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Are wealth managers counting the cost of rapid growth?

Valuations for most of the main players have begun to fall
February 22, 2018

The old adage that 'you get what you pay for' has proven to be correct when it comes to investing in the wealth management sector recently. All but one of the UK’s major listed players have outperformed the FTSE 350 index during the past five years. The macroeconomic factors that have driven demand for wealth management services – primarily the introduction of pensions freedom changes and an ageing population – have been often cited by wealth managers as the driver for increased demand for their services. 

But what’s also driven rising funds under management, as well as investor interest in the shares, is the long-standing shift towards managing money on a discretionary basis. That’s when an investor hands over the day-to-day management of their assets, without needing to sign off individual investment decisions. With management fees accounting for most of revenue, and commission earned on an execution-only basis declining, income streams for most wealth managers have become more predictable. Unsurprisingly, the former also attracts a higher margin.

With organic funds typically growing rapidly and consistently, it's also unsurprising that shares in wealth managers have typically traded at higher multiples than those in UK-listed asset managers. Shares in the former are trading at an average 16 times forward earnings, according to Bloomberg consensus estimates, compared with 14 times for the UK’s asset managers.

The premium attached to wealth management shares reflects the market’s high-growth expectations for the sector. However, with some wealth managers unveiling disappointing trading figures in recent months – causing share prices to come unstuck –  valuations for some of the sector’s constituents are beginning to fall below their historical averages. Is this a sign that the high-growth model is unsustainable, or could this be a buying opportunity?

 

A costly business

Brooks Macdonald (BRK) has epitomised the high organic growth on offer from discretionary wealth management. During the latter half of 2017 it gained £808m in net inflows, which coupled with investment returns of £474m, took funds under management to £11.7bn. That’s equivalent to a 12.3 per cent increase in funds during the period, compared with just 4.3 per cent by the WMA Balanced Index. In fact, funds under management have increased by a half in the last three years alone.

Yet rising competition, regulatory and investment costs and lower transactional income – given the historically low levels of market volatility – led management to warn in January that some of the benefits of its revenue growth would be offset by lower yields. The erosion in margins was partly due to a greater proportion of inflows into its lower-margin Managed Portfolio Service (MPS) funds, than into its Bespoke Portfolio Service (BPS) products – the former accounting for 12 per cent of overall funds under management in 2017, up from 7 per cent during the prior year. It was also burned by being forced to capitalise higher than expected costs relating to its IT overhaul. Brooks’ management has embarked on an efficiency drive, aimed at protecting margins, for example selling off non-core operations such as property management business Braemar Estates.

Charles Stanley (CAY) has spent almost three years restructuring its operations – consolidating five offices into one, revising its pay policy and selling its employee benefits and capital markets businesses. However, misjudging the cost of Mifid II compliance software, coupled with too high reliance on transactional income, means the wealth manager must make higher returns elsewhere during the second half to meet market expectations for the full year. It has made progress on boosting its core margins – which improved to 7.3 per cent, against a medium-term target of 15 per cent during its first-half trading – but it is much further behind peers in its transformation.

It’s not all been bad news on the margin front. Keeping a handle on costs means Mattioli Woods (MTW) is benefiting from its increased scale – growing its adjusted cash profit margin from 21.4 per cent to 22.9 per cent during the first half. Brewin Dolphin (BRW) has also managed to surpass its 5 per cent growth target for funds under management, while also hitting a 25 per cent profit margin target by the end of September. Unlike Brooks, its ‘full-fat’ discretionary products accounted for a greater proportion of new discretionary business won last year.

Intermediary risk

Financial advisers have been crucial for wealth managers in gaining new business. The introduction of the retail distribution review (RDR) in 2013 brought with it increased scrutiny of the suitability of investments chosen by advisers. More IFAs are offloading this regulatory burden onto larger wealth managers. The adviser’s role is the initial agreement of investment objectives and the subsequent selection and monitoring of the discretionary fund manager’s (DFM) performance. A 2016 survey carried out by consultancy threesixty found that of 130 companies offering financial advice, 87 per cent said they regularly recommend clients put their money with discretionary wealth managers. That was up from 78 per cent the previous year.

In many cases the adviser will collect an annual ad valorem fee of around 50 basis points from the client on the outsourced assets, a fee typically administered by the discretionary wealth manager. That’s on top of the wealth manager’s own fee for providing the actual investment services, which normally involves buying products from pure asset managers and resulting in a further 70 basis point charge to the client. The issue in this mutually beneficial arrangement may come if the Financial Conduct Authority (FCA) casts the spotlight on the total cost of investing for retail clients in the discretionary wealth management industry. That would likely make outsourcing business to a discretionary manager less worthwhile for financial advisers.

Shore Capital analyst Paul McGinnis reckons the 50 basis points charged by advisers for outsourcing to a discretionary wealth manager looks particularly vulnerable. "The regulator broke the conflicted relationship between advisers and fund managers with the retail distribution review, and is pressuring asset manager pricing via the Asset Management Market Study published early this year," he says. "It has moved on to examining the role of platforms and we would speculate that DFMs may get their ‘turn’ in the not too distant future."

Strong ties with intermediaries has helped Brooks Macdonald report higher-than-average organic growth in recent years, making it particularly vulnerable to any stemming of new business via third parties. The wealth manager says if instructed by the client it will pay fees on their behalf to the IFA for the services they provide.

Brooks’ deputy chief executive Andrew Shepherd says management has been preparing for regulators to potentially review total costs of services by IFAs for some time now. "The key is being able to show that you are adding value to the clients you serve and are charging proportionately," he says. "If your service is valued, then you should be able to charge for it."