Navigating Margin Compression, Private Markets, and Strategic Transformation in Asset Management

The asset management industry has undergone a profound structural transformation driven by multiple interconnected forces. Traditional asset managers are experiencing unprecedented pressure from the relentless rise of passive investment products, escalating regulatory compliance costs, and the increasing sophistication of institutional investors. 

The result is an increasingly commoditized landscape of products, particularly within the public markets, and continued margin compression for many managers. This multifaceted challenge is fundamentally reshaping the industry’s competitive landscape, compelling firms to reevaluate their core business models and value propositions.

The interest by traditional asset managers to expand their product coverage into private markets should therefore not be surprising. Whether such shops are better off partnering with credible alternative managers, rather than seeking to own these product manufacturing capabilities themselves, however, remains debatable.

The Passive Revolution and Margin Compression

The exponential growth of passive investment products and Exchange Traded Funds (ETFs) has systematically dismantled traditional revenue models. Market leaders like BlackRock’s iShares and Vanguard have dramatically disrupted the industry by offering low-cost exposure to broad market indices at a fraction of the cost of actively managed funds. This shift has compressed management fees across traditional actively managed strategies, with passive strategies now representing about 55% of total U.S. equity assets under management, as of January 2024.

Per Morningstar, performance for active large and mid-cap managers is essentially a coin-flip, with roughly 50% beating the benchmark over the past year and only 29% doing so over the last decade. Active fixed income has fared better with nearly 72% beating the benchmark over the past year, as the combination of shorter duration and greater credit risk by active managers has generally outperformed their more conservative indexed peers during a period characterized by higher interest rates and tighter credit spreads. Active real estate has proven to be the most consistent performer, with 66% beating their passive peers over the past year and 51% doing so over the past decade.

Still, the implications are stark. Average expense ratios for passive equity funds have plummeted below 10basis points, creating an increasingly challenging environment for traditional active managers who must be price competitive. Consistent net redemptions exceeding $500 billion annually underscore the magnitude of this transformation, forcing managers to confront the fundamental economics of their existing business models.

Regulatory Burden and Operational Expenses

Simultaneously, asset managers face mounting regulatory, compliance, and operational costs that further erode profitability. Post-financial crisis regulations like Dodd-Frank and MiFID II have dramatically increased operational complexity, transforming compliance from a peripheral function to a core operational requirement. These regulatory mandates demand substantial investment in technology, personnel, and sophisticated process management.

Indeed, compliance costs now consume between 5-10% of total operational expenses for mid-sized asset management firms. This represents a significant margin erosion that cannot be easily passed on to increasingly price-sensitive clients, creating a structural challenge for many traditional managers seeking to maintain profitability.

Private Markets: The Current Sanctuary for Margin Expansion

Against this challenging backdrop, private market strategies emerge as a potential sanctuary from commoditization. Unlike public market strategies plagued by transparency and fee compression, private markets offer a more nuanced value proposition. These strategies provide higher potential returns, less price transparency, more specialized investment opportunities, and genuine capacity for alpha generation.

However, many traditional asset managers lack the organic capabilities to successfully develop and scale these strategies. The requisite skills—deep sector expertise, complex deal sourcing, sophisticated due diligence capabilities—represent a fundamentally different approach compared to traditional public market investment strategies.

Moreover, these capabilities demand substantial intellectual and financial capital. Limited institutional knowledge about private market dynamics, combined with the significant upfront investment required for initial fund formations, makes internal capability development a high-risk endeavor with uncertain outcomes.

Talent acquisition also remains extremely competitive, with specialized professionals commanding premium compensation structures that diverge dramatically from traditional asset management models. Existing organizational cultures and incentive structures often fundamentally misalign with the requirements of private market investing.

Bank-owned asset management units face particularly acute constraints. Stricter capital adequacy requirements under Basel III and IV regulations limit strategic investment flexibility by mandating higher capital reserves. This regulatory landscape further restricts the ability of these institutions to pursue transformative acquisitions or capability expansions.

