Greg BrightThe funds management industry is in trouble. Of that there is little doubt. Head count among the major managers has been cut by at least 10 per cent, according to a Watson Wyatt report last month. Among hedge fund managers, the head count is down an average 20 per cent. And the worst is yet to come, from the funds managers’ business perspective.

The Watson Wyatt report says that funds managers started the year with a revenue ‘run rate’ down at least 30 per cent on the start of last year and they were looking to cut total costs by 20 per cent. Hedge fund managers are faring even worse.

For many, this year is about survival. For super funds, the economic health of their service providers is important. It’s supposed to be a long-term investment portfolio, so the sustainability of the businesses which manage that portfolio is important. When businesses go into decline their customers invariably suffer too.

Watson Wyatt believes that the possible ill health of many active managers is cause enough for funds to revisit their view of the passive versus active split. Passive versus active is already the biggest decision facing super funds at the moment, without factoring in manager risk.

AustralianSuper has created enormous interest in the market with its decision to sack 20-or-so active managers and index half of its Australian equities portfolio. Both sides of the argument are credible. If the broad markets have fallen 40 per cent or more, then the law of mean reversion says that they should rebound by a significant amount in the medium term.

So, if broad markets are going to come back at least 20 per cent or more, why should an investor spend any effort trying to eke out an extra 1-2 per cent of alpha at high fees? But, according to most observers and certainly most active managers, we are currently in the best environment in living memory for stock picking.

Investment banks’ proprietary trading desks have exited the market, leaving hedge funds with a new range of opportunities, provided they can get the credit for leverage. And a whole new range of distressed debt and equity funds have sprun up to take advantage of the troubles many companies are finding themselves in.

According to Watson Wyatt research paper, the ad valorem fee basis upon which the industry is centred means that profits will remain under pressure as long as market returns and new inflows remain low and while there is little appetite for raised fees.

It concludes that investment managers will continue to reduce headcount by around 10 percent (mainly in non-core roles) and costs (mainly in variable pay) by around 20 percent in order to return to profitability.

Hugh Dougherty, head of manager research at Watson Wyatt, says: “This is clearly a difficult business environment for active managers and ‘people’ issues are likely to be superseded by ‘business’ issues as the principal concern of management, and chief among these will be consolidation, regulation and sustainability.”

According to the research, pressure on profits can be countered by adding new assets to the existing cost base, which will result in increased consolidation in the short-term. However, while the merging of entities can make business sense, paying too high a price in a falling market could also damage rather than enhance their sustainability.

Dougherty says: “We have already seen several mergers, acquisitions, and firm closures over recent months, and we are expecting this trend to continue. The nameplates of existing investment managers will change substantially during the next few years.

While in the past there has generally been a bias against change in ownership, we need to consider that some of these changes could be materially positive for the survival of a firm.” Watson Wyatt is also predicting, along with many other observers, that government regulation of the funds management industry is likely to increase substantially, although banking will clearly be the most effected due to the bail-outs which have occurred in the US and Europe.

Tim Unger, head of investment strategy at Watson Wyatt in Australia says: “While we believe this prediction remains on track, the relatively clean hands of the funds management industry should mean an escape from additional regulation, but there is a chance that it gets caught by regulation aimed at banks, including a requirement to hold more capital.

This would be a further blow to the industry as higher compliance and operating costs would further damage margins and challenge their sustainability.”

According to the new research, entitled ‘The Future of the Asset Management Industry’, there is little that institutional investors can do about consolidation in and regulation of the asset management industry, but among the actions they can take to prepare themselves for changes to its sustainability is to revisit whether the current extent of active management remains appropriate for their fund.

Other actions are to continue to diversify the manager line-up, renegotiate fees and terms, focus on sustainability issues and think through scenarios where certain eventualities could compromise the future performance of their managers.

Dougherty says: “We do believe that pursuing active returns is a worthwhile activity provided that the resources exist to have a competitive advantage in identifying, hiring and terminating active managers. Equally, we believe in the virtues of passive management and continue to advise that this is an appropriate route for those funds which are unable to bring a competitive advantage to the manager selection process.

That said, we are very mindful of the fact that passive management firms are not immune from many of the business issues facing active managers.”

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