This article is part of a series joining the dots between market trends and assessing key themes emerging this year for the investment management and asset servicing industries. My previous article discussed implications of this year’s continuing themes of inflation volatility, liquidity concerns and deglobalisation, with particular focus on their implications for asset allocators.

Here I share ideas on trends particularly disrupting asset managers, and in particular how the combination of asset volatility, fee pressures and declining revenues should cause them to assess whether their current operating models remain fit for purpose.

As a result, we expect many firms to adopt ‘capital lite’ operating models in coming years that could offer not only reductions in fixed cost, but improved margin dynamics, resiliency, and agility and could potentially support a resurgence for active management.

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This article is part of Gary’s ‘Outside-In Thinking’ series of articles on how the asset servicing industry can design solutions and technology that brings clients closer to achieving their objectives. Read more about Gary and see further articles here. You can also view the article and comment here on LinkedIn.

Northern Trust’s role as an asset servicer to asset owners and asset managers provides us with a global view of the trends impacting the investment industry. As I've mentioned previously, part of my job is to view our business from the ‘outside-in’ through our clients’ eyes – I meet with them, work to understand the challenges they’re trying to solve and collaborate with colleagues and partners within our orchestrated ecosystem to help them achieve that.

Volatility and market performance

And looking at the challenges facing asset managers, we’re working through one of the toughest environments in living memory. As inflation and rising interest rates continue to drive costs up, the squeeze on pricing has continued.

Many managers have lowered fees to remain competitive in the face of multiple pressures: investor demands for lower prices, ongoing competition from lower-cost products and the need to lower fees to attract investors in new markets. At the same time, persistent market volatility is limiting performance growth and the launch of new fund products. Market performance has been responsible for 90% of the industry’s revenue growth for nearly two decades according to Boston Consulting Group,¹ begging the question of whether established industry models are fit for extended periods of shrinking AUM.

In our Q2 survey of long-only asset management with Coalition Greenwich, participants named “achieving better performance” as the top challenge they face, albeit they’re not planning significant changes to address those concerns². Our research indicates that in response to current challenges, managers are ready to double down on existing strategies: 47% of our participants said that to achieve alpha, they will implement a more disciplined investment process while 41% will focus on high-conviction ideas. Implemented in isolation, these actions may not be sufficient to meet the scale of the challenges ahead.

The need for scale economics…

Of course fee compression doesn’t hit equally across the industry: boutique or mid-tier managers are often impacted most, lacking economies of scale compared to larger counterparts. Note research by Investment Metrics showing that within equity investing between 2018 and 2021, median fees for large asset managers with AUM in excess of £100bn declined 5%, whereas smaller managers with assets under £5billion saw a 10% decline³.

And PwC report that latterly the biggest downward push on fees is coming from competition within the industry itself rather than demands by investors, as “large managers are able to exert a combination of scale and investment in the latest technologies to undercut competitors”. Also note that larger asset managers are moving to implement tiered pricing with investor discounts rising in line with fund size. This will increase competitive pressures and further drive firms’ need for scale.

…in the face of broken industry economics

Recent market studies indicate the pressures will only continue in the short and medium-term. PwC estimates last year’s fall in global AuM represents the greatest decline in a decade⁴. Estimated operating profits for 2023 are on course to be down on last year – down to 11.9 basis points across firms' average AuM from 13.1bp in 2022, according to McKinsey⁵.

The net effect of this combination of pressures is that the industry economics that have long underpinned asset management – that an increase in assets leads to an increase in margins – are broken. And the fall-out could be huge: again according to PwC, one in six asset management firms will disappear over the next four years in a wave of industry consolidation. This is driving us towards an industry crunch-point sooner rather than later.

Costs are rising and fixed

It’s unlikely these pressures will abate – not least because asset owners are consolidating faster than the market that serves them – so fee and margin pressure is likely to remain, save a radical overhaul of costs. Of course, managers know this and are looking to become leaner and cut costs where they can. But spending is actually rising significantly, driven by the complexity of increasing regulatory requirements and the costs of entering new markets or asset classes.

