Rising Interest Rate Environment a Mixed Bag for Asset Managers
Rising rates will help asset managers that run money market funds, but will likely prove a headwind to firms focused on fixed-income, writes Morningstar’s Gregg Warren.
For traditional asset managers, a rising interest rate environment is a mixed bag. For firms that offer money market funds to investors, rising interest rates would be a positive. For much of the past eight years, fund companies offering government agency and treasury funds have had to waive fees because historically low interest rates have left yields after expenses in negative territory. The general consensus is that once the fed funds rate gets up to 100 basis points, it would eliminate the need for most fee waivers. However, we're not entirely convinced that money market fee rates will return to the levels seen before the 2008-09 financial crisis, when cash management funds were generating fees of 27 basis points; we believe we'll probably see rates closer to 20 basis points, if not lower, as institutional clients push back on fee rate increases.
For asset managers as a group, a rising interest rate environment is a net negative for firms running fixed-income strategies. Those managers will have to deal with the potential impact of market losses on bond portfolios (as interest rates rise) and outflows (as investors respond to bond fund losses). That said, we expect market losses to be more of a problem than outflows--especially for the more institutional-focused managers like BlackRock (BLK) and Legg Mason (LM) (with most institutional investors having already reallocated their exposure to the asset class to accommodate a rising interest rate environment). Firms with heavier retail exposure are likely to see the combined impact of market losses and outflows, but with most of these companies having less than 25% of their total assets under management dedicated to the asset class, the impact is lessened somewhat.
BlackRock remains our top pick in the group. The firm generates most of its fixed-income AUM from institutional clients and also has the counterweight of a growing fixed-income exchange-traded fund market to offset any market losses in the portfolio.
As we noted above, rising interest rates would be a positive for the traditional asset managers in our coverage that offer money market funds to investors. Fee waivers on money market funds are on pace to reduce revenue and operating income at Federated Investors, which has the largest exposure to the asset class in our coverage universe, by $400 million and $125 million, respectively, during 2015 (which works out to around $0.78 per share). While the general consensus is that once the fed funds rate gets up to 100 basis points it would eliminate the need for most fee waivers, we're not entirely convinced that money market fee rates will return to historical levels.
Federated's (FII) management team basically confirmed this more recently, noting that it's only going to be able to recover about two thirds of this lost fee waiver-related pretax income when money fund yields increase to the point of eliminating the need for these waivers. There's also little to be gained by investors looking to cash in on the rising interest rate move, as we've been convinced that Federated's shares have traded more on the prospect of a rising interest rate environment the past few years than the underlying fundamentals of the business.
For the group as a whole, a rising interest rate environment is a net negative for companies running fixed-income strategies. Firms will have to deal with the potential impact of market losses on bond portfolios and outflows. In our coverage, the firms with the most exposure to the fixed-income market are Legg Mason (54% of total AUM), AllianceBernstein (AB) (54%), Franklin Resources (BEN) (38%), and BlackRock (32%).
But that's not to say that they will be the most affected, as both Legg Mason and BlackRock generate most of their fixed-income AUM from institutional clients. BlackRock also has the counterweight of a growing fixed-income ETF market to offset any losses in the portfolio. While AB is a bit more retail-focused, the preponderance of its portfolio is in credit products with low duration.
For Franklin Resources, the biggest part of its fixed-income portfolio, the global/international platform run primarily by Michael Hasenstab (and accounting for 22% of total AUM), is already negatively correlated with U.S. interest rates. Where we have concerns is in its U.S. taxable (7%) and tax-free (9%) platforms, where retail investors suffering through market losses in a rising interest rate environment are more apt to head out the door.
The same could be said for the fixed-income portfolios at Invesco (IVZ) (25% of total AUM), Janus Capital Group (JNS) (22%), Waddell & Reed (WDR) (19%), Eaton Vance (EV) (17%), and Federated (15%), which are all more exposed to the retail side of the market with their offerings. Janus in particular is dealing with bad fund performance from bond guru Bill Gross, as well as the loss of Gibson Smith (who helped build their fixed-income platform from the ground up). While T. Rowe Price (TROW) has about a fifth of its assets tied up in fixed-income products, its focus on retirement-based assets tends to insulate it from the outflows that would come in a rising interest rate environment.
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Greggory Warren does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.