One of the most fundamental tenets of investing and business is diversification — to avoid putting all one’s eggs into one basket. If the basket fails, there is a strong likelihood of a total loss. Such was the case with Northern Cross, a Boston-based asset manager with $25 billion AUM. Unfortunately, $20 billion was concentrated in one sub-advisor account it managed for Harbor Funds, which decided to drop Northern Cross for underperformance and excessive outflows. Within six months, Northern Cross was forced to close its doors and liquidate its assets.
It’s not uncommon for asset management firms to be highly concentrated, with a significant portion of their revenues coming from relatively few clients or products. Some firms are launched that way – with one strategy or large client as the primary source of revenues. Others grow highly concentrated, by narrowing their focus over time to a particular market, strategy, or type of client such as institutional or retail. Either way, from a business management standpoint, it is both risky and irresponsible. Just ask Northern Cross.
With the challenges facing asset management firms today, now is not the time to narrow your focus. For firms that want to control their destiny, they must commit to a real growth strategy, which includes diversifying their business to create additional revenue streams. There are a number of ways asset managers can diversify while maintaining or even building on their strengths.
The most obvious and sometimes most challenging way to diversify is by broadening the client base. Firms that rely on a small number of clients – institutional or retail – for a significant portion of their revenue are just one rationalization away from severe financial trouble. Whether it’s an institutional investment consultant under pressure to improve portfolio performance or a large family office deciding to shift its portfolio emphasis from active to passive, firms with a concentrated clientele are not in control of their destiny.
Platform and Intermediary Diversification
An increasing number of firms, especially smaller asset managers, are being “rationalized” into oblivion by fund platforms in reaction to thinning profit margins and shifting investor preferences. Several of the large broker-dealers, such as UBS, Morgan Stanley, and Merrill Lynch have rationalized away hundreds of funds due to underperformance, high management fees, excessive outflow, redundant strategies, or out-of-favor investment styles.
Firms that rely on their position on fund platform or a relationship with one intermediary, must be able to reinvent themselves to increase their appeal and relevance to other platforms and the investing public. While platforms may be cutting funds, some, such as UBS, are wide open to new strategies run by managers with only a one-year track record but who have a proven track record on a different fund. Fund managers might consider honing their niche specializations further to offer a strategy not widely covered on the fund spectrum. Done are the days when you can succeed by having 100 selling agreements but flows coming in to just three.
Some asset managers are discovering the limitations of having just one investment strategy. Firms that hitch their horse to one or two strategies in this market environment could suddenly find themselves with more risk exposure than they can tolerate; whereas having multiple strategies keeps alpha alive during changing market dynamics.
You don’t need to over-diversify or try to cover all the categories. It might only require drilling deeper into a niche or category. For example, if you focus on fixed income, you could add a global fixed income fund. Or, if your niche is small-cap, add a focused- or micro-cap. Some firms are adding an ESG component to their funds to meet the increasing demand for environmental and socially responsible investing.
Investors are told that, if they want to achieve sustainable, long-term growth, they must diversify. It’s no different for asset managers dealing with changing market dynamics and investor proclivities. A real growth strategy must include a plan to diversify, even if it involves pursuing sub-advisor opportunities, or adopting or acquiring a fund looking to exit due to the challenges in the industry.
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