Small and medium-sized asset managers find it more difficult than ever to gain profit as rising costs outpace revenue growth, states a recent report. As such, market players are stepping up efforts at cost reduction through measures such as outsourcing and mergers and acquisitions.

The shift in investment strategy and changing investor demand amid geopolitical and economic uncertainties have put harsher constraints on asset managers. More than half of the surveyed respondents are experiencing accelerating fee compression and widening gap between cost and revenue, according to the report, Rebooting the Global Asset Management Industry, prepared by Citi and CREATE-Research.

While the cost burden is intensifying as a result of technology advancements, regulatory compliance, and evolving demand for market insights, revenue is shrinking amid price reductions as asset managers compete with mega players, with low-cost passive funds swamping the market.

More than 60% of surveyed asset managers recognize the threat of hyperscale players, who encompass “a broad product base, privileged access to distribution channels and global reach” to woo investors away from smaller players. The one-stop-shop feature has overshadowed small and medium-sized specialists who, on the other hand, bank on higher fees for market-beating returns.

Product wise, mega players zero in on much-sought-after passive investment products, characterized by low cost, simplicity and broad exposure to the market. Such offerings stand out in an era of diversification. As well, sustainability-themed investment continues to drive this market, leaving the active managers less appealing.

“As active managers continue to face headwinds from the rise of passive funds, the old fund charges based on fees as a fixed proportion of assets under management will likely continue to be replaced by a low base fee and a performance fee based on the preset hurdle rate,” the report states.

“The rise of passive investing has reshaped the key points of competition. It has forced active asset managers to have razor-sharp focus on their core competency and outsource routine processes that can be readily scaled up by service providers.”

Outsourcing sharpens focus

As a result, smaller players adopt outsourcing as part of efforts to manage operating costs. In particular, back-office outsourcing allows them to centralize resources to alpha generation and research-related activities. Eventually, asset managers can regain favour from specialized investors with a rosier return.

“Outsourcing has served to sharpen the focus on alpha generation within a leaner and fitter operating model, so as to not only survive the big squeeze, but also prepare for the big wealth transfer.” 

At this stage, back-end activities, including custody, settlement and administration, are outsourced by a majority of surveyed respondents, and some front-office activities such as FX management and trade execution are picking up.

M&A activities are expected to increase as players seek to reduce costs, with close to two-thirds of respondents agreeing that this kind of activity can promote vertical integration in the industry.

Industry consolidation can facilitate penetration into high-margin asset classes by widening the range of capabilities, while scalability can lead to more competitive pricing and attract partners.

“At one end will be mega players with hyperscale production and distribution focusing on low-cost passive funds and active funds with acceptable levels of returns. At the other end will be specialist managers carving out a niche around their core strengths, using a deep talent pool and cutting-edge technology to deliver alpha, lower costs and scalable client experience,” says the report.