This article first appeared in Personal Wealth, The Edge Malaysia Weekly on September 16, 2019 - September 22, 2019

Asia continues to dominate the global asset management industry amid flagging performance overall. The region commanded more than half (56%) of global flows between 2013 and 2018.

Nonetheless, macroeconomic factors caused growth to slow sharply, with Asian assets under management (AUM) gaining just 5% last year. This comes after a compound annual growth rate (CAGR) of 15% in the previous six years.

According to McKinsey’s recent report, “Asian asset management: Protecting and creating value in disruptive times”, a major cause was an average 3.2% decline in market performance last year. This was driven weakened equity markets in Asia, which were highly volatile last year, according to the report. As a result, the industry’s total profits were affected, growing at just 3% for the year, down from about 14% on average over the previous six years.

Last year was marked macro events and geopolitical turmoil, both of which caused the global asset management industry to shrink 1% year on year for the first time since the 2008 global financial crisis. Last year saw Asia’s slowest AUM growth since 2011.

Despite the underperformance, profit margins in Asia remained strong, thanks to the higher revenue margins of 22.5 basis points (bps) of the average AUM. This is roughly double the revenue margins in North America (11.1bps) and Western European (12.3bps).

While McKinsey calls the slowdown “disturbing”, it notes that Asia commanded more than two-thirds of global flows — roughly US$1.5 trillion — last year alone. Broken down even further, emerging Asia registered rapid AUM growth in 2017/18 (about 10%) and accounted for 85% of all flows in Asia. Developed Asia stayed nearly flat, having lost 0.1% in AUM during the period.

Comparing the growth rates of the two sub-markets from 2008 to 2018, the report showed that emerging Asia got more than 80% of all flows in Asia while registering an annual growth of 22% in AUM. Developed Asia only grew 6% annually during that period.

Unsurprisingly, the vast majority of the flows in emerging Asia (money market funds included) came from mainland China. With the country in the midst of strong retail demand and an increasingly conducive regulatory environment, the market boom has contributed heavily to strong net flows over the past decade.

Recent regulatory changes have empowered foreign firms to explore the possibility of setting up shop in mainland China’s private fund market to serve institutional and accredited investors. In addition, there has been a proposal to allow global firms to enter the country’s public fund market, either through majority ownership of domestic firms or through conversion of the private funds’ licence. These liberalisation measures suggest that growth in mainland China will remain strong.

Not far behind are Indonesia and India, with an impressive asset growth trajectory of 17.7% and 17.5% respectively over the last decade. This is due to their strong capital markets and significant regulatory push to develop the asset management industry.

Southeast Asian markets have increasingly been contributing to the growth of the broader region, driven growing affluence, a shift from financial savings to investment products and increased regulatory impetus to growth the industry. These key factors are improving investor confidence and awareness in Southeast Asia.

Five key disruptions

There are five disruptions specific to Asia that can potentially have a significant impact on the region’s economic growth going forward.

First, rising cost pressures mean scale is becoming a critical issue for asset management firms. Absolute costs have risen rapidly — about 25% over the last two years — partly due to investments in growth markets. Asset management firms’ economies of scale vary widely, with the smaller firms at cost margins of about 41bps (cost as a percentage of the average AUM), versus larger firms at about 18bps.

Second, margin pressures and client demand are forcing firms to provide more non-traditional offerings. Multi-asset and passive strategies represented about 90% of the total flows last year. Drilling down further into passive strategies, exchange-traded funds have been a major offering, driving 70% to 80% of the flows in the region, with particular strength seen in Japan, Taiwan, China, and South Korea. Meanwhile, active equity funds registered net outflows.

In terms of multi-asset solutions, the demand has been for absolute return strategies and, increasingly, target-date and target-risk funds. In many cases, these new solutions-oriented offerings are a combination of traditional and non-traditional products.

The new product offerings have enabled managers to justify potentially higher fees, particularly for multi-asset and alternative strategies, in line with the sophistication and precision of the solutions offered. Last year, retail active equity and active fixed-income fees dropped 4% and 8% respectively while the multi-asset category registered a 12% increase in fees.

From a thematic standpoint, environmental, social and governance-oriented investing is gaining strong momentum due to growing client demand and greater regulatory focus on fiduciary responsibility. Asian firms are likely to invest further in developing their competencies in these areas.

A third disruption revolves around pension funds and insurance companies taking up more client share of institutional investors. For institutional asset managers, pension funds remain the dominant client segment, with 40% of AUM.

Over the last few years, pensions have seen an ongoing shift from defined benefits to defined contributions, with strong flows into the latter. Additionally, regulators across Asia are pushing for more mandatory and voluntary pension savings programmes to ensure broad-based retirement coverage.

Insurance companies have also gained share among institutional investors, representing the majority of institutional flows last year. This boosted insurers’ share of institutional AUM from 7% to 10%.

The increasing difficulty in finding fixed-income yields is prompting insurers to seek alternative sources of returns, in addition to outsourcing more mandates to third-party asset managers. The proliferation of unit trust-linked insurance plans and annuities in Southeast Asia has been driven primarily volatility in capital markets.

Fourth, increasingly sophisticated customers in this part of the world are forcing firms to provide broader regional and global access. This means Asian firms will need to improve on cross-border integration for long-term growth.

Cross-border investment schemes developed in Asia have still not gained significant traction because of varying taxation and regulatory regimes. Undertakings for the Collective Investment in Transferable Securities (UCITS) funds and feeder funds remain the key cross-border vehicles for Asian firms, with European locations dominating in UCITS, while Southeast Asian markets (Thailand and Malaysia in particular) lead in feeder funds.

Fifth, Asian asset managers have identified digitalisation as a priority, according to the report. Digitising various elements of the industry’s value chain will be critical to customer acquisition, investment performance and a reduction in operational costs. However, adoption has been slow. The report says only a third of firms are using or installing tools for digital marketing, big data to de-bias investment decisions and machine learning in risk management, among others.

The authors of the report predict that failure to adapt to these five key disruptors may reduce profit margins from the current 22.5bps about 10% over the next five years. Profit growth may also slow to about 3% annually, in line with last year’s growth.

Pressure on fees for traditional products (which still dominate the product mix) will reduce average revenue margins. At the same time, costs are expected to continue rising, partly because of investments in future business growth and partly because of challenges in achieving economies of scale.

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