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How asset managers are riding out volatility

Some companies in this highly correlated sector are weathering recent market volatility better than others
June 17, 2016

Asset managers are at the mercy of market sentiment perhaps more than any other sector on the London Stock Exchange. In buoyant markets values of mainstream asset classes rise, while retail investors are also more willing to invest their cash - all good news for asset managers. However, the opposite is true when markets get tougher. When the UK equity market was struck by volatility during the latter part of last year, listed asset managers suffered significant share price falls. For the vast majority of asset managers, assets under management (AUM) fell during the first quarter of this year as investors withdrew their money and negative market performance ate into returns.

Some asset managers have been hit more than others, depending on their exposure to certain geographies or asset classes. For some, the result has been a conscious decision to diversify their investment strategies. For others, varying performances across different asset classes have naturally shifted their investment exposure. The benefits of diversification have long been espoused by some asset managers to explain how they mitigate the risk of big market falls when managing clients' money. However, diversification can also protect managers against swings in market sentiment between asset classes and geographies.

 

 

Emerging market risk

It is no surprise that asset managers with a heavy bias towards emerging markets have had to endure some rocky trading during the past three years. A perceived slowdown in emerging market GDP and weak commodity prices resulted in a perfect storm. The effect a potential interest rate increase by the US Federal Reserve would have on developing markets has not helped either. Emerging market specialists Aberdeen Asset Management (ADN) and Ashmore (ASHM) have been natural victims of deteriorating investor sentiment and poor returns. IC sell tip Aberdeen had suffered 12 consecutive quarters of net outflows by the end of March 2016, previously peaking at £12.4bn during the second half of last year.

But market performance for these emerging market specialists has started to improve. For Ashmore a particularly strong investment performance in local currency - as emerging market currencies strengthened against the US dollar - multi-asset and overlay/liquidity strategies resulted in a $1.9bn (£1.3bn) boost to AUM during the third quarter of the year. Aberdeen also generated £10.1bn in investment gains during the first half of the financial year.

Yet Aberdeen is not relying on improved investor sentiment or a turnaround in markets to lift it out of this rut. In addition to a cost-cutting programme that management expects to reduce annual costs by around £70m, Aberdeen is trying to diversify by geography and asset mix. Management is trying to strengthen the group's alternatives business, purchasing hedge fund manager Arden Capital Management in December and private equity manager Flag Capital in August. More positive returns generated by these specialist asset managers could be a sign that the poor performance of developing market assets has bottomed out, although it will require a big call on the market.

 

Safe European home

On the flip side, managers with a skew towards developed market equities have done well. Last year further quantitative easing in Europe tempted domestic retail investors away from cash and into equities and fixed income. That was part of the reason for Henderson's (HGG) sector-beating results during the 12 months to December 2015. In addition, fears over further interest rate rises in the US also pushed investors out of domestic markets, convincing them to shift their money across the pond. The result was pre-tax profit growth of nearly a quarter to £168m last year.

Henderson is one of the more diversified asset managers by geography and product mix. Its SICAV range (an open-ended collective investment scheme popular in Europe) is sold not only in continental Europe but also in Latin America and Asia - accounting for more than half the £8.5bn of inflows last year. The group also expanded its distribution network in Australia, making three acquisitions in the country. However, during the first quarter of the year Europe-focused products fell out of favour with retail investors, leading to a net outflow of £271m from SICAV products. Demand for global equity income helped offset this, while £1.4bn in positive market and currency movements bumped up overall assets under administration.

 

Going for the big money

Henderson's funds have a higher than average reliance on performance fees, which are more unreliable and leave the asset manager more exposed to a market downturn. Around 62 per cent of its £92.7m AUM are retail investments. There is an argument that lessening reliance on retail flows in favour of institutional can result in more stable flows.