Technology expenditure – to be able to meet increasing investor expectations around technology and reporting – is also significant as managers know they must invest in disruptive technology or see competitors leave them behind. The survey by McKinsey⁶ mentioned above finds that firms’ spending on technology and operations has increased to more than one-quarter of their total costs. Inevitably again, smaller, or mid-tier managers are adversely affected, forced to allocate a larger proportion of revenue to this than larger counterparts.

And by costs, it’s not so much the level that’s the issue so much as the nature of them being fixed. Few managers I speak to are prepared to go through another 20% draw down in markets without some ability to manipulate their cost base.

A solution: Infrastructure as a Service

I’ve mentioned how positive operating leverage is scarce across the industry. This was foreshadowed in 2017 when despite strong AUM growth the industry did not deliver corresponding operating profits⁷. But today these pressures are more extreme and widespread.

Northern Trust has been anticipating today’s market conditions and discussing solutions for this inflection point. In 2020 we wrote that: “The drivers of change are global and go far beyond margin pressure. They include aspects of competition, the ability to leverage economics of scale, business resilience, changing economic models, variable costs, demographics, technology, and regulation – drivers no longer hidden under the veil of strong markets⁸.”

The lack of positive operating leverage for many asset managers – that their profits now barely increase even in rising markets – means that without significant changes to their operating structure margins will collapse. We think meeting these challenges will mean moving from a fixed to variable cost base – becoming capital-light by renting fixed-cost infrastructure from scale service providers and having activities delivered back ‘as-a-service’ on a variable cost.

In other words: operational Infrastructure as a Service – a flexible and comprehensive form of outsourcing that I believe will become a default model for many managers across our industry within the next five years.

Lessons from the tech sector

And if all that’s starting to sound a little like the technology sector, trust your instincts – it’s the perfect metaphor. A fund manager’s ‘product’ comprises their investment selection and decision-making. That’s their IP – their ‘software’ if you like – and so looking at how software companies are set up is instructive for our industry.

Successful software companies have significant focus on maximizing the value of their IP – that is, the clever systems and people who are fundamental to their business (including management and control). They then outsource the capital-intensive, lower-value aspects of their operations to scale providers. Such that what Microsoft is currently to IT, I expect asset servicers will become to asset managers.

Outsourcing in asset management: a brief history

Investment firms began to first outsource in the 1980s, when they shifted their custody operations to independent providers. Asset servicers such as Northern Trust have been evolving their services and skill sets ever since. Then, at the turn of the century, there was a ‘second wave’ of outsourcing. Managers now began outsourcing their middle office functions, not just to save costs, but to meet challenges of posed by the increasing range and complexity of investable assets and meet demands for greater transparency and monitoring, and access to more automation and scale.

The period around the turn of our current decade marked the ‘third wave’ of outsourcing, with managers outsourcing up the ‘value-chain’ – including outsourcing functions such as their trading desks, foreign exchange, or transition management capabilities – and in some cases, moving towards full outsourcing of all front-office capabilities.

Next up: a final wave of outsourcing

We wrote in 2020 that we were observing a growing number of clients wanting to outsource not just back, middle, and front office functions , but all post-investment decisions to a single vendor who can do “everything, everywhere” from trade execution and settlement through to record-keeping and reporting.⁹

We’re entering a fourth – and I believe final – wave, as this model of outsourcing begins to be taken-up at scale across our industry and evolves into ‘Infrastructure as a Service’. It will be integral to the fundamental business transformation that we will see across our industry in the coming years. And as we’ve seen in the IT and software industries, it will incorporate almost any function that asset managers do not consider to be ‘core’ to their businesses, and the provision of these services by hyper-scale asset servicing providers.

It’s not just about cost

As mentioned, moving a firm's fixed-cost infrastructure onto a variable cost model through outsourcing means they have the ability to manipulate the cost base when faced with excess volatility. This brings ‘margin resiliency’ – particularly important in volatile macro environments like the one we have today.

