The global asset-management industry seems to have the best of both worlds: fat margins and ongoing growth. But this state of nirvana can’t last forever, and, analysts agree, there are big changes ahead.

The asset-management sector has grown relentlessly over the past two decades on the strength of a demographic wave, solid economic growth and a powerful push for retirement savings. But could this golden age be nearing its end?

Previous predictions of its demise — or, at least, a dramatic slowing and the gutting of margins — have been proven wrong. What is clear, however, is that the world is changing. Populations are aging, investor needs are evolving, centres of economic power and wealth are shifting. In the years ahead, those trends will exert new pressures on the industry: clients’ product needs will change and the source of new funds will probably shift. In turn, the competitive landscape and the industry’s business models will have to evolve, too. The trick is divining just where these transformations will take us.

Brokerage firm Putnam Lovell (formerly owned by National Bank Financial Ltd. and now a division of New York’s Jefferies & Co. Inc. ) foresees a dramatic transformation in the money-management industry in the years ahead. In a recently published report, Putnam predicts that the industry’s bread and butter — people saving for retirement — will become a progressively less significant source of new funds.

With fewer new assets flowing from its traditional client base, the asset-management industry will have to look elsewhere for growth. Some of the slack may be taken up by the asset-management needs of so-called “sovereign wealth funds,” government-controlled funds that are accumulating vast pools of assets — in many cases, thanks to windfall energy profits. Some analysts expect these funds to become important new clients for the asset-management industry.

Merrill Lynch & Co. Inc. of New York suggested in a report last year that, as these vehicles seek to diversify into increasingly risky assets, they will turn to professional money managers. The report projected that US$1.5 trillion-US$3 trillion of assets could flow into the global asset-management industry from SWFs in the next few years, generating estimated fee revenue of US$4 billion-US$8 billion.

The Putnam report disputes that prediction. It agrees that SWFs, which already have massive pools of capital, are likely to get much larger in the years ahead. Putnam argues, however, that the asset-management industry will see less SWF business than some expect. “Sovereign funds will not farm out most of their assets to money managers,” the report maintains. The reason: SWFs have high liquidity requirements and governments see them as domestic policy tools. So, while SWFs have recently been making a splash in the mainstream capital markets, Putnam expects that ultimately they will make the bulk of their investments locally on things such as infrastructure, and that investments will be managed internally.

Instead, the Putnam report predicts, wealthy individuals will be the industry’s primary source of future growth: “The rich and, to a lesser extent, the mass affluent with portfolios exceeding US$100,000 are the groups that hold out hope for further expansion of the fund-management industry. Wealthy individuals continue to diversify out of illiquid businesses and properties into a broader range of traded securities, boosting the size of their investible portfolios.”

Increasingly, these wealthy people are to be found in Asia and elsewhere outside the traditional markets of Europe and the U.S. According to data from Boston Consulting Group Inc. of Boston, the U.S. represents about 48% of global assets under management, with Western Europe accounting for 36%. (Canada contributes less than 3% of worldwide AUM.) But the Putnam report predicts that investors from Asia and Australia will account for most of the fund industry’s net new business over the next few years.

Moreover, the report suggests that these high net-worth individuals tend to be more risk-tolerant and favour sophisticated, higher-fee products — making their impact on industry revenue even more significant than their share of AUM would suggest.

The increasing importance of wealthy clients will probably also translate into more power for their advisors. “During the next five years, fund managers will need to spend more time learning about gatekeepers to these asset pools, and less time lining up outside large pension and sovereign funds,” the Putnam report counsels.

@page_break@Amid these shifting client dynamics, the demands on the global asset-management industry will change. As large groups of people reach retirement age, their focus will move from saving for retirement to generating income from their nest eggs. That probably means less organic growth for the industry and more demand for products that can efficiently produce income.

To some extent, the effects of that demand are already in evidence. For example, the hunger for yield was largely behind Canada’s income trust boom, and the desire for asset protection has helped create a nascent market for a variety of guaranteed products.

Clients are also getting more sophisticated and more demanding. Institutional investors are leading a charge into greater use of alternative assets such as hedge funds and private equity. Increasingly, traditional fund firms are adopting some of these strategies. A number of Canadian mutual fund firms have secured permission to add short-selling to their repertoire, as they seek the ability to offer more hedge fund-like strategies — and returns — to their clients.

It’s these types of tactical responses that have enabled the asset-management industry to defy previous expectations of its demise. Fund industry analyst Dan Hallett, president of Windsor, Ont.-based Dan Hallett & Associates Inc. , recalls past forecasts for much slower industry growth. He notes the industry has inevitably managed to continue to grow — largely on the strength of its ingenuity at adapting to clients’ evolving needs.

“Such predictions clearly didn’t make allowances for the fact that strong markets drive big fund sales,” Hallett says, “or that a punishing post-2000 bear market would drive people into the hands of bundled products such as wraps and funds-of-funds at a rate that is at least triple that of stand-alone funds.

“Nor did it predict the continued convergence of mutual funds and principal-protected products, nor of the convergence of traditional long-only and hedge fund strategies,” he adds. “In short, financial product innovation and changing investor preferences can void even the most well-reasoned prediction.”

Hallett remains confident that Canada’s asset managers will be able to change to respond to inves-tors’ demands: “They have inves-tors’ money. They have strong distribution ties. They have the resources to innovate and the scale to be competitive. So, I would not be making any dire predictions for the fund industry.”

While the industry itself may not be in jeopardy, individual firms cannot expect to stand still and be able to compete effectively in an evolving market. For example, it appears that traditional money-management firms offering long-only mutual funds are going to have to transform themselves if they hope to stay relevant.

In BCG’s fifth annual study of the industry published in late 2007, it suggests that asset managers will have to take “bold steps” to adapt to the volatile new environment they are facing. the report calls for firms to stake out territory in which they have a competitive advantage, pursue product and marketing innovation, enhance risk management and try to penetrate new markets.

Product innovation and creative marketing often hold more sway over investors’ decisions than straight investment performance, the BCG report advises. That means cultivating new asset classes, which it suggests asset-management firms are well positioned to do, in emerging areas such as infrastructure investment, distressed securities and actively managed structured products. It also means developing products that meet emerging needs, such as more packaged solutions and absolute-return products.

Developing the type of expertise that will be needed to compete in the asset-management industry of the future is also likely to lead to some shuffling of the prevailing business models, with more of the actual portfolio management out-sourced to specialist boutiques that are better able to deliver the products and performance that firms will need to stay competitive. That would reverse a trend toward vertical integration that some firms have adopted in an effort to control costs. As a result, the Putnam report predicts that by 2012, as much as 20% of long-term mutual fund assets will be run by subadvisors.

Additionally, the report sees a strategic bifurcation taking place as investors demand more customized portfolios with cheap, passive products such as exchange-traded funds used to deliver market returns (beta), and more pressure for active managers to deliver genuine excess returns (alpha). This, in turn, is leading to a change in industry compensation structures, with asset managers adopting mechanisms already familiar to hedge fund managers, such as performance fees that reward their ability to generate alpha.

As a result, the Putnam report predicts that by 2012, actively managed, long-only portfolios will be contributing less than half of total industry revenue, down from more than two-thirds in 2006. Instead, revenue from performance fees, alternative investments and long/short strategies will supplant this historical, primary revenue source. At the same time, underperforming, closet-indexing hedge fund managers will be exposed, and the report foresees 20% of them being driven out of business by 2012.

The global asset-management industry will surely thrive in the coming years, but analysts are expecting it to go through some fairly fundamental changes as it does. IE