Last year, Morningstar’s sector strategist Greggory Warren noted that only two of the U.S.-based asset managers--BlackRock and T. Rowe Price--have wide economic moats, as they not only have the ability to differentiate themselves from the competition with low-cost fund offerings and repeatable investment strategies but have demonstrated a willingness and an ability to prudently adapt to the changing competitive environment.
I found it very interesting that the willingness and ability to prudently adapt to the changing environment was considered to be part of the moat.
He went on to state that no-moat firms will struggle to consistently earn excess returns, as limitations in their product mix, fee structures, and/or abilities to adapt to a changing competitive environment impact their competitive positioning.
Prateek Agrawal, business head and chief investment officer at ASK Investment Managers Pvt. Ltd., believes that fund management stocks offer long periods of sustained organic growth. The growth rate for AMC businesses is much higher because assets grow on the back of fresh inflows, as well as the underlying and existing corpus based on returns of the debt and equity asset class. When considering fresh inflows, he also advises to keep in mind the extreme under-penetration of equity funds.
To understand this business from a stock investing perspective, I share insights from the research notes of Greggory Warren.
Moats in the asset management space.
The asset-management business is conducive to economic moats, with switching costs and intangible assets being the most durable sources of competitive advantage.
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 of time. As a result, money that flows into asset-management firms tends to stay there.
Traditional asset managers can improve on the switching cost advantage inherent in their business models with organizational attributes (such as product mix, distribution channel concentration, and geographic reach) and intangible assets (such as strong and respected brands and manager reputations derived from successful, sustainable track records of investment performance). This can provide them with a degree of differentiation from their peers.
Asset stickiness (the degree to which assets remain with a manager over time) tends to be a differentiator between wide- and narrow-moat firms, 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 of time.
While the more broadly diversified asset managers are structurally set up to hold on to assets regardless of market conditions, it has been firms 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. Firms 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.
The barriers to entry are not all that significant for the industry, the barriers to success are extremely high, as it not only takes time and skill to put together a long enough record of investment performance to start gathering assets but even more time to build the scale necessary to remain competitive in the industry. This has generally provided the larger, more established asset managers with an advantage over the smaller players in the industry.
What gives BlackRock a leg up over its peers?
With $6.467 trillion in total assets under management at the end of March 2020, BlackRock is the largest asset manager in the world.
Solid organic growth.
Poor relative active investment performance, and the growth and acceptance of low-cost index-based products, has made it increasingly difficult for active asset managers to generate organic growth.
Unlike many of its competitors, the firm is currently generating solid organic growth with its operations, with its iShares platform, which is the leading domestic and global provider of ETFs, riding a secular trend toward passively managed products that began more than two decades ago.
Commitment to risk management, product innovation, and advice-driven solutions.
Having been principally focused on institutional investors for much of its existence, BlackRock has had to be concerned not only with investment performance, but also with the risks taken to generate those results, as most of its institutional clients come to the table with required levels of performance and volatility in their investment mandates. As a result, the company has developed tools to assess both security- and portfolio-level risks, which it not only uses internally but also offers to external clients for a fee. This has also enhanced the firm's ability to roll out new products and to combine existing products to create outcome-based investment offerings.
BlackRock's (and, hence, CEO Larry Fink's) insistence on one common culture, focused on one common vision, operating on one common platform.
A major reason BlackRock has had success with acquisitions (Merrill Lynch Investment Management and Barclays Global Investors) where so many have failed is that Fink has insisted on one culture for the firm--commonly referred to as One BlackRock.
Although it is easy to dismiss culture as something that cannot be measured, over the long run asset managers with a single corporate culture dedicated to a common purpose (which is ultimately reflected in the consistency of their investment performance, their rate of organic growth, the focus and importance that is placed on risk management, and the amount of employee turnover they experience) tend to perform better than companies that are operating with less cohesive and/or inconsistent organizations.
A confluence of several issues
The growth and acceptance of low-cost index-based products has resulted in an environment where active fund managers are under assault for poor relative performance and high fees. While there will always be room for active management, the advantage when it comes to getting placement on platforms will likely go to those asset managers that have greater scale, established brands, solid long-term performance, and reasonable fees.
The biggest differentiators for the firm are:
- Size and Scale of its operations
- Strength of its brands
- Reasonable fees
- Organic growth
- Ability to offer both passive and active products
- Greater focus on institutional investors
- Product mix that is fairly diverse
- Distribution channel
- Geographic reach
In the Indian context
The mutual funds industry can be viewed as a growth sector with high Return on Equity (RoE). Once the fund house breaks even, there is scale and operating leverage as fixed costs do not rise in the same proportion as the assets under management.
In India, we have just two listed AMC stocks – HDFC Asset Management and Nippon Life India Asset Management. Hopefully in the future, that list will increase.
