Chapter 1
The asset management industry faces a key inflection point
The polycrisis of 2022 is pushing firms to take bold steps.
The investment outlook is growing far more dynamic
When the world changes, so do markets. Asset owners and asset managers face a highly unpredictable investment outlook. Higher interest rates have already transformed financial markets, and their effects will be felt throughout 2023. Recent comments by leaders of major central banks suggest a high likelihood of further monetary tightening. Periods of squeezed liquidity and disorganized repricing are also likely to recur as investors rebalance their portfolios.
Short-term swings in inflation, interest rates and asset prices are not the only drivers of disruption. Accelerating drivers of long-term change mean that the exit from current volatility will take us into an altered world, creating new threats — and exciting opportunities. The investment markets of the future will be very different from those of the past. Some of the underlying forces reshaping the investment outlook include:
- Deglobalization and nationalism: The pandemic, together with growing geopolitical rivalry, has reversed the substantial progress made over the last 20 years toward economic integration. The links created by globalization will evolve and endure, but a desire for greater strategic autonomy and national resilience will also slow cross-border flows and inflate the price of labor, commodities and goods.
- Demographics and healthcare: The global population is aging; those aged 60 and older will increase from 1 billion in 2020 to 1.4 billion in 2030, and 2.1 billion in 2050.4 In many markets, higher life expectancy is putting strain on retirement provisions and making public healthcare unaffordable. Countries like China face a demographic deficit, but India and young countries in Africa are among those expecting a demographic dividend.
- Gender rebalancing: Demographic shifts, economic and social changes and family planning are accelerating female financial empowerment. By 2030, studies suggest that 55% of the world’s wealth will be owned by women.5
- Urbanization and migration:By 2050, it is projected that 68% of the world’s population will live in urban areas.6 Internal migration from the countryside and cross-border economic migration will have a major impact on future infrastructure requirements and personal financial needs.
- Sustainability and climate: Demand for sustainability is growing; 54% of consumers will use environmental, social and governance (ESG) data for decision-making by 2027. Despite scepticism in some markets — including political pushback in US states like Texas and West Virginia — and short-term challenges caused by 2022’s surge in energy prices, the overall trend is clear. Climate change is the main driver, but other goals like biodiversity are gaining importance.
- Innovation and technology: The next few years will see rapid changes such as: artificial intelligence (AI) and other tools leveraging a tidal wave of data (more was created in the last two years than in all of history); new investment themes such as nuclear fusion and green hydrogen; and growing potential for quantum computing or the metaverse and Web 3.0 to revolutionize our lives.
Asset managers are under acute financial pressure
The disruption of 2022 had a stark effect on asset managers’ financial performance. Falling markets and net outflows caused assets under management (AUM) to fall steeply, driving down revenues. At the same time, inflation pushed up expenses. In addition, asset managers continued to invest and upgrade their capabilities in areas like private markets, ESG integration and digital transformation. The inevitable effect was to put average profit margins under significant pressure. Between Q4 2021 and Q3 2022 the world’s 40 largest asset managers experienced, on aggregate, a 14.9% fall in AUM, a revenue decline of 22.9%, versus a fall of 12-percentage-points in operating margins.
The new year is unlikely to reverse these pressures. The investment assumptions of recent years have been overturned and, even if current economic headwinds are partially reversed, altered market conditions will have profound effects on asset management:
- Recent events are leading investors to demand a challenging combination of outcomes including reversing capital losses; stabilizing and protecting assets; generating income; and accelerating drawdowns.
- Asset managers need to review their investment strategies in the light of new economic realities. How are leverage-driven strategies affected by a rise in risk-free rates from near-zero to approximately 4%? With corporate debt yielding annualized returns of 5%to 10%, what is the rationale for investing in illiquid alternatives?
- Instability will create active management opportunities, and interest in alternative investments will continue to grow. At the same time, retail and institutional clients will increase their demands for lower fees and greater tailoring. Expectations for investor education and guidance, and demands for sustainability data, will accelerate too.