Asset management giant Schroders (SDR) has had its eye on gaining a greater share of the institutional market for the past five years. The rationale from newly appointed chief executive Peter Harrison is that these big mandates will provide greater longevity and help the group ride out times of volatility, when retail sentiment is more likely to weaken. Diversification is the buzzword at Schroders, which is also moving further into multi-asset and fixed-income strategies.

The benefits of this approach were evident during the first quarter of this year. Institutional investors placed £4.5bn with Schroders, compared with £1.8bn of outflows from intermediaries. Investment returns from institutional assets also reached £5.3bn of a total £8.7bn generated during the first three months of the year. This offset weakness in wealth management and intermediaries, ensuring assets under management still grew 4 per cent to £325bn compared with the final quarter last year.

 

IC VIEW: Investing in asset managers is an exaggerated play on the markets. We're not ready to call the bottom of the emerging markets rout and so stand by our Aberdeen sell tip for now. A natural consequence of the sector's strong correlation with the markets means in times of volatility, any downturn in share price is often magnified. However, there are good dividend yields on offer and we reckon investors willing to take a longer-term view can pick up some shares with good growth potential at a reduced rating.

 

Favourites:

Schroder's is the most diversified of all the listed asset managers. The group has a 65/35 per cent split in institutional and intermediary assets under management and a further £33bn in its wealth management business. Servicing more institutional clients is doing the business good. After recent rough markets, the shares are down about a quarter on our August buy tip. Analysts at Numis are forecasting adjusted EPS growth of 2 per cent this year to 176p, but this rises to 187p in 2017. Schroders is a quality stock and is trading at 14 times forward earnings. This is below a historic three-year blended average of 16 times.

Outsiders:

Hedge fund manager Man Group (EMG) has had a torrid time recently, with the shares plunging 30 per cent during the past 12 months and trading at a yearly low. Concerns are growing over the performance of its flagship AHL investment strategies. This put pressure on group performance fees last year, which were down 11 per cent. Plus average net management fee margins have been falling as the manager has shifted towards lower-margin institutional work. With analysts at Goldman Sachs forecasting EPS of 20¢, the shares are trading on just eight times forward earnings. However, we see think the shares have further to fall and stick to our sell rating.

 

The broker's view: Only two buys

The asset management sector continues to be well rated, which when coupled with generally anaemic earnings growth, margin pressure, scarce organic growth and volatile markets, means we are generally cautious on most names. We have just two buy recommendations: Liontrust and Schroders.

We like Liontrust because it is among the cheapest in the sector despite delivering far better than average earnings growth, through organic growth in its particular range of funds/recent hires and operational gearing. Aside from short-term market sensitivity, the biggest risk to our recommendation is the high level of fund concentration - around 50 per cent economic advantage, 20 per cent macro, 15 per cent cash flow solutions and 15 per cent across five other processes - should key people leave or experience a prolonged period of underperformance or even fall out of favour with buyers. Nonetheless, we believe the current low valuation and expected growth outweigh the risks.

Schroders is a totally different proposition. It is far more diversified by asset class, geography and client type than Liontrust or any other UK listed manager. Additionally, it has an overcapitalised balance sheet, with £1.5bn surplus capital: more than 20 per cent of the company's market cap. Also, the Schroder family's 45 per cent control means that management is more insulated from short-term market pressures than peers and are therefore more focused on the medium to long term.

Overall, we would characterise Schroders as the 'dull and boring', ie consistent performer in the sector. We believe it is likely to be a quartile two performer in the sector over the long run, quartile three during strong bull markets in a particular area and quartile one during difficult market conditions. While Schroders by virtue of its size suffers from all the key sector issues outlined (namely anaemic earnings growth, margin pressure, scarce organic growth and volatile markets), we are still positive because it is during difficult conditions that we believe the benefits of being diversified, with downside protection, shine through relative to the sector. We believe it is unusually comparatively cheap today, around 11 times forward enterprise value to net operating profit after tax versus, around 14.5 times its long-term average - 15 times the current sector average and around 14.5 times the long-term sector average.

David McCann, James Hamilton, Jonathan Goslin are analysts at Numis