But it’s not just about cost. In conversations with clients and industry contacts, I feel the narrative around outsourcing is changing. It’s about creating a new operating model that's more future-fit and more resilient than ever before. It means providing a platform on which managers can run their businesses regardless of their size. With the freedom to invest to help improve performance, service clients, grow assets and gather flows.

Transforming how organisations invest

This model of outsourcing will help equip managers with the new technology and real-time data they need to advance their strategies. We predicted in 2020 that: “Because the industry is constantly evolving, as the Third Wave becomes increasingly prevalent, asset managers will begin to position themselves for the Fourth Wave. We believe the Fourth Wave will focus on alpha – not the decision-making process itself, but on tools to improve and measure that process¹⁰.”

This prediction is coming true as significant technological advancements – and in particular the marriage of data with new technology – allows us to redefine what’s possible for how organizations can invest with greater efficiency and insight.

Examples abound: the API economy reduces delays in sharing data between service provider and investment manager, helping digitize investment processes and helping managers make decisions based on more timely information. Microservices will allow us to move away from monolithic “one size fits most” applications and service models and accelerate technology enhancement. And Data science is helping firms derive value from internal data – drawing on behavioral analytics to analyze past decisions and identify patterns that have in the past led to good or bad outcomes, and allowing managers to take pre-emptive action.

Bending the scale curve

Today’s market conditions mean managers only really have two routes to gain the scale economics they require: grow the numerator via consolidation – a process which is gathering pace across our industry – or decrease the denominator – move to a capital-lite model via renting fixed-cost infrastructure. In this latter way, mid-size and smaller firms are able to buy scale – once the preserve of only the largest players – potentially eroding the in-built advantages of larger peers and levelling the playing field.

And I believe the broader industry benefits too, as this model allows smaller firms to bend the scale curve and compete on alpha, not price – which should increase choice for investors and encourage competition and innovation among asset managers.

A lifeline for active management?

For example, if we are entering a depressed market in the areas where value has traditionally been found – such as a range-bound market in the US that could last for several years – active managers have an opportunity to differentiate from their passive counterparts by identifying longer-term opportunities and exercising disciplined selling (I have some ideas around this).

Freed from having to manage unnecessary fixed costs and with improved resiliency and agility, adoption of this capital-lite model could well support a renewed resurgence in active management.

For asset managers, Infrastructure Is Now a Service

So: Infrastructure is now a Service for asset managers. If you agree that margin pressure is here to stay, this reinforces the importance of optimizing efficiency and having cost-effective operating models in place. But equally important are the potential opportunities to access optimal technology, talent and capabilities that were solely the preserve of only the very largest players.

As I mentioned at the outset, as more firms go down this route, I expect it to become the default model for many: offering radical reductions in fixed cost while helping improve margin dynamics, resiliency, and agility. Helping asset managers run their businesses more efficiently, while drawing on the technology and infrastructure of scale service providers – and allowing them to focus more explicitly on their fundamental strengths of managing money and managing clients.

1 Boston Consulting Group: The Tide Has Turned: Global Asset Management 2023, May 15, 2023

2 Northern Trust and Coalition Greenwich: Asset Managers Project Future Growth Amid Challenging Environment, June 28, 2023

3 IG Prime: What is fee compression & how does it affect asset managers? November 24 2022

4 PwC: 2023 Global Asset & Wealth Management Survey, July 10, 2023

5 Ignites: Cost cutting fails to keep up with declining revenues: McKinsey, August 30, 2023

6 Ignites: Cost cutting fails to keep up with declining revenues: McKinsey, August 30, 2023

7 Christian Edelmann of Oliver Wyman: The Emerging New World of Asset Management, December 2018

8 Northern Trust: From Niche to Norm, The Accelerated Adoption of Front Office Outsourcing, 23 September 2023

9 Northern Trust: From Niche to Norm, The Accelerated Adoption of Front Office Outsourcing, 23 September 2023

10 Northern Trust: From Niche to Norm, The Accelerated Adoption of Front Office Outsourcing, 23 September 2023

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