Notwithstanding the sharp rebound in markets from their December lows, we continue to have a negative outlook for the asset management sector. We continue to see numerous headwinds for the industry, including passive market share gains, declining fees, and active performance that can be characterized as mediocre at best. Furthermore, financing costs have stayed low, which could continue to fuel appetite for incremental debt issuance. This has been one of the primary drivers of our negative rating actions in the year-to-date period and could be another headwind for ratings over the remainder of the year.

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Although we can't predict the direction of the markets going forward, we continue to believe that the next several years will not be a repeat of the current decade-plus bull market. Asset managers have benefited from a rising tide and have masked years of net outflows with buoyant asset prices. S&P Global economists forecast that the S&P 500 will be roughly flat over the next several years. As such, we don't expect asset appreciation to meaningfully buttress assets under management (AUM) and, consequently, credit ratings.

We believe that alternative managers are less exposed to the ongoing sector challenges because of their largely locked-up capital bases and hard-to-index strategies. Given this, we believe they currently are relatively better positioned than their traditional cousins. However, we don't expect alternative asset managers to be completely immune, especially if the market environment takes a turn for the worst.

So far this year, we have taken 12 rating actions, of which 75% were negative in direction--meaning either negative outlooks or downgrades. Additionally, we have negatively revised several companies' business risk subscores this year, highlighting our expectations for challenging competitive dynamics to persist. Our negative outlook on the sector continues to underscore our view that we expect more negative rating actions than positive ones. However, rating actions overall will likely be idiosyncratic, with leverage remaining a key factor for both positive and negative actions.

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Frequently Asked Questions

Where does the industry stand today?

Unsurprisingly, the asset management industry is becoming increasingly passive, especially in equities, and has become highly concentrated by firm (see the mergers and acquisitions [M&A] section below). Passive strategies now comprises 36% of U.S. registered assets. Over 20 years ago, this metric was less than 2%, amounting to a growth rate of 12.6% per year.

Domestic equity strategies have borne the burden of the shift toward passive since equities are largely homogenous, mostly liquid, and have a well-defined benchmark. Consequently, flows into passive domestic equity products have been almost unabated. Since 2005, we estimate that cumulative flows into passive strategies have been just shy of $1.7 trillion, while active domestic equity strategies have experienced over $2.0 trillion in outflows (see chart 1).

Chart 1

Not only has passive taken market-share from active, but also it has pushed fees lower across the board. Average mutual fund expense ratios have dropped for equity, hybrid, and fixed income products to current average expense ratios of 55 basis points (bps), 66 bps, and 48 bps, respectively.

Chart 2

What is your outlook on active management?

Despite the decline in active investing, we still believe that active will have a role going forward for several reasons. First, certain asset classes will be difficult to replicate with passive strategies. For instance, investments in infrastructure or certain portions of credit markets don't easily lend themselves toward indexing. Furthermore, we still believe that active corporate selection is necessary for smaller companies (i.e., small caps) or in early stage investing (i.e., venture capital). Additionally, certain strategies will involve some type of active selection. For example, environmental, social, and governance (ESG) is becoming an integral part of the investing universe. Screening for companies that qualify for this universe will become increasingly important as the demand for this type of product grows (our assumption is that ESG will become integral over the next several years).

Our view on the active-passive debate is also largely shaped around our view for prospective returns. To be clear, we continue to believe that passive takes market share over the long term, particularly in large-cap domestic equity. That said, we believe that the current beneficial environment for passive strategies has the potential to reverse over the intermediate term. Since the financial crisis, we have witnessed unabated central bank intervention at the slightest downtick in markets, not only in the U.S., but also globally. With negative real interest rates and very accommodative global central banks, which has led to high correlations among equities, it has been easy for passive to gain share. Proverbially, all one had to do is "buy the dip" and watch as the tidal wave of liquidity pushed up all assets. Investors reacted accordingly by allocating increasing amounts to beta, since central bank policy made alpha hard to come by.

We don't think that the next decade will be like the last decade. A decline in markets or long-stretches of sidewise movements will not be endearing to passive strategies. For example, the Japanese Nikkei index is currently around 21,100, the same level that was first crossed in 1987. We don't think passive investors, or any investor, will tolerate 30 years of close to zero returns (returns are likely to be slightly positive once accounting for the dividend). We do caveat that in such an environment, active would have to generate alpha and that investors would still have to have an allocation to risk-assets and not simply move to cash or cash equivalents.

