Many U.S. asset management firms aren’t spending enough on client service relative to other drivers of firm profitability, suggests new research from Greenwich Associates suggests.

The firm reports that its research reveals that strong client service capabilities can as an important factor in retaining assets. Among the 58 firms participating in the study, outflows of separate account assets were significantly higher for firms with client service functions rated low in quality by plan sponsors.

“Senior executives at asset management firms appear to understand the importance of client service, rating it the third most important factor to achieving business objectives behind only investment performance and senior management team strength,” says Greenwich Associates consultant Rodger Smith. “Nevertheless, U.S. asset management organizations continue to under-invest in this key function.”

For the typical asset management firm, investment management comprises about 40% of operating expenses. Other important drivers of firm profitability such as sales, executive management, and marketing account for 8.4%, 7.4% and 5.4%, respectively. Only 4% of operating expenses are spent on client service.

The competitive environment for U.S. asset managers is poised to become much more competitive as corporate plan sponsors close defined benefit pension plans and the DB asset pool begins to shrink, it notes. As Greenwich Associates consultant Andrew Klebanow explains, “In such a market, cross-selling and client retention will become critical to asset retention and growth, and firms with superior capabilities in client service will be best positioned to succeed.”

However, Greenwich’s research also reveals that success in client service is not dependent on higher levels of spending alone. “The research shows that a few best-in-class firms are able to deliver a superior level of client service at lower expenses than the majority of their peers,” says Smith. “But in many cases, increased spending may be the necessary first step that poor performers must take to improve their client service quality.”

The firm adds that asset managers saw a second consecutive year of positive growth in 2004. Assisted by strong capital markets, organizations began reaping the benefits of expense controls and efficiency measures put into place during the past several years.

Among U.S. asset managers, top line revenue growth accelerated from 5% in 2003 to 20% in 2004 and net asset flows increased from 1.2% to 6%. Over the same period, inflows as a percent of assets under management increased from 11% to 15%. However, outflows also increased from 12% to 16%, indicating increased manager turnover and reallocations. Fee realization was flat at 38 bps year over year.

Average operating expense growth increased from 2.6% in 2003 to 16.7% in 2004 and was in line to slightly below most firms’ revenue growth rate, Greenwich reports. Compensation expense as a percent of revenue remained near 45%, close to historical norms.

Technology expense as a percent of revenue increased from 6.2% in 2003 to 7.3% in 2004, a move driven by technology projects and infrastructure building. A notable and continued decline of investment operations and portfolio accounting expense as a percent of revenue from 5% to 4% indicates a continued effort to improve efficiencies realized in this area of the business, it adds.

Overall, operating profit growth accelerated from 5.9% in 2003 to 26.5% in 2004, while profit margins remained relatively flat near 25% year over year. Fees remained stable and were not a contributor to improving profitability during the period; rather, profits increased due to expense controls and top-line growth. Looking ahead, senior managers remain optimistic and plan to increase profit margin targets over the next five years from 28% to 35%.