Mutual fund and other asset management firms need to do a better job of analyzing the profitability of products, channels, clients and back-office systems to improve operating margins, according to a report from Capco Institute of New York. Although assets under management have increased for many firms and average operating margins are above 30%, among the highest in the financial services industry, profits vary widely among firms, depending on their offerings and the scalability of their business models.

"Sustaining Growth in Asset Management Profitability: Trends, Challenges and Opportunities," written by Edward Hawthorne, managing principal of Capco, takes a deeper look into recent trends that have impacted the financial performance of U.S.-based asset management firms, and suggests ways that firms can sustain asset management profitability.

"What is interesting to us is to see that certainly the industry as a whole is very strong, but the composition and strategy of individual firms is what dictates their ability to profit from assets under management," Hawthorne said. "Increases in contributions to traditional and non traditional investment products overall have fueled a resurgence in assets under management. Equity market performance is the number-one driver of assets under management, both international equity and emerging market equity."

However, pre-tax earnings on assets under management have decreased over the past five years, with asset managers earning, on average, four basis points less on assets under management in 2005 than in 2000. The average pre-tax earnings on assets under management fell from 22 basis points in 2000 to 18 basis points last year. This 18% decrease suggests that today, asset managers need more assets to deliver the same earnings.

"This erosion of the profitability of managed assets has been driven by declining revenues earned on fund assets and cost profiles that have been difficult to scale," the Capco report said.

Although 2005 showed slight improvement in pre-tax earnings on assets under management, a continued trend in declining fees and changing investor preferences will continue to drive margins lower, Capco predicts. Since 2000, average fees and expenses for equity funds have declined from 128 basis points to 119 basis points, and for bond funds, they have declined from 103 basis points to 92 basis points.

On top of this, low-cost funds, most notably exchange-traded funds, have been gaining in popularity and taking away market share from higher-fee products.

"Combined with more frequent investments in index strategies to deliver low-cost beta exposure, lucrative active fund management is losing ground to alpha and beta specialists," the report said.

Meanwhile, operating expenses have been rising, and many fund firms have not benefited from automation or integration. In addition, technology and service providers are increasingly charging fees based on assets under management, and with assets rising, the increase in service costs has also put pressure on margins.

And for managers that have grown through mergers and acquisitions, combining back-office systems has proven difficult, particularly since the objective of many of these acquisitions has been to maintain independent business lines.

Thus, asset management firms need to do a better job of attracting assets to higher-margin products and making their business platforms more scalable.

Fund managers must "invest in understanding product, channel, client and process costs to inform pricing , product and relationship decisions," Capco recommended. They should eliminate overlapping, poor-performing and low-margin products.

Firms should also diversify their offerings across asset classes, strategies and channels. This includes offering alternative investments. They must also develop a sound strategy to capture retirement assets as they are rolled out of 401(k) plans and IRAs.

Asset managers also need to revisit their back offices, consolidating middle- and back-office functions and technologies. Particular areas to consider include data management, order management and trading, portfolio risk management and accounting. In addition, according to Capco, many functions in the middle- and front-office could be automated, including investment research, compliance, portfolio risk analysis and settlements.

Funds could be better run by organizing investment teams by strategy and leveraging each team's investment policy decisions across multiple products, according to Capco.

"A sizable opportunity exists for those firms that are deliberate in optimizing their product portfolio and steadfast in pricing discipline," the report said. "A manager with $300 billion in assets under management could increase pretax earnings by $30 million, a 5.5% increase, through an improvement of one basis point in net fees."

While market conditions have recently improved and the near-term outlook remains favorable, firms must ensure long-term growth in profitability by progressively repositioning toward higher-fee, higher-growth opportunities, while doing the hard work of consolidating business operations to realize enterprise-wide synergies, Capco concluded.

(c) 2006 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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