Do you expect asset managers to consolidate?

The industry has become increasingly concentrated over the past decade plus. The largest five mutual fund companies now comprise 51% of the total mutual fund/exchange-traded fund (ETF) market, up from 35% in 2005. Additionally, the largest 25 companies are 79% of the market, up from 67% in 2005.

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It's not hard to see why this is occurring. Take a look at the top five fund families at the end of 2018, BlackRock (mostly passive), Vanguard (mostly passive), State Street Global Advisors (mostly passive), Fidelity (active), and BNY Mellon Investment Management (active). The top three are all largely passive.

We expect the market to continue to bifurcate. At one end, we expect large fund families to remain entrenched as they garner the predominant amount of flows. At the other end, we believe that there remains a roll for smaller companies who provide distinct services from the larger complexes. Currently, in our view, we don't see much of a middle ground as the sector evolves. Recently, the industry buzzword has been "obtain scale"--namely try to get as large as possible to compete with the passive behemoths at the top of the list.

That said, we don't expect a surge in large M&A deals. Instead, we think deals will likely be smaller in size and centered around adding new investing or distribution capabilities. Given that the most important asset for an asset manager is its human capital, we think large deals could potentially disrupt corporate culture and damage what made each individual firm unique. Moreover, we view simply acquiring AUM as a losing strategy. Deals have to make strategic sense and most midsize firms already have a relatively diversified product offering. Adding similar strategies to the ones a company already offers just to gain scale doesn't really accomplish much.

Year to date, Invesco closed on its acquisition of OppenheimerFunds, and Victory closed on its acquisition of USAA Investment Management. Both of these acquisitions (which were solely, in the case of Victory, or predominantly, in the case of Invesco, funded with debt or debt-like securities) resulted in downgrades. We would expect asset managers to largely continue to lean toward debt-financing acquisitions given the relatively low cost of debt and in some cases languishing share prices, which would likely not respond favorably to share issuance.

What is S&P Global Ratings' view on the recently announced exemptive relief granted by the SEC for non-transparent ETFs?

Precidian Investments, a company that specializes in creating and designing products for the financial services industry, announced during the second quarter of 2019 that it had received exemptive relief from the SEC for the company's non-transparent ETFs structure (named ActiveShares). As a result of this development, companies that acquire the license (pending some further regulatory steps) can effectively skip the requirement of making their holdings available to the public on a daily basis, which could in turn protect asset management firms from disclosing the way they structure these types of portfolios. Through an ETF wrapper, entities that obtain the license are hoping for a more tax-efficient and cheaper product relative to traditional mutual funds while safeguarding the value of active portfolio management.

While we are still in the early days for this product and the impact of this development on the growing ETF industry remains uncertain, several industry players like Legg Mason (which owns a minority stake in Precidian), BlackRock, and Nuveen, among others, have already licensed the product. Following years of outflows from mutual funds to the benefit of ETF portfolios (a significant portion of it in passive offerings), some traditional asset managers that might have elected to avoid ETF products in the past could now be more prone to launch ETF strategies that benefit from the features displayed by ETFs while protecting their "secret sauce."

However, the new ETF structure is not without drawbacks. For instance, there are limitations on the type of investments that can be included in active ETFs. Accepted investments include common stocks, American depositary receipts (ADRs), preferred stocks, ETFs and other exchange-traded notes, REITs, commodity pools, and some type of futures, and all these investments have to trade on a U.S. stock exchange contemporaneously with the ETF shares. Based on these premises, leverage or short positions, illiquid investments, or global/emerging markets strategies are not currently suitable for this type of ETFs (although some exceptions might apply depending on the case).

Furthermore, there are considerations related to board oversight, fair disclosure, and other provisions that will likely be taken into account by entities looking to license their strategies with Precidian. We anticipate that the exemptive relief provided by the SEC to Precidian could support further growth in the ETF space, but we do not expect a meaningful change in cash flow generation for our rated asset managers in the near to medium term. In short, this remains uncharted waters for active management, and we will take a wait-and-see approach on how active ETFs fare in the market, both against other active products and passive. We expect little rating implications from active ETFs.

Where does the asset management sector stand from an ESG perspective?

