American Banker

Note to Smaller Asset Managers: Diversity Is Eating Your Profits

Many asset management firms are pursuing the wrong business strategy. Why? Strategies that make for successful investments differ fundamentally from those needed for business success.

Par Paul Wilson and Paul Rosenberg

First published on décembre 12, 2003
min


Many asset management firms are pursuing the wrong business strategy. Why? Strategies that make for successful investments differ fundamentally from those needed for business success. Leaders of asset management firms succeed as asset managers largely by diversifying their holdings to optimize risk-adjusted returns. But as business managers they often fail to focus their firms in ways that maximize performance. Rather than diversify the asset classes and geographies they cover, small and midsize firms should learn from successful corporate managers and focus on a few areas where they can excel. Then they should build scale and competence in those areas. Our company recently looked at 12 U.S. firms with total assets under management of between $25 billion and $200 billion. Our research shows that profitability tends to deteriorate as the number of asset classes offered increases and the assets under management per class decreases. In 1996, Waddell & Reed, a niche firm in Boston, maintained a 49% operating margin while offering products in four asset classes. After it diversified to seven asset classes, its operating margin dropped to 21% in 2002, while some of its most focused competitors were able to achieve margin growth. What's driving this tendency to diversify? Traditionally, asset management firms reward managers who generate the highest returns from their portfolios. And asset managers know from their training that the best way to achieve high risk-adjusted returns is to diversify and manage risk while creating alpha. So believing they're minimizing risk, executives of asset management firms often accept and even promote asset-class and product diversity. We have seen firms launch funds in order to placate or reward top asset managers, and we have watched firms invest in new products and areas that stand little chance of turning a profit. (Even when executives aren't explicitly aiming to diversify a firm's activities, they may decide to offer a new product or asset class simply to retain a top-performing portfolio manager.) This desire for diversification has led to poor financial performance among small and midsize asset managers, often despite above-average investment performance. Returning to Waddell & Reed, though 79% of its funds achieved a Morningstar five-year ranking of 4 or 5, the lack of scale in these funds has continued to drive margins down. Profitability lies in focusing on what you're good at. Firms with more assets per class, such as Invesco and Federated, with over $15 billion per class, have higher margins. Smaller companies trying to manage a wide range of classes, with assets per class of $4 billion to $8 billion, tend to have margins closer to 20% and may be spreading themselves too thin. In deciding on product strategy it is useful to compare the attractiveness of the product market with the company's capabilities in it. Consider these cases: Attractive market, limited capabilities. Consider investing to strengthen those capabilities and to gain market share and scale. Attractive market, strong capabilities. Invest to maintain and enhance those capabilities, and perhaps exploit adjacencies to these "star" products. Unattractive market, limited expertise. Obviously, resources can be better used elsewhere. Unattractive market, strong expertise. It may indeed make sense to offer such funds, but only if a profitable niche strategy can be identified. Mr. Wilson is a partner in London in the global financial institutions practice of the Bain & Co. consulting firm. Mr. Rosenberg is a partner in Boston, where Jacob Homiller, who also contributed to this essay, is a Bain manager.

Many asset management firms are pursuing the wrong business strategy. Why? Strategies that make for successful investments differ fundamentally from those needed for business success.

Leaders of asset management firms succeed as asset managers largely by diversifying their holdings to optimize risk-adjusted returns. But as business managers they often fail to focus their firms in ways that maximize performance.

Rather than diversify the asset classes and geographies they cover, small and midsize firms should learn from successful corporate managers and focus on a few areas where they can excel. Then they should build scale and competence in those areas.

Our company recently looked at 12 U.S. firms with total assets under management of between $25 billion and $200 billion. Our research shows that profitability tends to deteriorate as the number of asset classes offered increases and the assets under management per class decreases.

In 1996, Waddell & Reed, a niche firm in Boston, maintained a 49% operating margin while offering products in four asset classes. After it diversified to seven asset classes, its operating margin dropped to 21% in 2002, while some of its most focused competitors were able to achieve margin growth.

What's driving this tendency to diversify?

Traditionally, asset management firms reward managers who generate the highest returns from their portfolios. And asset managers know from their training that the best way to achieve high risk-adjusted returns is to diversify and manage risk while creating alpha.

So believing they're minimizing risk, executives of asset management firms often accept and even promote asset-class and product diversity. We have seen firms launch funds in order to placate or reward top asset managers, and we have watched firms invest in new products and areas that stand little chance of turning a profit. (Even when executives aren't explicitly aiming to diversify a firm's activities, they may decide to offer a new product or asset class simply to retain a top-performing portfolio manager.)

This desire for diversification has led to poor financial performance among small and midsize asset managers, often despite above-average investment performance. Returning to Waddell & Reed, though 79% of its funds achieved a Morningstar five-year ranking of 4 or 5, the lack of scale in these funds has continued to drive margins down.

Profitability lies in focusing on what you're good at. Firms with more assets per class, such as Invesco and Federated, with over $15 billion per class, have higher margins. Smaller companies trying to manage a wide range of classes, with assets per class of $4 billion to $8 billion, tend to have margins closer to 20% and may be spreading themselves too thin.

In deciding on product strategy it is useful to compare the attractiveness of the product market with the company's capabilities in it. Consider these cases:

Attractive market, limited capabilities. Consider investing to strengthen those capabilities and to gain market share and scale.

Attractive market, strong capabilities. Invest to maintain and enhance those capabilities, and perhaps exploit adjacencies to these "star" products.

Unattractive market, limited expertise. Obviously, resources can be better used elsewhere.

Unattractive market, strong expertise. It may indeed make sense to offer such funds, but only if a profitable niche strategy can be identified.

Mr. Wilson is a partner in London in the global financial institutions practice of the Bain & Co. consulting firm. Mr. Rosenberg is a partner in Boston, where Jacob Homiller, who also contributed to this essay, is a Bain manager.