of increasingly difficult access to assets, pressure on fees, new offshore competitors and disruption of investment teams through emigration are here to stay.
We expect to see consolidation or attrition among investment businesses. The industry simply has too many fund managers for what has been a relatively slow-growing pool of assets. Going forward, we are keeping a keen eye on these issues and the potential implications for the funds we cover. We hope to see the strong businesses emerge so that we have the luxury of choice in future.
 Source: RMI Boutique Asset Management Study, 2016