Our Top Two Picks in the Asset Management Industry
BlackRock and Invesco are well-positioned to navigate turbulent markets.
With global stock markets up more than 50% since their bear market lows in March 2009, most of the asset managers we cover are in much better shape than they were just a year ago. Higher average assets under management, or AUM, have allowed many firms to return to revenue and profitability levels not seen since before the bear market.
That said, there remains the risk that some asset managers, especially those with a majority of their AUM in equities, could underperform this year if the markets head lower. The main reason for this is that almost all of the gains that have been seen in equity AUM over the last year have come from market appreciation as opposed to investor inflows. With most retail investors viewing stocks as being "too risky to invest in" (according to a recent survey conducted by Franklin Resources (BEN)), inflows into stock funds have been difficult to come by. That's not to say there haven't been inflows, because there have been periods where sales have been outpacing redemptions. It's just that the majority of these inflows have been concentrated with firms--like BlackRock (BLK), Invesco (IVZ), and T. Rowe Price (TROW)--that have not only had solid relative fund performance, but have done a better job of selling their fund offerings.
According to fund flow data recently released from Morningstar DirectSM, close to $15 billion flowed out of domestic stock funds during May 2010, with another $6 billion coming out of international stock funds. This was likely a knee-jerk reaction to growing concerns that the Greek credit crisis would derail the global economic recovery. With the S&P 500 index (SPX) declining close to 10% in just the last six weeks, it will be difficult for firms that are heavily reliant on the equity markets to maintain their AUM, as both market depreciation and investor redemptions impact their managed assets. As you can see from the following table, this is likely to be most problematic for Janus Capital Group (JNS), Gamco Investors (GBL), and Waddell & Reed (WDR), as each of these firms has an overwhelming majority of their AUM tied up in equity strategies.
Having struggled with outflows from INTECH over the last two years, Janus is now reporting net outflows from its core Janus funds for the first time since the bear market bottomed in March of last year. Gamco looks to be in a similar predicament, as its Gabelli family of funds had their first monthly outflows since the third quarter of last year, which is likely to translate into the firm's first quarterly period of net outflows since the first quarter of 2009. As for Waddell & Reed, the firm has been extremely successful at generating sales regardless of the market environment, due to the strong relative performance of its two largest funds, Ivy Asset Strategy (WASAX) and Ivy Global Natural Resources (IGNAX.) However, Waddell & Reed may see those inflows diminish, given that performance has fallen off this year. With these two funds accounting for one third of Waddell & Reed's total AUM, and responsible for almost all of the firm's inflows, there's always been the risk that slower sales or increased redemptions would impact AUM, revenue, and profitability.
Stickiness of Niche Asset Managers
Looking at the other equity heavy asset managers-- Affiliated Managers Group (AMG), T. Rowe Price, Franklin Resources, and Eaton Vance (EV)--we believe AMG has the greatest exposure to outflows of this group. The company's strategy of acquiring equity stakes in boutique asset management firms leaves AMG with far less control over its AUM than more traditional asset managers. The same cannot be said for T. Rowe Price, which despite having a substantial potion of its AUM tied up in equity strategies, has one of the stickiest asset bases in the industry. It has also been one of the few asset management firms to generate equity inflows over the last couple of years. Much of this has been due to the stronger relative performance of T. Rowe Price's funds, the effectiveness of its sales efforts, and the continuous flow of funds the firm receives from defined contribution plans.
Eaton Vance is another asset manager that benefits from a fairly sticky asset base. The company is a leading issuer and manager of closed-end funds, which tend to have much stickier assets than open-end funds, and has carved out a niche for itself by providing tax-managed equity and fixed-income investment strategies to retail investors. With the Bush era tax cuts set to expire at the end of 2010, and the federal government expected to increase the tax rate on capital gains and dividends, the firm has witnessed a large uptick in investor inflows this year. However, having a competitive advantage built on a niche can also be detrimental, as evidenced by the difficult time that Federated Investors (FII) has had holding onto money market AUM over the last year. While the company's almost singular focus on money market funds has allowed it to build a fairly wide moat around its cash management operations, it has also exposed the firm to the volatility of fund flows that has existed in this particular asset class over the last two years.
During the last two quarters of 2008, nearly $700 billion flowed into money market funds, as the collapse of the credit and equity markets sent investors scrambling for safety. Money started to flow back the other way midway through the second quarter of 2009, with the credit markets steadily improving, and the equity markets well on their way to achieving one of their biggest rallies in the last century. Surprisingly enough, most of the capital leaving money market funds was not chasing the strong performance of the equity markets; it was flowing into fixed-income funds at a record pace. In just the last year alone, more than $350 billion has flowed into (mainly taxable) fixed income funds, and around $25 billion has flowed into (primarily international) stock funds, while close to $850 billion has come out of money market funds.
The large disconnect between the money market outflows and the inflows into other asset classes was due to increased competition from bank deposits (which are not picked up in the data gathered by Morningstar DirectSM). With banks now offering overnight rates that are competitive with money market funds, it has been difficult for firms like Federated to hold onto investors. This trend is likely to continue until interest rate rise, but with the Federal Reserve unlikely to begin a tightening phase anytime soon, we don't expect Federated to find much relief this year. This demonstrates the importance of asset class diversification, which has traditionally allowed asset managers to hold on to AUM whenever one or more asset classes fall out of favor. While Federated does have equity and fixed-income operations, the firm does not have enough scale in either business to offset the impact that its money market operations have on its AUM, revenue, and profitability.