In short, investor expectations will become increasingly demanding, complex and costly. That, together with slower AUM growth and increasing competition for business, will put firms’ financial performance under exceptional pressure.
EY modelling shows that the outlook for industry profitability is firmly to the downside. Our approach assumes growing asset allocations to passives and institutional alternatives, decelerating fee compression, annual fixed cost growth of 3% and fixed expense ratios. At the time of writing:
- Our base scenario, which assumes total AUM growth of 20% over the period from January 2023 to December 2027 (a five-year cumulative average growth rate of 3.7%), predicts a fall in aggregate profit margins of 4.1 percentage points by 2027.
- In a more pessimistic scenario of 10% AUM growth over five years, the model predicts a 7.9 percentage point fall in average profit margins over the same period.
- All else being equal, AUM would need to grow 32.7% by 2027 (equivalent to a five-year CAGR of 5.8%) just to maintain average industry margins.
Since the largest asset managers tend to attract the bulk of asset inflows, the majority of asset managers are likely to experience steeper margin decline than these figures suggest.
Strategic decisions on savings and growth are required
Faced with an increasingly challenging operating environment, transformation is now a necessity for many asset managers — both to strengthen performance, and to enhance differentiation. How can leaders respond?
For most firms, major cost reductions are the overriding priority. This requires much more than a generalized push for firmwide efficiency. The majority will need to make structural changes to achieve the necessary level of savings. Organizations that lack scale or a clear source of differentiation will come under particularly acute pressure to make cuts.
Many asset managers will choose to combine a structural approach to cost management with a wider process of strategic renewal. Firms should revisit their business models and contemplate fundamental changes, such as exiting subscale markets, combining retail and institutional capabilities, or monetizing support functions like technology or risk management.
EY research shows that business leaders around the world identify investment in key growth areas as a strategic priority. Our global CEO-based survey, CEO Outlook Pulse, shows that 63% of financial services’ CEOs expect to make significant investment in digitization and technology, and 60% plan to invest in innovation and R&D. Optimizing products or services, improving scalability and integrating sustainability across the business are among CEOs’ leading goals.
Chapter 2
2023 needs to be a year of change
Wealth and asset managers can take a range of actions to improve performance and find opportunity within disruption.
EY research shows six key areas that are consistently important for asset managers seeking to enhance their current performance and differentiate themselves in an uncertain future. For each of these areas, we’ve highlighted specific actions that could be particularly helpful in the exceptional circumstances that firms currently face.
1. Reorientate around clients
Asset managers are finding new ways to deliver client-centric experiences to all their investors. Counterintuitively, removing internal silos and simplifying systems is often key to providing more specialized offerings. Possible areas of focus include:
- Democratizing retail investment: Making a wider range of alternative investments available to semi-professional and approved retail investors is a growing priority. Regulators are taking more flexible approaches to suitability, too. Private market platforms providing secondary liquidity and trading windows within longer investment periods will continue to see strong growth. Direct indexing has the potential to give more retail investors the kind of portfolio tailoring previously available only to institutions or the very wealthy. Collaborating with others in the investment ecosystem will be key to accelerating the delivery of democratization at scale.
- “Consumerizing” institutional investing: Large asset owners increasingly expect the sort of flexibility, convenience and digital interactions typically offered to retail clients. The use of retail techniques, such as constructing client personas for pension trustees or investment consultants, will accelerate. Some asset managers are creating new client experience roles focused on institutional investors for the first time.
- Improving generational focus: Aging populations and growing life expectancy are increasing the need for healthcare and retirement funding. Older generations not only need to accumulate more long-term savings, but to drawdown those savings over longer periods. The need for effective intergenerational transfer to Generations X and Y is growing, too. Those cohorts are highly aware of the links between financial, physical and mental health. Asset managers could play a key role in boosting wellness by helping them to save for retirement — while also finding new ways to elevate investment education and financial inclusion.
