Predictions of Pain Ahead for Advisers and Managers

The beloved American author and playwright Arthur Miller was known for a keen insight into tragedy and human frailty—so it should send a clear message that McKinsey and Company’s most recent asset management industry analysis opens with a Miller quote: “An era can be said to end when its basic illusions are exhausted.”

According to the report, “Thriving in the New Abnormal: North American Asset Management,” the U.S. asset management industry is on the brink of a once-in-a-generation shift in competitive dynamics. The paper’s authors—Pooneh Baghai, Onur Erzan, Ju-Hon Kwek and Nancy Szmolyan—suggest this is due mainly to five converging trends that may be unprecedented in their combined impact.

“All asset management firms will face challenges in the new environment—including those that have been consistent leaders over the past several years,” the report warns.

The first trend is simply the fact that we are “at the end of 30 years of exceptional investment returns.” According to the authors, any expectation that these returns would continue indefinitely was simply misinformed.

“Research from McKinsey Global Institute indicates that the global market returns of the past three decades have been an historical anomaly and that the macro trends fueling these returns are all fading to some degree,” the report suggests. “The result will be a decline in average returns for equities of 150 to 400 basis points and of 300 to 500 basis points for fixed-income assets. This decline has implications that extend well beyond the asset management industry, but for the industry the impact will be unambiguous.”

Perhaps most troubling, the McKinsey researchers predict asset management firms “will begin to feel the loss of the cushion of beta-driven revenue growth that buoyant markets have been providing for decades, particularly following the financial crisis.”

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According to the report, the second major shift impacting the asset management industry will be a shake-up in preferences related to active management. McKinsey expects that “a large pool of benchmark-hugging active assets,” up to $8 trillion, will be up for grabs over the next several years as clients re-examine their core investment beliefs and manager relationships.

“This money in motion will be a battleground over the next decade where low-cost passive managers, high-conviction fundamental managers and innovative alpha generators will compete intensively for share,” the report predicts. “As average market returns from passive products begin to decline, McKinsey expects a surge of innovation from leading active managers … These managers will restructure their platforms for greater efficiency, develop new levers for value creation, and move beyond security selection to grow new capabilities in risk budgeting, sector selection and asset allocation and embed these as differentiators in their products.”

Tied directly to these first two trends, the report suggests a third theme over the next decade or longer will be continued momentum for alternative investments. McKinsey expects that these flows will be redirected heavily toward illiquid private markets, “as investors seek alpha in less efficient segments of the market,” the authors explain. “Several years of underperformance in the hedge fund sector will add momentum to this shift. Real assets, such as infrastructure, represent an especially large growth opportunity.”

As these themes play out, there will also be a dramatic increase in the use of digital advising technology and straight-through processing.

“This is the fourth trend reshaping asset management,” the report explains. “We are witnessing the beginning of a true digital revolution that incorporates advances in data and analytics to expand beyond a narrow focus on disintermediation in retail distribution to become a driving force for radical improvements across the entire asset management value chain, including portfolio management, capital markets activities, and the back and middle office … Digital tools and advanced analytics have the potential to generate vast improvements in the effectiveness and efficiency of operating models.”

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Undoubtedly, asset managers will use digital tools to increase engagement with clients and achieve significant productivity gains, the report suggests. In areas such as product innovation, digital capabilities will help firms develop a differentiated edge in portfolio management, as well as “radical and sustainable improvements in back- and middle-office processes with meaningful cost savings.”

Describing the fifth trend that will dominate asset manager decisionmaking in the coming decade, the research report concludes the industry is entering an “era of heightened regulation.”

The report points specifically to the Department of Labor (DOL) fiduciary rule as a perfect representation of this final trend—especially how regulations targeted at one particular niche of advisers or managers seldom prove to have an impact limited to just that narrow domain.

“While [the DOL rulemaking] applies more directly to wealth managers, the rule will accelerate several current trends in asset management, including the demand for passive strategies and ETFs, the shift from brokerage to advisory programs, the growth of digital advice, and a culling of asset management partners by wealth managers,” the report concludes. “Additional waves of regulation are expected: the potential extension of DOL-like rules to retail assets beyond those focused on retirement, as well as regulations governing liquidity management, stress-testing and the allocation of client expenses.”

The authors conclude the rise of regulation will “only add to the already high legal and compliance costs the industry is currently shouldering, but will also serve as a disruptive force to well-established segments of the market … especially channels with a high share of proprietary products.”

The full report, including rich collection of charts and figures contextualizing these five trends, is available for download here.