Strong markets paper over wealth management cracks

'Sticky' is the adjective used by analysts to describe the assets that are held by the traditional wealth manager. Once the money is on the books, it generally stays there, as these are businesses where relationships with clients are central to future growth.

Wealth managers, like fund management houses, obviously benefit from rising markets, which drive up asset prices - and thus fees - and encourage new customers into the sector. But the relative stability of their investment flows means wealth managers are protected from the worst of the cyclical peaks and troughs: as a result, companies in this sector have a lower beta to the market than their asset manager counterparts.

Like fund managers, wealth managers have had a strong run over the past three years as markets have marched on, but the volatility of recent weeks could threaten that performance, if investment appetite sours. "Just now we are going through a period where equity markets are bouncing around without showing any clear direction," says Stuart Duncan, head of financials at Peel Hunt. "That's a challenge."

Indeed, years of decent market conditions have largely masked a difficult period for the sector as it has had to deal with the Retail Distribution Review (RDR), which wiped out a swathe of the independent financial advisers that had been a traditional source of referrals for the sector. And there are also problems linked to scale: many savers are now refusing to pay for advice that they previously thought free - in fact, it was actually paid for via commission. As a result, it is difficult to provide an adequate, advised product for those investing less than £100,000.

This feeds into the growing challenge from DIY investing, as companies such as Nutmeg offer a risk-graded, non-advised investment strategy to serve the RDR refugees. These platforms are sometimes known as 'discretionary direct'.

Hargreaves Lansdown (HL.), which sits in its own niche on the edge of this sector, is the dominant force among those going it alone, with a whopping 71 per cent operating profit margin from its market-leading fund platform. It now has such a non-advised, model portfolio service.

Wealth managers have also struggled to catch up with the suitability requirements of the Financial Conduct Authority. Private bank and wealth manager Coutts set aside £110m last year for administrative and redress costs associated with customers who may have been advised to take unsuitable investment strategies.

Companies such as Brooks Macdonald (BRM) have spent huge amounts of time and money modernising company infrastructure to meet risk, compliance and oversight needs. This is typical of the increased spend for companies across the board. "They have all said it has been a huge burden on them," says Paul McGinnis, a research analyst at Shore Capital.

In the mix

The more traditional wealth managers such as Rathbone Brothers (RAT), Brewin Dolphin (BRW) and Brooks have a large amount of discretionary assets under management - where clients pay to have their portfolio managed on their behalf. This business line is favoured by analysts as it is better protected from the clutches of the new DIY providers.

The short-term challenge here is distribution, especially with the reduction in the intermediary market, and getting the right revenue mix. Brewin took a hit in the market after its first-half results showed that despite fee income increasing by 12 per cent to £96m for the six months to the end of March, its dealing commission revenue had fallen by 17 per cent to £40m. Charles Stanley (CAY) has suffered a similar impact.

Although this was affected by adverse market conditions, it also reflects a drop in clients' appetite for commission fees, as more simple 'fee-only' charges based purely on assets managed become more popular. "Going forward we are going to see fee-only as an ever-increasing part of our business," says Brewin's chief executive Stephen Ford. The commission revenue is currently a matter of hot debate at the company, which has evolved from stockbroker to investment manager to wealth manager. Rathbone Brothers launched a 'clean' fee-only structure for new clients at the beginning of the year.

There is also MIFID II (Markets in Financial Instruments Directive) coming down the tracks, which is expected to further increase compliance costs, and perhaps threaten margins if fees come under scrutiny. The central issue is linked to the layering of fees. Depending on their investment set-up, customers can pay a wealth management charge, a fund management charge and a platform fee that might add up to between 2 and 3 per cent of their assets, meaning that they need to be achieving a fairly sizeable return to feel the benefit. While they defend the value of advice, companies understand costs need to be restrained in a world where all managers are competing with low-cost passive options. Mr Ford says it is about reducing the "component" costs by using scale to push down third-party fees: "The more that we can do that, the more we can preserve our fee - but also because it is the right thing to do."

Pension benefit?

Retirement reform that abolished the effective requirement to buy an annuity should keep people invested past the previously normative point of retirement. This has an obvious benefit to wealth managers' fee income, plus many of these companies also provide a drawdown service, which is predicted to be a route of choice for the new wave of retirees. This scenario is backed by an annual survey published by St James's Place (STJ) - involving feedback from 47,000 of its clients - which supported its experience "that people keep their money invested as long as possible, contributing to our strong retention of funds under management".

This change flows into a longer-term shift from defined benefit to defined contribution pensions, with the latter increasingly a retail product. David McCann, director in the speciality finance research team at Numis, described this "a big wall of money coming into the sector".

Because every wealth manager is keen to talk up the historic retirement reform as an inevitable good for its business, the challenge for the investor is cutting through the fluff and understanding which stocks are set to benefit. "One very good way of looking at it is what proportion of current flow is coming in from pensions," says McCann, given the longer term trend is well established. Hargreaves is the clear example of a company that has done spectacularly as pensions have become more of a retail product.

Favourites

It is hard to find a bargain in this sector, with strong secular trends lifting established names such as St James's Place well beyond 20 times forecast earnings. In May, we tipped Brooks Macdonald as we saw scope for it to return to healthy growth after a period of internal investment. It has motored up 17 per cent since our buy tip. The company's growing funds business and decent intermediary network should keep that momentum going over the medium term. Mattioli Woods' (MTW) historic expertise in pensions leaves it ideally placed to benefit from the pension reforms, as more people take hold of their retirement income.

Outsiders

Brewin has had a stormy time of it after disappointing half-year numbers, but its share price drop may provide an entry point, as they now trade at 14 times Bloomberg consensus earnings for the next 12 months - that's low in the context of this sector. Charles Stanley reported a pre-tax loss for the year to 31 March after good performance from its investment management business was dragged down by impairments and for-sale assets.

IC VIEW:

There is a shift under way in how people manage their money as they approach retirement, and the structural change should benefit wealth management. But this sector faces technological and regulatory challenges that could threaten margins over the medium term. Still, if global markets continue to heal, these fee-earning businesses will remain in high demand