2. Digitize distribution
With digitization playing an increasingly dominant role in distribution, technology will not merely enable investor interactions. It will become central to delivering tailored, value-added experiences including education and support. Emerging themes include:
- Accelerating investor education: Finding new ways to digitally educate end investors and financial advisors will be key to delivering best in class experiences and outcomes. This could include the use of gaming to improve investor understanding and financial literacy. Education is closely linked to enhanced tailoring, especially as more investment strategies become available and as firms reach more first-time investors.
- Aligning investments with purpose: A deeper understanding of investors’ views and preferences, together with investor education about the full implications of investment decisions, will help firms to integrate ESG into their operations and ensure that investors can express their views through their financial choices.
- Improving hybrid models: Metaverse-based applications could allow firms to replace physical distribution hubs with virtual centers for financial advice. Virtual portals could be used to create new hybrid distribution models for retail and institutional clients that not only blend digital and human interactions, but which also harness new, virtual ways to engage with individual advisors.
- Preparing for tech-enabled ecosystems: The coming years will see the growth of complex investment ecosystems, with connected webs of asset managers, banks and technology firms collaborating in real time to deliver seamless experiences to clients. Asset managers need to ensure they have the digital distribution capabilities to play a range of active roles in multiple scenarios. At different times, this might include acting as an ecosystem orchestrator, or providing specialized offerings via an ecosystem. The importance of flexibility means that the ability to take a modular approach to partnering will be vital.
3. Reimagine investment propositions
The rapid advance of innovation, urbanization, sustainability and other megatrends will force asset managers to continually reimagine how they conduct their core investment management activities.
- Harnessing the AI revolution: The industry’s current use of AI will soon be eclipsed by a step change in availability and capability. Where machine learning enabled AI to follow rules better, deep learning will generate new rules based on the analysis of a wide range of data. This, combined with an explosion in available data that includes carbon emissions, satellite images and the “digital exhaust” created by internet use, will help firms to apply quantitative analysis to intractable problems.
- Steering the transition: Asset managers will play a growing role in facilitating action on climate change and other environmental issues. To truly effect change, this means swapping exclusion for engagement, working more closely with investee companies to encourage change, and also helping investors to understand how to fit their investment choices into national and industry-specific decarbonization strategies. The rise of engagement will make it all the more essential for firms to carefully scrutinize the clarity of their offerings in the light of growing regulatory sensitivity to greenwashing.
- Leveraging new investment themes: Seizing the investment potential of new technologies – and even new industries — will become increasingly important as the global pace of innovation and disruption accelerates. Possible areas of focus could include nuclear fusion, green hydrogen or quantum computing.
4. Maximize growth areas
Alternative investments, such as private markets and digital assets — including tokenized real-world assets — will enjoy growing demand from investors. Long-term economic drivers such as demographics and urbanization will also unlock new growth opportunities in several areas:
- Private markets: Over 85% of companies with revenues above US$100m are now privately held. This will drive further growth in demand for private assets, and an increasing effort by asset managers to tap into that growth — and its potential for higher margins. Acquisitions of private market specialists by large asset managers are likely to continue, and the growing use of key private market platforms by multiple firms is likely to create new industry ecosystems and interdependencies
- Digital assets: Investor interest in cryptocurrencies, non-fungible tokens and other digital assets is growing — albeit from a low base. The collapse of FTX and limited investor protection from regulators mean that digital assets are not the most urgent priority for many firms, although 86% of financial institutions are investing in digital asset type activities.7 The ability of distributed ledger technology to enable fractional investing and the tokenization of real assets makes this a potentially significant area of long-term growth.
- Infrastructure: A fast-changing world requires vast capital investments in decarbonization (such as clean energy generation, power networks and battery storage), urbanization (transport networks, education, housing, and sanitation) and other types of infrastructure. Asset managers can play a growing role in connecting the users and providers of capital, making it easier for retail and institutional investors to fund real assets — including via public-private partnerships aimed at upgrading national infrastructures.