 

Strategic Responses: Acquisition vs. Partnership

Given the challenges attributable to organic development, traditional managers essentially face two strategic pathways: acquisition or collaborative partnership models. 

Acquisitions are often the first port of call, particularly for large incumbent managers who seek to offer a full vertically integrated platform. Witness, for example, Blackrock’s recent acquisitions of eFront, Global Infrastructure Partners, and Preqin. Not all are asset managers, of course, yet the goal for Blackrock is clearly to enhance the private market capabilities of its overall platform.

Still, acquisitions present significant challenges, including prohibitively high valuation multiples, complex cultural integration risks, and the potential for key talent exodus post-transaction. These challenges are hardly unique to the investment management industry, of course, as similar risks accompany acquisitions in virtually all industries. As a result, acquisitions too often fail to achieve the stated or economic objectives defined at inception.

Partnership models, in contrast, represent a more nuanced strategic response. By partnering with specialized private market managers, traditional asset managers can leverage their more mature distribution capabilities without the need to own the full manufacturing plant. 

In some cases, a large incumbent may still take a minority position in an alternative manager, though the manager remains largely autonomous. This allows the traditional manager to introduce enhanced alternative strategies, while sticking to their core competencies and maintaining lower fixed-cost structures.

The model, of course, is consistent with many industries, including consumer goods, pharmaceuticals, automotive, food and beverage, as well as other sectors where manufacturing and distribution are often separate. The separation allows each part of the supply chain to specialize and operate more efficiently. Even in financial services, such separation can be seen in wealth management, reinsurance, and correspondent banking.

As with any partnership, of course, it’s important to define clear and concise goals, responsibilities, and performance metrics, supported by regular check-ins and progress reports to help drive successful outcomes. Too many partnership agreements invest considerable time in contractual frameworks, only to then sit idle and atrophy when the parties fail to deliver consistent mutual benefit.

Data-Driven Channels

Emerging technologies also offer an additional strategic avenue, allowing such partnerships to create more dynamic and client-focused solutions. For example, advanced data analytics and AI can help traditional managers enhance asset allocation and risk management capabilities, develop more sophisticated Outsourced Chief Investment Officer (OCIO) services, and transition from product-centric to solution-oriented models.

Paired with an open multi-manager architecture, these capabilities represent a next-generation omni-channel distribution strategy, while offering clients greater alignment with their investment objectives. Such a solutions-orientation is also stickier and can position traditional managers further up the value chain. In an era of increased product commoditization, this is particularly important. 

For a more detailed account of the opportunity and technologies, we encourage you to read our prior piece, “From Products to Solutions: Climbing the Investment Management Value Chain.”

Conclusion

The asset management industry stands at a critical inflection point. Survival and success will depend on managers’ ability to embrace technological transformation, develop flexible partnership models, create genuine client value beyond traditional product manufacturing, and continuously innovate in strategy and delivery.

Confronted by increased product commoditization and margin compression, traditional asset managers in particular must find new ways in which to differentiate themselves and enhance their value proposition to clients. Alternative strategies will certainly be an important tool to help diversify client investments, enhance returns, and improve margins. However, organic expansion into these strategies may prove difficult for some managers, leaving acquisition and partnering as two strategic pathways. 

For those managers willing to pursue an open architecture strategy, we believe partnering offers many advantages and still does not preclude the incumbent traditional manager from retaining a minority equity interest in its alternative counterpart. This is especially true for bank-owned asset managers that may face additional capital and regulatory constraints. When further enhanced by a robust data-driven platform that allows managers to deliver more customized solutions to clients at scale, we believe traditional managers can climb the value chain by leveraging existing distribution channels to become super-allocators. In our view, this represents the next-generation OCIO business model.

Those who can successfully navigate these challenges will emerge stronger, more resilient, and better positioned to meet the evolving needs of sophisticated institutional and individual investors. Ultimately, we strongly believe that the future belongs to those who can reimagine their role as solution providers rather than mere product manufacturers.