S&P Global Ratings is in the early stages of rolling out company-specific ESG commentary for those asset managers whose E, S, or G, in our view, deviates materially from our view of the overall sector's E, S, or G component.

We consider the asset management sector as having low environmental risk (1, on a scale of 0 to 6, where 0 is low risk and 6 is high risk) due to these companies' limited use of physical infrastructure and facilities. Asset managers are primarily service providers that produce low levels of greenhouse gas emissions, low levels of pollution, and have inconsequential land and water usage.

However, asset managers are exposed to climate change through the potential impact on their investment performance if the value of the companies they invest in becomes depressed because of the transition to a low-carbon economy. This could hurt their investment fees, reputation, and competitive position. Still, some asset management companies intend to reduce their exposure to the most polluting sectors/entities as they start to introduce tighter ESG criteria in their investment decisions. The asset managers in our rated universe typically have well-diversified investment portfolios. The industry also benefits from the increasing adherence to the U.N.-supported Principles for Responsible Investment.

We assess social exposure for the asset management sector as fairly low as well (at 2, on a scale of 0 to 6, low to high), reflecting the risks coming from social cohesion, demography, and human capital management. At the same time, asset managers face material reputational risks that could damage their customer franchise. For instance, data privacy and security issues could lead to a rapid loss of confidence. The industry benefits from being regulated and supervised, although it is less strict than for banks and not uniform across regions.

Governance factors are more relevant than environmental and social factors for most asset managers. Beyond board and management governance qualities at the asset managers themselves, we believe that large asset managers, who have influence over substantial swaths of corporate America, are becoming a focal point for governance issues at the companies they invest in.

What ratings are most at risk in a downturn scenario?

This depends on numerous variables, including the depth and duration of the downturn. If a brief downturn were to occur followed by a swift bounce back (similar to the recent market drop in late 2018), then it would be challenging to see any real risks to ratings (all rating changes this year have been idiosyncratic). Our main concern to credit ratings is a prolonged downturn in capital markets, which would expose the entire sector to credit deterioration, given its procyclical nature. In this scenario, we would expect a relatively large portion of our universe to be at risk for a downgrade.

Those that would be best insulated would clearly be our largest and highest-rated managers, which we expect to exhibit the greatest level of rating stability. For instance, we see little risk to BlackRock in a downturn given its substantial diversification, market leadership, and strong cushion relative to our downside leverage threshold. That said, we see three different groups as more exposed than others: entities with volatile sources of earnings (generally equity- or performance-fee driven) that could potentially cross over their leverage thresholds in a stress scenario, companies that are below investment-grade that lack substantial cushion relative to their leverage thresholds, and those companies that currently have a negative outlook.

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Related Research

• Lazard Group LLC Outlook Revised To Negative On Weaker Earnings And Rising Leverage; 'A-' Ratings Affirmed, July 26, 2019
• Brookfield Asset Management 'A-' Long-Term Rating Affirmed; Short-Term Rating Raised to 'A-1'; Outlook Remains Stable, July 17, 2019
• FEH Inc. Outlook Revised To Negative On Continued Outflows; Recovery Rating Revised To '4', 'BB+' Ratings Affirmed, July 16, 2019
• FIL Ltd. 'BBB+' Ratings Placed On CreditWatch Negative On Potential Demerger Of Its Proprietary Investment Arm, June 26, 2019
• Victory Capital Holdings Inc. Downgraded To 'BB-' On Higher Leverage; Outlook Is Stable, May 20, 2019
• Focus Financial Partners Outlook Revised To Positive On Good Business Performance And Stronger Credit Metrics, May 15, 2019
• Legg Mason Inc. Outlook Revised To Positive On Projected Lower Leverage; Ratings Affirmed At 'BBB', April 15, 2019
• BrightSphere Investment Group plc Outlook Revised To Negative On Persistent Outflows And Potential For Higher Leverage, March 12, 2019
• CI Financial Outlook Revised To Negative On Continued Outflows And Potential For Higher Leverage; 'BBB+' Rating Affirmed, Feb. 12, 2019
• Apollo Global Management LLC Outlook Revised To Negative On Proposed Senior Debt Issuance; New Notes Rated 'A', Feb. 4, 2019

For further insights regarding S&P Global Ratings views on ESG, please see our ESG website: https://www.spglobal.com/en/capabilities/esg-evaluation