We’ve updated our economic moat and trend ratings for a handful of U.S.-based asset managers: Invesco (IVZ), Affiliated Managers Group (AMG), Franklin Resources (BEN), Eaton Vance (EV), and Waddell & Reed Financial (WDR). This resulted in several downgrades, one upgrade, and a handful of changes in our fair value estimates. As we look at the industry today, we see a confluence of a few issues--poor relative active investment performance, the growth and acceptance of low-cost index-based products, and the expanding power of the retail-advised channel--that have made it increasingly difficult for asset managers that run predominantly active portfolios to generate organic growth, leaving them more dependent on market gains to drive managed asset levels higher. While we continue to believe that there will be room for active management, we expect the advantage will go to asset managers with greater scale, established brands, solid long-term performance, and reasonable fees.
Although most of the asset managers we cover have the size and scale to be competitive, we’ve taken a much deeper look at the switching costs and intangible assets we view as sources of economic moats for the industry. With Invesco, we maintained our narrow moat rating but took the trend rating (which is being influenced more by industry events) to negative and lowered our fair value estimate to $35 per share. We lowered our moat and trend ratings for Franklin Resources and Eaton Vance to narrow and negative and reduced our fair value estimates to $37 for Franklin and $55 for Eaton Vance. With Waddell & Reed, we changed our narrow moat rating to none with a negative trend and reduced our fair value estimate to $20. We actually lifted AMG’s moat rating to narrow, albeit with a negative trend, and lowered our fair value estimate to $200. In almost all cases, the reduction in fair value estimates reflects our assumption of a larger equity market decline (20%) than we were projecting previously (10%) midway through our five-year forecast.
We’ve been working toward a system that would allow us to put more quantitative rankings on many of the different organizational attributes (such as product mix, distribution channel concentration, and geographic reach) and intangible assets (such as strong and respected brands and manager reputations that are derived from successful and sustainable records of investment performance) that we believe can provide asset managers with a degree of differentiation from their peers.
In our view, the asset-management business is conducive to the creation of economic moats, with switching costs and intangible assets being the most durable sources of competitive advantage for companies operating in the industry. Although the switching costs might not be explicitly large, inertia and the uncertainty of achieving better results by moving from one asset manager to another tend to keep many investors invested with the same funds for extended periods. As a result, money that flows into asset-management companies tends to stay there--borne out in the U.S. by an average annual redemption (retention) rate for long-term mutual funds of around 30% (70%) during the past 5-, 10-, 15-, 20-, 25-, and 30-year time frames.
While the barriers to entry are not significant for the industry, the barriers to success are extremely high, as it takes time and skill to put together a long enough record of investment performance to start gathering assets and build the scale necessary to be competitive. This has meant that the larger, more established asset managers in the industry have tended to have an advantage over smaller players, especially when it comes to gaining cost-effective access to distribution platforms. Competition for investor inflows can be stiff and has traditionally centered on investment performance, especially in the retail channel. Although institutional investors and retail gatekeepers are exerting pressure on pricing, competition based on price has been rare, aside from what we’ve seen in the U.S. market for exchange-traded funds. While compensation remains the single-largest expense for most asset managers, supplier power has been manageable as many companies have reduced their reliance on star managers and have tied manager and analyst pay to portfolio and overall company performance.
Asset stickiness (the degree to which assets remain with a manager over time) tends to be a differentiator between wide- and narrow-moat companies, as those asset managers that have demonstrated an ability to gather and retain investor assets during different market cycles have tended to produce more-stable levels of profitability, with returns exceeding their cost of capital for longer periods. While the more broadly diversified asset managers are structurally set up to hold on to assets regardless of market conditions, it has been companies with solid product sets across asset classes (built on repeatable investment processes), charging reasonable fees, and with singular corporate cultures dedicated to a common purpose that have done a better job of gathering and retaining assets. Companies offering niche products with significantly higher switching costs--such as retirement accounts, funds with lockup periods, and tax-managed strategies--have tended to hold on to assets longer.
When assessing the strengths and weaknesses of the U.S.-based asset managers we cover, we believe it is important to look deeper into the ability of an asset manager to differentiate itself from the competition with lower-cost offerings and repeatable investment strategies, as well as a willingness (and an ability) to prudently adapt to a changing competitive landscape. Being able to not only identify but rank many of the more qualitative aspects that differentiate the asset managers that we cover should, in our view, allow us to better assess the economic moats and moat trends for these companies--especially in light of the secular trends (like the growth of passive investments and a retail channel disruption) that we expect to continue to affect the industry longer term.
Greggory Warren, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.