Importance of Diversity in AUM
While Franklin Resources may carry a bit more equity AUM than it does any other asset class, the diversity it has within its product lines, distribution channels, and geographic reach has allowed the firm to not only maintain its managed assets, but generate investor inflows as well. While the company has had the most success generating inflows into its fixed-income funds, Franklin has geared up sales efforts to capture equity inflows once investor risk appetite increases (which, based on the firm's own market research, could take awhile to come to fruition). With less than 1% of its AUM tied up in money market funds, Franklin has been free of the trouble that Federated and other asset managers with large cash management operations have had with their AUM.
The same could not be said for Legg Mason (LM), which, along with having one fifth of its managed assets tied up in money market funds, has had more trouble than most maintaining its AUM, despite being one of the more diverse asset managers in our coverage universe. Legg Mason's problems started well before the bear market began, as poor relative fund performance in its Western Asset Management division, which accounts for 70% of managed assets and is the main source of Legg Mason's fixed income AUM, started a flood of outflows from the firm. The collapse of the credit and equity markets only added to its woes, as Bill Miller's Legg Mason Value Trust (LMVTX) significantly underperformed, and exposure to structured investment vehicles in its money market operations undermined what little confidence investors had left in Legg Mason and its products. While things have improved significantly in the last year, the firm still faces a long road to recovery, and will have a difficult time recapturing investor inflows (especially from institutional clients) until it posts a big improvement in relative fund performance.
AllianceBernstein (AB) is another well-diversified manager that has struggled with outflows over much of the last two years. Much like Legg Mason, the firm has a seen significant level of outflows from its institutional client base, with the main difference being that it has been AllianceBernstein's equity offerings that have taken the hit. While the firm has been able to offset some of the equity outflows with inflows into its fixed-income operations, it hasn't been enough to offset the impact that its struggling equity operations have had on its operations. With the company starting to post much better relative fund performance in its equity strategies, and the firm actually gaining some traction with retail investors, it may just be a matter of time before AllianceBernstein sees a recovery in its institutional business, which would go a long way toward getting it back to pre-bear market levels of AUM, revenue and profitability.
Our Two Favorite Names Right Now
Aside from being two of the more diverse asset managers in our coverage, BlackRock and Invesco share several other characteristics. Both firms have done transformational deals in the last year--BlackRock, with its purchase of Barclays Global Investors (BGI), and Invesco, with its purchase of Morgan Stanley's (MS) retail fund operations (which include the Van Kampen family of funds)--that have broadened out their product offerings and made them more formidable competitors. Both have passive investment strategies--BlackRock with iShares, the largest domestic provider of exchange-traded funds (ETFs), and Invesco with PowerShares--providing them with exposure to one of the fastest growing segments in the asset management industry. Both have the scale--BlackRock with more that $3 trillion in AUM and Invesco with around $550 billion--and diversity of product offerings to give them the clout they'll need to negotiate for shelf space with the brokers, advisers, and bankers that sell the vast majority of mutual funds to retail investors. Both firms also have unique relationships with intermediaries--BlackRock though the equity stakes PNC Financial Services (PNC), Bank of America / Merrill Lynch (BAC), and Barclays PLC (BCS) hold in the firm, and Invesco, through the equity stake Morgan Stanley took in the asset manager as part of the Van Kampen deal--that should aid them in their efforts to expand their operations. With both BlackRock and Invesco trading at or about our Consider Buying price, we think investors would do well to keep both names on their radar.
We believe BlackRock has the widest moat in the asset management industry. With its purchase of BGI, the company is now the largest asset manager in the world. BlackRock's diverse product portfolio and ability to offer both active and passive investment strategies gives it a huge leg up over competitors. With a large majority of the firm's managed assets sourced from the institutional channel, it also has a much stickier set of managed assets than many of its peers. BlackRock is also more diverse geographically, with clients in over 100 countries and more than one third of its AUM coming from investors domiciled outside of the United States and Canada. Cross-selling opportunities within BlackRock's traditional base of institutional clients, which have shown a growing interest in passive investments, and efforts to expand the firm's reach into the retail channel, should drive solid near-term growth. With much more stable cash flows than many of its peers, BlackRock should be able to continuously reinvest in its business, making it all that much harder for smaller, and weaker, competitors to compensate.
Of all the acquisitions Invesco could have done, the purchase of Morgan Stanley's retail fund operations provided it with the best possible mix of products and distribution. With Invesco's strong positioning in the defined contribution and defined benefit channels, and Van Kampen having a strong presence in the broker-dealer channel, Invesco will now be able to cross-sell the best products from each fund family through the different distribution networks. While Invesco is now more exposed to retail investors and clients domiciled inside of the United States, the firm remains well-diversified across asset classes, distribution channels, and geography. More importantly, the deal gave Invesco the additional size and scale it will need to remain competitive in an industry that is being reshaped by the bear market's impact on investors, and the financial services firms that cater to them. While there is probably more integration risk involved with Invesco's acquisition, the company has the potential to grow at a faster rate longer term than BlackRock, given that its is starting off from a smaller asset base.
Disclosure: Greggory Warren does not own shares in any of the securities mentioned above.
Greggory Warren does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.