- High-growth markets: Asian markets will generate the strongest potential growth over the coming decade. India’s young population provides huge untapped potential, and despite political risks China is still a key target for leading asset managers, with some international firms recently receiving approval for wholly-owned local subsidiaries.8 In the longer term, African countries with attractive demographic profiles could represent a huge opportunity for asset managers able to take advantage.
5. Transform business models
Asset managers need to achieve a step change in operating efficiency, as well as maximizing their growth prospects and maintaining long-term strategic flexibility.
- Strategic cost transformation: Significant cost reductions are vital to protecting profitability and enabling large-scale investments in areas of long-term growth. The use of outsourcing and managed services, driven by not only cost savings but addressing the impact of accelerated digitalization and expanding compliance needs, is likely to increase during 2023 and beyond in areas such as cyber, finance operations and risk/compliance. These decisions will help firms to focus their capital on strategic priorities and growth.
- Transforming operating models: Asset managers will increasingly integrate cost management efforts into wider processes of business transformation. Migrating to the cloud will deliver operational savings and make it easier for firms to harness external tools such as AI. This, together with making data a core element of operating models, will help firms to maximize their innovation capabilities.
- Enabling innovation: In addition to data and technology, firms can take a range of actions to optimize their innovative capabilities — a crucial response to growing disruption. Key steps include creating the right incentives, removing barriers to change, empowering teams to try new approaches, delegating responsibility, making quick decisions and providing appropriate oversight. The ability to pivot in mid-journey, for example by identifying alternative use cases for new ideas, is also important.
6. Leveraging external opportunities
In the past, approaches to external growth were often dominated by a focus on M&A. Deal-making will remain an important response to margin pressure, but the industry will increasingly view flexible tech-enabled collaboration as the leading source of external opportunities.
- Using M&A effectively: Dealmaking will continue as firms seek to build scale and drive inorganic growth, aided by banks and insurers offloading captive asset managers. However, large-scale M&A will be a less important strategic tool than in the past. Instead, firms will focus on delivering planned synergies from past deals and on using tactical investments to strengthen their capabilities in key areas such as ESG or private markets.
- Improving collaborative skills: The ability to forge productive relationships with rivals, financial institutions, technology firms and public bodies will become increasingly vital. Connections will accelerate creativity and enable many of the other business model transformations that asset managers are hoping to achieve.
- Getting “future flexible”: In the long term, flexibility and modularity will be crucial to asset managers’ ability to play a key role in complex, fluid, tech-enabled ecosystems. Whatever their areas of competitive advantage — such as fund manufacturing, wealth advice or specialist service provider — the ability to connect digitally with a range of partners will be essential to the ability to provide investors with seamless experiences in real time.
In addition to these priority actions, asset managers should dedicate significant resources to thinking about radical but plausible futures. Conventional planning processes tend to exaggerate continuity and limit flexibility. Firms should model scenarios, monitor weak signals and consider how emerging trends and technologies could intersect or interact to accelerate transformation.
Hypothetically, for example, there is no reason why investors could not have their needs met by an ecosystem that links AI-powered chatbots with virtual advice tools and tokenized assets held on a distributed ledger. With appropriate regulation, such an ecosystem could provide interactive, customized experiences and a low-cost virtual fund for every investor.
That may seem far-fetched, but accelerating disruption means it is probably closer than many asset managers think. The services the industry provides will always be needed, but that doesn’t mean that asset managers as they exist today will remain indispensable. What role would today’s firms play in such a scenario?
An uncertain future is not a bad one, and disruption will create opportunities as well as threats. Even so, asset managers should clearly understand that incremental change is unlikely to be a sufficient response to the challenges they face in 2023 and beyond. Confronted with unprecedented disruption, leaders must take decisive action to strengthen performance and ensure their firms can create value for clients, staff, shareholders and society long into the future.
Summary
An altered world calls for bold strategic changes that can transform performance and position firms for success in an uncertain future.
