“The Asset Management Industry: A Growing Gap Between the Winners and the Also-Rans”

By: McKinsey & Company
Published: 2006

This McKinsey report echoes a theme discussed by Tim Price, the CIO of Global Strategies at UBP.  It essentially concludes that is is the best of times and worst of times for asset managers.  To back up this argument, McKinsey reports on a survey showing a widening disparity between the most profitable asset managers and the least profitable.  Their research shows that, as recently as 2005, there was a 41% difference between the gross margins of the top third and bottom third of asset managers.  The report continues:

“Moreover, an increasing proportion of asset managers are now earning margins under 20 percent as the bottom-tier performers fall further behind the rest of the pack.  Unless these players move quickly to revamp their business models, the profit gap is almost certain to expand even further.”

In such a highly scalable business, a flight to quality can swiftly separate the strong from the weak.  But is the flight to quality actually a flight to alpha?  Yes, says McKinsey:

“…the warning bells have already begun to toll for many traditional firms not willing to depart from their business-as-usual approach…both demand and pricing for a host of traditional products are now in sharp decline…as flows quickly polarize between “true” alpha and “cheap” beta.”

In fact, the consulting firm lists “rapid polarization of flows arising from alpha / beta separation” as #2 on its list of “five key pressure points” in the industry.  And while it acknowledges that pensions have been using alpha and beta as building blocks for some time (e.g. portable alpha), it expresses surprise at the speed of the shift from traditional assets to alpha and beta.  Like us, McKinsey believes it’s no coincidence that “high alpha” (e.g. hedge funds) and “cheap beta” (e.g. ETFs) have exploded in tandem:

“In 2005, higher alpha strategies captured 20 percent of overall AUM; at the other end of the spectrum, cheap beta garnered 24 percent of assets.  In both cases…this far outstripped industry averages.”

The report suggests that traditional asset managers who do not provide “higher alpha” and/or “cheap beta” products will suffer pricing pressure.  And while we often consider alpha/beta bifurcation too esoteric for retail investors, McKinsey warns that this pricing pressure is particularly evident amongst retail asset managers (from 0.59% margins in ’01 to 0.48% margins in ‘05).  Comments McKinsey:

“The implications for the asset management industry, which has enjoyed consistent annual price increases for the past two decades, are profound”

But perhaps the most troubling news for asset managers is that – unlike other sectors of the financial services industry – this pricing pressure hasn’t spurred efficiency gains.  In fact, McKinsey notes that industry-wide headcount rose in lock-step with net new assets during 2005.

Notwithstanding this report’s advocacy of alpha / beta bifurcation, it neglects to provide evidence of “true alpha” and “cheap beta”.  In fact, its survey of some of the world’s largest investors doesn’t seem to even solicit pricing data on each of these categories.  We look forward to future updates containing hard data on alpha-centric investing.

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