What is fee compression & how does it affect asset managers?

Several trends and factors affecting the asset management industry in recent years have resulted, directly or indirectly, in downward pressure on fees.

This fee compression in asset management has in turn been caused by asset managers’ desire to remain competitive and continues to put downward pressure on fees which, while beneficial to investors, continues to reshape the asset management landscape.

But fee compression in asset management has not hit equally. Within equities investment, for example, for the three years between 2018 and 2021, median fees for large asset managers with AUM in excess of £100bn declined 5% whereas smaller managers with assets under £5billion saw a 10% decline, research from Investment Metrics for Institutional Investor showed.

Hedge funds have also seen a decline. HFR research found that average management fees of 1.4% and performance fees of 16.4% in Q4 2020 were down from 1.6% and 19%, respectively, a decade ago .

Here we consider the factors that have contributed to fee compression in asset management, and what this might mean for the industry.

The rise of passive

One of the factors contributing to fee compression has been a shift in investor interest towards passive investing and ETFs . As investors increased allocations to low-cost index mutual funds and ETFs between 2000 and 2020, fees for active managers gradually declined, with the lowest average basis point fees seen among U.S. large-cap and passive core fixed-income, according to research from Callan.

Research from Morningstar found that the average asset-weighted fee for investors for U.S. open-ended mutual funds and ETFs fell from 0.91% in 2000 to 0.43% in 2020. The figure decreased by one basis point alone to 0.44% between 2019 and 2020, saving investors $6.2bn in total.

The trend has seen net flows decrease for active managers in public U.S. funds, as investors have increasingly looked to park money in lower-cost index funds. The rise in popularity of ‘cheaper’ options in the growing ETF space has also forced active managers to look at trimming fees to retain investors.

As ETFs continue to rise in popularity and as active managers lose ground to passive investments, costs continue to decrease, thus affecting margins in asset management and potentially leading to what PwC terms a “passive race to zero”.

Passive investing is not invulnerable to fee compression either. Amid strong competition and “minimal differentiation capabilities”, PwC predicts that global asset-weighted passive fees will continue their decline to as low as 0.12% by 2025. The consultancy suggests that larger managers able to benefit from scale will profit in the low-margin environment.

The increase of competition and pricing struggles

The decade-long bear market leading out of the financial crisis created a wealth of opportunities for asset managers to deliver returns but, as Institutional Investor notes, it also protected some “mediocre” asset managers from really suffering from the effect of negative trends, such as the rising popularity of passive investments.

An increase in competition has contributed towards fee compression in asset management , as managers lowered fees to attract new investors and keep existing ones. Keen to trim fees to compete with their counterparts by the use of either temporary fee waivers or permanent cuts, asset managers may well continue this behaviour. As research from Cerulli Associates suggests, fee compression in asset management will continue , as managers seek to reduce costs to remain competitive.

Furthermore, as the industry consolidates, big asset managers able to utilise economies of scale to help reduce operating costs and expense ratios have been able to offer investors lower-cost options, diminishing fees and contributing towards fee compression .

These same organisations may be able to continue to benefit by increasing scale as consolidation in the asset management industry continues, as larger firms look to use M&A activity to access different asset classes and regions.

Transparency and access to knowledge

Fee compression in asset management has also been spurred by increasing transparency around operating practices and fees, which in turn has made investors more aware of and sensitive to what they’re paying asset managers for.

Better and more available information has empowered investors to negotiate concessions from asset managers . Furthermore, transparent fee structures within the passive investing landscape have also appealed to some institutional investors, according to PwC, drawn by the increased ability to assess and analyse what they’re paying for and entrenching the shift towards passive investments.

Public sector pension funds have benefited from access to fee information, according to research from Investment Metrics for Institutional Investor, which showed these funds paid lower fees than other institutional investors such as corporate funds, endowment funds or foundations, on a three-year annualised basis to 2021. As the information regarding what public pension funds are paying in fees is publicly available, pension plan managers are better placed to negotiate lower fees.

Technology driving change

Innovation and adoption of emerging technologies by asset managers have spurred changes to investment strategies and fees. Artificial intelligence, data analytics, machine learning, blockchain and process automation are providing opportunities for asset managers to streamline operations and increase productivity.

Investing in new technologies and replacing legacy technologies can be costly, as can hiring technology-focussed experts. But, technology has also increased efficiency and helped lower operating costs , which in turn has allowed asset managers to offer reduced fees. These technologies are now something that investors have come to expect and are becoming a necessity for those asset managers hoping to remain competitive.

Combatting fee compression in asset management

Continued adoption of emerging technologies and innovation may help asset managers to compete in an increasingly competitive landscape by offering new value to investors .

Furthermore, the adoption of different strategies and the development of new products, such as ETFs and those focussed on environmental, social, and governance (ESG) have been embraced by some asset managers.

Those asset managers able to provide an offering that properly evaluates the risks and costs associated with ESG issues may find themselves able to command higher fees, even in the face of fee pressures, research by Investment Metrics for Institutional Investor suggests. The issue of ESG is also particularly important for asset managers hoping to attract investment from institutional investors, according to PwC.

Those looking for protection against fee compression might also consider turning to niche assets, although there are questions over scaling these models. Another alternative may be to look at fee structures and fee innovation, with a focus on outcome-based models , previously introduced by the use of fulcrum fees , to help protect profits in the face of fee pressure.